8A. Appendix: Indirect Method

Now that you have some experience with sources and uses of cash, and making adjustments in operating section of the Statement of Cash Flows, let’s look at a different way of presenting this information. Before we move on, I want to make clear that the direct method is the best way of presenting cash flow information. But many companies still use the indirect method to prepare their operating section, so let’s take a look.

The indirect method starts with net income and backs out all non-cash amounts and accruals. Basically, the indirect method is a calculation of cash provided by (used in) operating activities. But because the items are not grouped into sources and uses of cash, for example cash from customers, cash paid to suppliers, etc.. Because adjustments are listed with no grouping or contextual information, the indirect method is not the preferred method of preparing the operating activities section. However, many companies still use this method because it is easier and still allowed, so we will cover it briefly here.

You’ll notice that the indirect method and the direct method make the same adjustments, and the ending cash provided by (used in) operating activities is identical under both methods. The difference lies in the starting point and groupings. The indirect method does not group by source/use of cash, while the direct method yields helpful groupings that provide information on how the company gets its cash and how it uses its cash. For example, a company get its cash from customers, and pays cash to suppliers, for operating expenses, for interest, and for income taxes. It’s no wonder that financial statement users prefer the direct method to the indirect method: it provides the best information!!