Cash flow from operations: the indirect method

How do you get from net income to operating cash flow?

Memorize

Start with net income, then undo everything that made profit differ from cash. Four steps, in this order.

1. Start with net income.
2. Add back non-cash charges: depreciation, amortization, depletion, impairments, stock compensation, amortization of a bond discount.
3. Remove gains and add back losses that belong to investing or financing, such as a gain on selling equipment.
4. Adjust for changes in operating working capital.

Indirect method is the name because it works indirectly, from net income, instead of listing cash receipts and payments. The result is cash flow from operating activities (CFO).

$$CFO = NI + \text{non-cash charges} - \text{gains} + \text{losses} - \Delta\text{op. assets} + \Delta\text{op. liabilities}$$

Net incomethe starting point, an accrual figure

• Add back Memorize
  • Non-cash charges depreciation, amortization, depletion, impairment, stock compensation, bond discount amortization
  • Losses on investing and financing items for example a loss on selling equipment
  • Deferred tax liability increase tax expense above tax paid
• Subtract Memorize
  • Gains on investing and financing items the full proceeds appear in investing
  • Non-cash income for example equity-method income not received, bond premium amortization
  • Deferred tax liability decrease
• Working capital Memorize operating accounts only
  • Operating assets receivables, inventory, prepaid: increase → subtract, decrease → add
  • Operating liabilities payables, accruals, taxes payable, unearned revenue: increase → add, decrease → subtract

Why add back depreciation, and why remove gains?

Depreciation and similar non-cash charges reduce net income but no cash leaves, so add them back. The depreciation and amortization add-back is not a source of cash; it only reverses a deduction that never cost cash.

Gains and losses work differently. The gains and losses on sale of equipment are investing items. Selling equipment at a gain raises net income, but the whole sale price is reported in investing activities. Keeping the gain in CFO would count it twice, so subtract it. A loss is added back for the same reason.

Exam tip Gains out, losses in. Asset up, cash down. Liability up, cash up.

How do changes in working capital affect cash?

An increase in an operating asset ties up cash, so subtract it. An increase in an operating liability means you kept cash you owed, so add it. These are the changes in working capital .

Account	Increase	Decrease
Receivables, inventory, prepaid expenses	subtract	add
Payables, wages payable, interest payable, taxes payable, unearned revenue	add	subtract

Only operating accounts count. A change in cash itself, in short-term borrowings or in dividends payable is not an adjustment to CFO: those are financing items or the result being solved for.

Worked example: Orchard Pumps

Orchard Pumps is our running example for the next three lessons (USD thousands). Revenue 10,000, cost of goods sold (COGS) 6,000, wages 1,200, depreciation 500, other operating expenses 700, gain on sale of equipment 100, interest expense 200, tax 375. Net income is 1,125.

CFO of 1,520 is well above net income of 1,125, mainly because of the 500 depreciation add-back.

Exam questions often give the working capital as one net number, or ask you to work backwards to net income, the gain or the change in working capital. Solve from any side.

Build the bridge yourself, bar by bar, and flip a sign to see what the trap option looks like.

Go deeper Why the gain is removed and what happens to deferred taxes

The proceeds of a sale appear in full in investing activities (lesson 4), so the gain that net income already contains must come out of operating cash flow. Deferred taxes work like a working capital item with a twist: an increase in a deferred tax liability means tax expense exceeded the tax actually paid, so it is added back; a decrease is subtracted. The same applies to a deferred tax asset in reverse.

Go deeper Why most companies use the indirect method, and what analysts lose

It is cheaper to prepare because it uses data already in the accounts, and it reconciles profit to cash, which helps analysts see earnings quality. What it hides is gross cash receipts and payments, so you cannot see directly whether collections from customers are keeping pace with sales. Lesson 3 shows how to convert it to the direct format.