The initial line item is operating profit when generating a cash flow statement using the indirect method. The idea behind using this amount is ‘’we need to convert accrual-based profit/loss to the cash balance’’.

For this purpose, we divide the cash flow statement into three categories.

Operating activities

Adjustments for non-cash items

We add up non-cash losses and deduct non-cash income from the current year’s profit/loss. The logic behind this addition/deduction follows.

• Non-cash expenses are added back because the business did not pay cash for these expenses. These expenses were deducted from operating profit/loss because of the accrual concept, and it had nothing to do with cash. Examples of non-cash expenses include depreciation, impairment, provisions, etc.
• Non-cash income is deducted from operating profit/loss because this income was not recorded by receiving cash but by using the accrual concept of accounting. Examples of non-cash income include gain on recognition of claim receivable (not received but recorded) during the current period.

Adjustments for changes in working capital in the context of the prior accounting period

Adjustments are made in the working capital with the following logic in mind.

• The increase in inventory is deducted from operating income/loss, logically, because the business spent more cash to accumulate inventory. The increased pile-up, compared to last year’s inventory levels, reduced the current year’s cost of sales and increased the profit. Hence, this increase should be deducted from the current period’s profit or loss to adjust the impact of accrual adjustment.

Following inventory calculations helps to further elaborate this concept,

Opening inventory + purchases – closing inventory= cost of sales, further,

Sales – cost of sales = gross profit/gross loss.

So, if closing inventory is higher in the above equation, the cost of sales is reduced, and profit is increased due to the higher amount of closing inventory (accrual accounting).  Hence, the impact of the increase in inventory (in comparison to the last accounting period) should be deducted from the operating income/loss of the current accounting period.

Similarly, the decrease in inventory compared to the last accounting period should be added back (consider the above discussion for logical understanding).

• An increase in receivables should be deducted from current profit/loss as an increase in receivables signals more sales were recorded than cash received. This recording of sales was made per the accrual concept. So, we must deduct this balance from operating profit/loss to reflect cash sales only.
• A decrease in receivables should be added to the current profit/loss as a decrease in receivables means more cash was collected in comparison to recorded sales via accrual accounting. So, as part of converting accrual profit/loss to cash, we need to add back sales that were received (recorded in the prior accounting period).
• An increase in accounts payable means your purchases/expenses were more, but payment to the vendors was comparatively less in the current accounting period. So, cash outflow was less, but more expense was recorded under the accrual basis of accounting. So, we need to add back expenses that were not incurred via cash.
• As per the accrual concept, a decrease in accounts payable means you paid more than current expenses in the profit or loss statement. Hence, excess paid expenses in cash should be deducted from the current profit/loss to make it cash.

We’ve discussed the logic behind each line item’s increase or decrease in operating activities and their impact on profit or loss.

Converting accrual profit/loss to cash requires thinking about what adjustments are needed to convert accrual profit/loss to cash.

Let’s go through the impact of financing activities on the cash movement.

Financing activities

The impact of financing activities is comparatively straightforward. The cash inflow due to raising the loan is added back, and repayment is simply deducted.

Similarly, proceeds from the sale of capital assets are added back to the cash flow, and capital expenditures are deducted.

Investing activities

The proceeds via investing activities like raising share capital are added to the cash flow and vice versa.

Likewise, dividends paid to shareholders are deducted from the cash flow

Conclusion

The indirect method of cash flow statement preparation starts from operating profit/loss. Non-cash expenses like depreciation, impairment, and provision are added back, and non-cash income is deducted to remove their impact from the operating profit/loss.

The impact of line items like receivables, inventory, and payables is logically adjusted to covert the operating profit/loss and appear as cash.

Additionally, financing and investing activities related to cash are adjusted in the operating balance to reach a closing cash via opening base balance.