3. Indirect Method

Let's do an example using the indirect method to find cash flow from operations. So I've got an example all written up here, and the problem is gonna say something like, "Find cash flow from operations." Now, when we're doing cash flow from operations using the indirect method, we always start with net income. So start with your net income at the very top. Then we need to make a couple of adjustments because the net income is revenues less expenses, but some of these revenues and some of these expenses aren't exactly right, so what we do is we go through and we make some adjustments. The first and easiest is to look for depreciation.

So depreciation is a non-cash expense, so we wanna remove depreciation. And how do we remove depreciation? Well, depreciation was an expense, and it was subtracted from the revenues to get to net income. So since it was subtracted, we need to add it back. So we're gonna add 30,000 back to the net income because it decreased our net income, but it didn't decrease our cash flow, so we're gonna add it back.

The next one we're gonna look at is this gain on sale of equipment. This gain on sale of equipment right here, first of all, this is an investing. That's an investing activity because it's a plant, property, or equipment, and when we're dealing with operations, we're talking about day-to-day stuff. We're talking about revenues and expenses. So this is not even in the right category to begin with. But additionally, if you look at the disposal of plant, property, and equipment, so we dispose it for 1,200. It was worth 1,000. We have a gain of 200. This gain, that's on paper. The cash transaction is 1,200, and this 1,200 is going to be accounted for in the investment section.

This gain is strictly an income statement recognition gain. So since this was included to take us from 105 to 155, we need to back it out because it shouldn't have been included if we're talking about cash. It should have been for net income, but for cash it's not relevant.

In the same way that this depreciation expense is a non-cash event, this gain is a non-cash event, so we take that out. Now we get to what I like to call the fun stuff. We've got all of these accounts down here. So this is the balance sheet down here, and we've got all of these accounts, and from Year 1 to Year 2 there was some kind of change. Let's just go ahead and mark the changes. Plus 10,000, minus 20,000, plus 2,000, plus 1,000, and minus 10,000, because what we're dealing with here is we're dealing with the increases and decreases of current assets and current liabilities.

Let's think our way through this first one, this accounts receivable one. Our accounts receivable went from 90 to 100, so that looks something like this. We had 90, bunch of stuff happened. We ended up at 100. Okay? Well, what is some of the stuff that could have happened? Well, at its very simplest it was an increase of 10,000, right? That's what we decided right here. So with this increase of 10,000, what we're saying is we recognized 10,000 of revenue because when you make a sale, typically we'll put 10,000 in and the corresponding credit is sales revenue.

This is the typical selling on account journal entry, and the journal entry when we actually collect is cash of some amount and accounts receivable of some amount. Now, with this T-account right here, what we're saying is we had sales revenue of 10,000 that we put into accounts receivable. Then over here on the collection side we had a big old goose egg. We didn't collect any. And of course, it could have looked something like this. This could be 110,000, and this would be 100,000. But the difference is still the 10,000, and that's all that really matters. So it doesn't matter if this is 1,010,000 and this is a million, this is 110,000 and this is 100, or this is 10,000 and it's 0.

What we're worried about is this difference. So what this tells us is in aggregate we recognized 10,000 in revenue more than we collected in cash. So our revenue was 10,000 higher than our cash. Our cash was at 0. So in that equation, revenues minus expenses is net income. Our revenue was 10,000 higher than our cash, so we need to decrease this net income by $10,000 to get to the cash flow. What about accounts payable? Accounts payable went from 50 down to 30. Let's see if we can figure that one out.

Let's do something similar with accounts payable. Accounts payable went from 50 down to 30. 50 ended at 30. So where is the 20? The 20 is over here. And again, this could be 120 and this could be 100. All that matters is the difference. What is the difference? And in this case, the difference is $20,000 on the debit side. And how do you typically debit accounts payable? Well, if you'll remember, that journal entry typically looks like this: accounts payable, 20,000; cash, 20,000. And how do you credit accounts payable? That normally looks like this. You have some sort of, we'll say, wage expense of some amount, and then you put it into your accounts payable when you don't pay it right away of some amount.

We call this the cash side. When you pay cash, typically, the corresponding journal entry is on the left. And when you recognize expenses, we typically put them over here on the credit side. Right? A credit to accounts payable is normally corresponded with an expense, and a debit to accounts payable is normally corresponded with a cash. So in this example, what we're saying is we had 0 recognized expenses, but we paid 20,000 in cash because our payable went down. So if our payable went down, that means we paid some of it off. And the amount that we paid off was this 20,000. So if you look at how we got to net income again, we got to net income by subtracting 0 for this particular account for this expense.

When in reality, for cash, we should have subtracted 20. So now what we're gonna do is we're gonna say, "Okay, yes, the expense was 0, but the actual cash was negative 20 because we paid out this 20,000." So we're going to subtract 20,000 for this one. Now that we've got a couple under our belt, let's say accounts receivable is a current asset, payable is a current liability. Any prepaid is a current asset, any payable is a current liability, and inventory we know is an asset. So we've got a couple under our belt, and we can just use the ones that we've already done to figure out the others.

This one was an increase, this one was a decrease, an increase, an increase, and a decrease. For an increase in a current asset, we subtracted it. For a decrease in a current liability, we also subtracted it. Increase current asset is a subtract. And like I said, a decrease in a current liability is the one we subtracted. So a decrease in a current liability is also a subtract, and you can just fill out with the opposite. So if a decrease in a current liability is a minus, an increase in a current liability is a plus. If an increase in a current asset is a minus, well then a decrease in a current asset is a plus.

At that point, it just becomes an opposites game. So let's move our way down and see if we can figure it out. Prepaid advertising expense went up by 2,000. Current asset went up. Current asset went up by 2,000, so we subtract 2,000 out of our net income. And that makes sense because our prepaid increased, that means we put more in. We put more cash into this prepaid bucket than we took out as an expense. Right? So you're putting cash in as you prepay, and then you're decreasing your prepaid as you recognize expenses. So if the prepaid went up, we put more cash in, which means we need to take some out of this net income, because this net income only recognized the expense and it didn't recognize the increase in the payable that we had to do using cash.

Next is wages payable. A current liability went up. A current liability goes up, it's an add, so we're gonna add 1,000. And if you think about this one, that makes sense also, because our payable went from 4,000 to 5,000, that means we didn't pay $1,000. We incurred some amount of expenses that were recognized here, but we didn't pay 1,000 of whatever expenses were included in the net income, so we get to add back the cash difference for that, that cash that we didn't pay. And finally, inventory. Inventory is a current asset that decreased. A decrease in a current asset is a plus, so we have plus 10,000 here.

And the reason we have that is we used up some of this current asset instead of paying cash. Right? So we decreased our current asset inventory. We decreased that by $10,000. So instead of having to pay $10,000 towards inventory, we just used up some of what we had. So that wasn't actually a cash expense, it was just eating up some of the inventory that we already had in the warehouse. So we add that back as a non-cash expense. And when you total all of that up, it comes out to be $114,000. That is your cash flow from operations.

So just as a quick recap, the things you wanna look out for when you're starting, start with depreciation. Start with depreciation or amortization. Those are non-cash expenses. That's depreciation expense and accumulated depreciation. There's no cash anywhere in there. So when you take that out to arrive at net income, you're strictly doing that for revenue and expense recognition purposes. You're not doing that because it has any effect on cash. So when you want to use net income to get to cash, you have to add depreciation back because it has nothing to do with cash. Then we moved on to this gain, and this gain is the exact same way.

This gain has nothing to do with cash. It's just a revenue recognition thing. If you were to even recognize this gain in the cash flow statements, it would be over in the investment section. Don't recognize it there either, but here it's double wrong. It's not operating and it's a paper gain. Gains look like this. You have cash, gain, and plant, property, and equipment. Here's the thing you're going to recognize in your cash flow statement, not this gain. This gain has nothing to do with cash.

So it's those two. It's depreciation, amortization, and it's gain/loss on sale of equipment. Then you move on to all this balance sheet junk where you have to determine what was the change in the accounts and what do I do with those changes. If you look at a payable and you say my payable went from 50 down to 30, you know that you paid more. You paid off an additional $20,000 that you did not incur this year. To get a payable to go down, you have to pay cash for it. So what you do is you say my net income did not account for that cash I used to pay down my payable, so I'm going to subtract $20,000.

Same thing with these prepaids. If a prepaid goes up, that means you prepaid more, which means you paid cash. So you take out the $2,000 there. With a payable, if your payable goes up, that means you did not pay, right? Now you owe even more because you didn't pay. So that's an increase in your cash. So like I said, if you can remember any one of those, if you can figure out any single one, then you can draw this out on your test and you'll know what to do with all of the accounts. You only have to remember one. If you can logic your way into one, then you'll be able to get the other three.