Indirect Method

What is the indirect method?

The indirect method presents operating cash flows by starting with net income and adjusting for items that affected net income but not cash. Depreciation is added back because it reduced income but required no cash payment. Increases in accounts receivable are subtracted because revenue was recognized, but the cash has not yet been collected. The result reconciles accrual earnings to actual cash generated.

Reading the indirect method reconciliation

Start with net income at the top. Add back non-cash expenses like depreciation and amortization. Subtract gains or add losses on asset sales since these belong in investing activities, not operating. Adjust for changes in working capital: increases in assets subtract from cash; increases in liabilities add to cash. The final figure is net cash from operating activities.

Why the indirect method dominates

Accounting systems track accrual data natively. The indirect method converts this existing data to cash flow without requiring separate cash tracking. It also reveals the relationship between profits and cash, which can be illuminating. A profitable company with declining cash from operations has a working capital problem that the indirect method makes visible. This diagnostic value, combined with practicality, explains its prevalence.