Indirect method
Cash flow statements.
In relation to a Cash flow statement, the indirect method means starting with a reported profit/(loss) figure, and then adjusting it to calculate the net cash movement for a period.
Contrasted with the conceptually simpler Direct method of presentation, which shows all the main categories of gross cash receipts and payments explicitly.
The indirect method is more widely used in external financial reporting.
Indirect method (Q&A)
(Q)
I have been studying the indirect method of the cash flow statement and I understand the formula, but I am confused about how cash is affected in practice. Using the indirect method, I have the following information:
Profit from the income statement 45 - Increase in working capital 20 = Net increase in cash 25
The formula is shown as: Profit ± differences between profit and net cash flow = net increase in cash
My confusion is with the adjustment for the increase in working capital. Why is the increase in working capital deducted from profit rather than added, especially when cash itself may not physically decrease?
(A)
Working capital includes items like inventory and receivables from customers.
These items ABSORB cash. For example, if we buy inventory we will have less cash than we otherwise would have. Let's say we buy inventory for 20, and we haven't sold it yet. Cash goes down by 20 as a result of this transaction. Inventory goes up by 20. Working capital goes up by 20.
An additional 20 of our cash is tied up in the form of working capital, reducing our cash. This is the reason that an INCREASE in working capital during a period REDUCES the amount of cash that we'd otherwise be enjoying at the end of the period
