Solutions/Accounting & Finance
Accounting & FinanceLevel: Intermediate

Operating Cash Flow Using the Indirect Method, Step by Step

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Problem Statement / Assignment Scope

A company made a net profit of Ā£95,000. Depreciation was Ā£14,000. During the year receivables rose by Ā£9,000, inventory fell by Ā£6,000 and payables fell by Ā£4,000. Prepare the operating activities section of its statement of cash flows using the indirect method.

Prerequisites: The difference between profit and cash, and what working capital is.

Step-by-Step Worked Solution

1. From profit to cash

Item Amount (Ā£)
Net profit95,000
Add back: depreciation (no cash paid)+14,000
Less: increase in receivables-9,000
Add: decrease in inventory+6,000
Less: decrease in payables-4,000
Net cash from operating activitiesĀ£102,000

2. Why each line moves the way it does

  • Receivables up: some sales haven't been paid for yet, so cash is lower than profit.
  • Inventory down: stock bought in an earlier year was used, so less cash went out this year.
  • Payables down: the business paid off more of what it owed suppliers, which used cash.

Key Takeaways & Core Principles

  • An increase in a current asset uses cash (subtract); a decrease releases cash (add).
  • An increase in a current liability saves cash (add); a decrease uses cash (subtract).
  • Depreciation is added back because it reduces profit without any cash leaving the business.
  • Under IAS 7, interest and dividends can be classified in more than one section, so state your choice.

Frequently Asked Questions

Why do most companies use the indirect method?

It starts from figures the company already has, profit and the changes in the balance sheet, so it's quicker to prepare than listing every cash receipt and payment as the direct method does. It also shows clearly why profit and cash differ.

Academic References & Standards

  • [1]International Accounting Standards Board (IASB). (2023). IAS 7: Statement of Cash Flows. Source Link
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