Which method adjusts net income for items that affected reported net income but did not affect cash?

Learning Outcomes

  • Distinguish between the direct and indirect methods of preparing a statement of cash flows

Cash flows from operating activities show the net amount of cash received or disbursed during a given period for items that normally appear on the income statement. You can calculate these cash flows using either the direct or indirect method. The direct method deducts from cash sales only those operating expenses that consumed cash. This method converts each item on the income statement directly to a cash basis. Alternatively, the indirect method starts with accrual basis net income and indirectly adjusts net income for items that affected reported net income but did not involve cash.

The direct method converts each item on the income statement to a cash basis. For instance, assume sales are stated at $45,785 on an accrual basis. If accounts receivable decreased by $15, from $1,750 to $1,735, cash collections from customers would have been $45,800, which you could calculate in a T account or in a table as follows:

Beginning balance $     1,750
Accrual basis sales 45,785
Balance before payments 47,535
Less: Ending balance 1,735
Cash payments from customers $   45,800

Here is a hypothetical example of a statement of cash flows prepared using the direct method:

Rumble Corp. Statement of Cash Flows

for the year ended 12/31/x1

Description Amount Total
In millions
Subcategory, Cash flows from operating activities
Cash receipts from customers $ 45,800
Cash paid to suppliers (29,800)
Cash paid to employees (11,200)
Cash generated from operations Single Line
Interest paid (310)
Income taxes paid (1,700)
Net cash from operating activities Single Line Single Line
Subcategory, Cash flows from investing activities
Purchase of property, plant, and equipment (580)
Proceeds from sale of equipment 150
Net cash used in investing activities Single Line Single Line
Subcategory, Cash flows from financing activities
Proceeds from issuance of common stock 1,000
Proceeds from issuance of long-term debt 500
Dividends paid (460)
Net cash used in financing activities Single Line Single Line
Net increase in cash and cash equivalents 3,400
Cash and cash equivalents at beginning of period 1,640
Cash and cash equivalents at end of period Single Line $5,040

Double Line

The indirect method adjusts net income (rather than adjusting individual items in the income statement) for (1) changes in current assets (other than cash) and current liabilities, and (2) items that were included in net income but did not affect cash. We’ll explore this in more detail in a later section.

Operating cash flow is cash generated from the normal operating processes of a business. A company's ability to generate positive cash flows consistently from its daily business operations is highly valued by investors. In particular, operating cash flow can uncover a company's true profitability. It’s one of the purest measures of cash sources and uses.

The purpose of drawing up a cash flow statement is to see a company's sources and uses of cash over a specified time period. The cash flow statement is traditionally considered to be less important than the income statement and the balance sheet, but it can be used to understand the trends of a company's performance that can't be understood through the other two financial statements.

While the cash flow statement is considered the least important of the three financial statements, investors find the cash flow statement to be the most transparent. That's why they rely on it more than any other financial statement when making investment decisions.

  • Operating cash flow is cash generated from the normal operating processes of a business and can be found in the cash flow statement.
  • The cash flow statement is the least important financial statement but is also the most transparent.
  • The cash flow statement is broken down into three categories: Operating activities, investment activities, and financing activities.
  • Cash flow is calculated using the direct (drawing on income statement data using cash receipts and disbursements from operating activities) or the indirect method (starts with net income, converting it to operating cash flow).
  • OCF helps investors gauge what's going on behind the scenes and is a better indicator of profitability than net income.

Operating cash flow can be found in the cash flow statement, which reports the changes in cash compared to its static counterparts—the income statement, balance sheet, and shareholders’ equity statement. Also known as the cash flow from operations (CFO), it specifically reports where cash is used and generated over specific time periods, tying the static statements together.

By taking net income on the income statement and making adjustments to reflect changes in the working capital accounts on the balance sheet (receivables, payables, inventories) and other non-cash charges, the operating cash flow section shows how cash was generated during the period. It is this translation process from accrual accounting to cash accounting that makes the operating cash flow statement so important.

The cash flow statement is broken down into three categories. These are segregated so that analysts develop a clear idea of all the cash flows generated by a company’s various activities:

In some cases, there is a supplemental activities category as well. Supplemental information basically refers to anything else that does not relate to the other major categories.

Net income refers to the total sales minus the cost of goods sold and expenses related to sales, administration, operations, depreciation, interest, and taxes.

Operating activities are normal and core activities within a business that generate cash inflows and outflows. They include:

  • Total sales of goods and services collected during a period
  • Payments made to suppliers of goods and services used in production settled during a period
  • Payments to employees or other expenses made during a period

Cash flow from operating activities is anything it receives from its operations. This means it excludes money spent on capital expenditures, cash directed to long-term investments, and any cash received from the sale of long-term assets. Also excluded are the amounts paid out as dividends to stockholders, amounts received through the issuance of bonds and stock, and money used to redeem bonds.

Investing activities consist of payments made to purchase long-term assets, as well as cash received from the sale of long-term assets. Examples of investing activities are the purchase or sale of a fixed asset or property, plant, and equipment and the purchase or sale of a security issued by another entity.

Financing activities consist of activities that will alter the equity or borrowings of a company. Examples of financing activities include the sale of a company's shares or the repurchase of its shares.

To see the importance of changes in operating cash flows, it’s important to understand how cash flow is calculated. Two methods are used to calculate cash flow from operating activities, both of which produce the same result:

  • Direct method: This method draws data from the income statement using cash receipts and cash disbursements from operating activities. The net of the two values is the operating cash flow.
  • Indirect method: This method starts with net income and converts it to OCF by adjusting for items that were used to calculate net income but did not affect cash.

Image by Sabrina Jiang © Investopedia 2021

The direct method adds up all the various types of cash payments and receipts, including cash paid to suppliers, cash receipts from customers and cash paid out in salaries. These figures are calculated by using the beginning and ending balances of a variety of business accounts and examining the net decrease or increase of the account.

The exact formula used to calculate the inflows and outflows of the various accounts differs based on the type of account. In the most commonly used formulas, accounts receivables are used only for credit sales, and all sales are done on credit.

If cash sales also occur, receipts from cash sales must also be included to develop an accurate figure of cash flow from operating activities. Since the direct method does not include net income, it must also provide a reconciliation of net income to the net cash provided by operations.

Under the indirect method, cash flow from operating activities is calculated by first taking the net income from a company's income statement. Because a company’s income statement is prepared on an accrual basis, revenue is only recognized when it is earned and not when it is received.

Net income is not a perfectly accurate representation of net cash flow from operating activities, so it becomes necessary to adjust earnings before interest and taxes (EBIT) for items that affect net income even though no actual cash has yet been received or paid against them. The indirect method also makes adjustments to add back non-operating activities that do not affect a company's operating cash flow.

The direct method for calculating a company's cash flow from operating activities is a more straightforward approach in that it reveals a company's operating cash receipts and payments, but it is more challenging to prepare since the information is difficult to assemble. Still, whether you use the direct or indirect method for calculating cash from operations, the same result will be produced.

The image below shows reported cash flow activities for AT&T (T) for the 2012 fiscal year. All figures reflected are in millions. Using the indirect method, each non-cash item is added back to net income to produce cash from operations. In this case, cash from operations is over five times as much as reported net income, making it a valuable tool for investors in evaluating AT&T's financial strength.

Image by Sabrina Jiang © Investopedia 2020

OCF is a prized measurement tool as it helps investors gauge what’s going on behind the scenes. For many investors and analysts, OCF is considered the cash version of net income, since it cleans the income statement of non-cash items and non-cash expenditures (depreciation, amortization, non-cash working capital items).

OCF is a more important gauge of profitability than net income as there is less opportunity to manipulate OCF to appear more or less profitable. With the passing of strict rules and regulations on how overly creative a company can be with its accounting practices, chronic earnings manipulation can easily be spotted, especially with the use of OCF. It is also a good proxy of a company’s net income. For instance, a reported OCF higher than NI is considered positive as income is actually understated due to the reduction of non-cash items.

Operating cash flow is just one component of a company’s cash flow story, but it is also one of the most valuable measures of strength, profitability, and the long-term future outlook. It is derived either directly or indirectly and measures money flow in and out of a company over specific periods.

Unlike net income, OCF excludes non-cash items like depreciation and amortization, which can misrepresent a company's actual financial position. It is a good sign when a company has strong operating cash flows with more cash coming in than going out. Companies with strong growth in OCF most likely have a more stable net income, better abilities to pay and increase dividends, and more opportunities to expand and weather downturns in the general economy or their industry.

If you think cash is king, strong cash flow from operations is what you should watch for when analyzing a company.