Indirect Method Cash Flow: 4 Simple Steps with an Example
The indirect method is a way to prepare the operating section of the statement of cash flows. You start with net income, add back noncash expenses such as depreciation, remove gains and losses on asset sales, and adjust for changes in noncash operating assets and operating liabilities. The result is net cash provided by or used in operating activities.
Indirect method cash flow formula for common adjustments: Net cash provided by or used in operating activities = Net income + Depreciation and amortization − Gains on asset sales + Losses on asset sales − Increases in noncash operating assets + Decreases in noncash operating assets + Increases in operating liabilities − Decreases in operating liabilities.
This formula covers the common adjustments used in this lesson. Other noncash income and expenses may require additional adjustments. Exclude cash and cash equivalents from operating asset changes, and avoid counting the same item twice.
It is called indirect because you do not list cash receipts and payments one by one. Instead, you work backward from profit. That is why this method is so good at explaining why profit and cash are different numbers.
The rules come from the Financial Accounting Standards Board (FASB) in Accounting Standards Codification (ASC) Topic 230, Statement of Cash Flows. The example below follows U.S. generally accepted accounting principles (GAAP).
Key takeaways
- The indirect method starts with net income and ends with net cash provided by or used in operating activities.
- Add back noncash expenses such as depreciation. They lowered net income, but no cash left the company.
- Subtract gains and add back losses on asset sales. The full sale proceeds go in the investing section.
- Subtract increases in noncash operating assets such as accounts receivable. Add increases in operating liabilities such as accounts payable.
- Investing and financing cash flows are the same under the indirect and direct methods. Only the operating section looks different.
- Always finish by checking that beginning cash plus the net change equals ending cash.
Video: Statement of Cash Flows: Indirect Method Step-by-Step Example
Watch Professor Farhat build a statement of cash flows with the indirect method from start to finish. The video runs about 37 minutes.
The video uses a different company, Adam Consulting Company, where $59,000 of net income becomes $10,000 of operating cash flow. It breaks the operating section into five smaller steps, while this article groups the whole statement into four. The logic is the same, so use the video to see it again with new numbers.
Watch this lesson on the Farhat Lectures YouTube channel.
Jump to the part you need:
- 11:48 Adam Consulting Company example
- 14:34 Indirect method: five steps
- 15:12 Why add back noncash expenses?
- 18:27 Why subtract a gain on an asset sale?
- 21:58 Accounts receivable: why increases are subtracted
- 26:05 Accounts payable: why increases are added
- 28:45 Calculate $10,000 operating cash flow
- 34:57 Reconcile the change in cash
What information do you need?
You need three things: comparative balance sheets (the balance sheets at the beginning and end of the year, shown side by side), the current income statement, and details of transactions such as asset purchases, borrowing, and dividends. A balance change alone may not reveal a cash movement. Equipment might increase because of a cash purchase or because the company issued a note directly to the seller.
Identify the beginning and ending cash balances as a check. For the classification rules, review the statement of cash flows and its three sections. This one-page SEC staff resource on the cash flow statement also introduces the indirect approach.
| Information | Amount or change |
|---|---|
| Net income | $48,000 |
| Depreciation included in net income | $8,000 |
| Accounts receivable | $14,000 beginning; $21,000 ending |
| Operating accounts payable | $9,000 beginning; $12,000 ending |
| Equipment acquired for cash | $25,000 |
| Cash received from new bank borrowing | $20,000 |
| Cash dividends paid | $6,000 |
| Cash | $10,000 beginning; $51,000 ending |
Assume these are the only relevant changes. Cedar has no inventory, prepaid expenses, gains or losses, cash equivalents, or restricted cash. All other revenue and expense items were settled in cash during the year.
Step 1: Calculate cash flow from operating activities
Begin with $48,000 net income. Net income is measured on the accrual basis. That means revenue is recorded when it is earned and expenses when they are incurred, not when cash changes hands. The indirect method undoes those timing differences. First, add back $8,000 depreciation because it reduced profit without a current-period cash payment. This adjustment does not create cash; it removes a noncash expense from the starting profit figure.
Accounts receivable increased by $7,000. Revenue exceeded cash collections by that amount, so subtract $7,000. Operating accounts payable increased by $3,000. Some expenses reduced profit before they were paid, so add $3,000.
| Item | Adjustment to net income | Reason |
|---|---|---|
| Depreciation or amortization expense | Add back | Expense did not itself use cash |
| Increase in operating current assets other than cash | Subtract | Receivables: recognized revenue exceeds collections. Inventory: purchases exceed cost of goods sold; related cash payments also depend on accounts payable. Prepaid expenses: new prepayments exceed the expense recognized |
| Decrease in operating current assets other than cash | Add | Receivables: collections exceed recognized revenue. Inventory: cost of goods sold exceeds purchases; related cash payments also depend on accounts payable. Prepaid expenses: expense recognized exceeds new prepayments |
| Increase in operating current liabilities | Add | Accounts payable: purchases on account exceed supplier payments. Accrued expenses: expense recognized exceeds cash paid. Unearned revenue: customer advances received exceed revenue recognized from those advances |
| Decrease in operating current liabilities | Subtract | Accounts payable: supplier payments exceed purchases on account. Accrued expenses: cash paid exceeds expense recognized. Unearned revenue: revenue recognized from customer advances exceeds new advances received |
| Gain on sale of productive assets | Subtract | Remove gain; report sale proceeds in investing |
| Loss on sale of productive assets | Add back | Remove loss; report sale proceeds in investing |
Here is a quick memory aid. Operating assets move in the opposite direction from cash, and operating liabilities move in the same direction as cash. Use this shortcut only for operating balances, and only after you have read the transaction details. Cash is the amount being reconciled. Bank loans are financing, and equipment purchases are investing. Do not apply the shortcut to every balance sheet account.
Step 2: Determine investing and financing cash flows
Cedar paid $25,000 for equipment, an investing outflow. It borrowed $20,000 and paid $6,000 of dividends, producing $14,000 of net financing cash inflow. Dividend payments are not expenses in net income, so they are not an additional operating adjustment.
Read the transaction details before using an account’s net change. If equipment was both purchased and sold, the change in its carrying amount would not equal cash spent on purchases. Show relevant cash receipts and payments separately rather than netting unrelated transactions.
Step 3: Calculate the net change in cash
| Line item | Cash amount |
|---|---|
| Operating activities | |
| Net income | $48,000 |
| Add depreciation | $8,000 |
| Subtract increase in accounts receivable | ($7,000) |
| Add increase in operating accounts payable | $3,000 |
| Net cash provided by operating activities | $52,000 |
| Investing activities | |
| Purchase of equipment | ($25,000) |
| Net cash used in investing activities | ($25,000) |
| Financing activities | |
| Borrowing proceeds | $20,000 |
| Cash dividends | ($6,000) |
| Net cash provided by financing activities | $14,000 |
| Net increase in cash | $41,000 |
| Beginning cash | $10,000 |
| Ending cash | $51,000 |
The three section totals give $52,000 − $25,000 + $14,000 = $41,000. The operating cash flow of $52,000 is neither the $48,000 profit nor the $41,000 overall change in cash. Each answers a different question.
Step 4: Reconcile beginning and ending cash
Add the $41,000 increase to $10,000 beginning cash. The result, $51,000, agrees with the ending balance sheet. If the amounts disagree, check signs, omitted transactions, and noncash items. Do not insert an unexplained “other cash flow” merely to force agreement.
A successful reconciliation confirms the arithmetic but does not prove classification is correct. Moving a cash payment from investing to operating leaves the total unchanged. Review both the category and the amount.
Once the statement is prepared, use cash flow ratios and free cash flow to assess what the operating total means in relation to obligations and capital spending.
A fuller example: inventory, prepaid expenses, and a gain
Cedar was kept simple on purpose. Homework and exam problems usually add a few more accounts. Here is a second hypothetical company with the adjustments you will see most often.
| Line item | Amount |
|---|---|
| Net income | $60,000 |
| Add depreciation expense | $10,000 |
| Subtract gain on sale of equipment | ($4,000) |
| Subtract increase in accounts receivable | ($6,000) |
| Subtract increase in inventory | ($9,000) |
| Add decrease in prepaid expenses | $1,000 |
| Subtract decrease in accounts payable | ($5,000) |
| Add increase in accrued liabilities | $2,000 |
| Net cash provided by operating activities | $49,000 |
Operating cash flow = $60,000 + $10,000 − $4,000 − $6,000 − $9,000 + $1,000 − $5,000 + $2,000 = $49,000.
Here is why each new line moves the way it does:
- Inventory went up $9,000. Assuming no inventory write-downs or other noncash changes, purchases exceeded cost of goods sold by $9,000. Subtract the increase, then use the accounts payable adjustment to account for payment timing. An inventory purchase on credit does not itself use cash.
- Prepaid expenses went down $1,000. Prepaid expenses are costs paid in advance, such as insurance. Birch used up $1,000 of old prepayments, which created an expense this year without a new cash payment. Add it.
- Accounts payable went down $5,000. Assuming these payables relate to inventory purchases, Birch paid suppliers $5,000 more than its inventory purchases for the year. Subtract the decrease. Together, the $9,000 inventory increase and $5,000 payable decrease mean supplier payments exceeded cost of goods sold by $14,000.
- Accrued liabilities went up $2,000. Accrued liabilities are expenses recorded but not yet paid, such as wages owed to employees. The expense lowered net income, but the cash has not been paid. Add it.
- The $4,000 gain is inside net income, but it is not operating cash. Subtract it here and report the full sale proceeds in the investing section.
Notice the result. Net income was $60,000, but operations produced only $49,000 of cash, mostly because cash is tied up in receivables and inventory.
What are the most common indirect method mistakes?
Hypothetical gain example. Equipment with a $9,000 carrying amount sells for $11,000 cash. Carrying amount, also called book value, is the cost of the asset minus its accumulated depreciation. The $2,000 gain is included in net income. Subtract the gain in the operating reconciliation and report the full $11,000 proceeds as investing cash. Do not report only the gain as the investing inflow.
Do not subtract depreciation after already starting with net income; that would count the expense twice. Also, equipment acquired entirely by issuing a note creates a separate noncash disclosure, not a pair of cash flows. A signed note is not evidence that cash passed through the company.
Indirect method vs. direct method: what is the difference?
Both methods give the same net cash provided by operating activities. They only differ in how the operating section is laid out. The investing and financing sections are identical under both methods.
| Point of comparison | Indirect method | Direct method |
|---|---|---|
| Starting point | Net income | Cash received from customers |
| What the operating section shows | The adjustments that turn net income into operating cash | The main types of cash receipts and cash payments |
| What it explains best | Why profit and cash are different | Where cash came from and where it went |
| Supplemental U.S. GAAP requirements | Disclose interest paid, net of capitalized amounts; provide applicable income-tax disclosures | Provide the net-income-to-operating-cash reconciliation and applicable income-tax disclosures |
| Use in practice | Used by most companies | Encouraged by the FASB, but used less often |
The FASB encourages the direct method but allows either one (FASB ASC 230-10-45-25 and 45-28). Most companies choose the indirect method because it can be prepared from the income statement and the balance sheets they already have.
A direct method statement still has to include the indirect method reconciliation in a separate schedule (FASB ASC 230-10-45-30). So you need to know the indirect method either way.
What disclosures go with the indirect method?
Two items are easy to forget.
First, an entity using the indirect method must disclose cash interest paid, excluding amounts capitalized, under ASC 230-10-50-2. Capitalized interest is included in an asset’s cost. The disclosure may appear on the statement or in the notes.
Income taxes paid, net of refunds received, must be disclosed under either method. ASC 230-10-50-2A points to ASC 740-10-50-22 through 50-23. For annual periods subject to ASU 2023-09, entities within Topic 740 disclose federal (national), state, and foreign totals and separately identify each jurisdiction representing at least 5% of total income taxes paid, net of refunds.
Second, investing and financing transactions that did not involve cash must be disclosed separately, either in a narrative note or in a schedule (FASB ASC 230-10-50-3 through 50-6). Buying equipment by signing a note payable is the classic example. It never appears in the body of the statement.
Exam note: If you are studying for the CPA Exam, this is FAR material. The FAR blueprint effective January 1, 2026 includes preparing a statement of cash flows using the indirect method, together with the required disclosures. The statement of cash flows is also part of CMA Exam Part 1, Section A, External Financial Reporting Decisions.
Indirect Method Cash Flow: Interactive Practice Quiz
Net cash provided by operating activities is the excess of operating cash receipts over operating cash payments. The indirect method reconciles accrual-basis net income to operating cash flow by adjusting for noncash income and expenses, gains or losses whose cash effects belong in investing or financing activities, and changes in operating assets and liabilities. This analysis uses the current year’s income statement, comparative balance sheets, and selected transaction data.
Review the core concepts in these five questions before moving to the calculation practice below. Choose an answer for each question, then select Check answers for your score and explanations. Use Try again to reset the quiz.
Answer key and explanations
- What is net cash provided by operating activities?
- It is the excess of cash receipts over cash payments from operating activities.
- How is a gain on the sale of equipment treated?
- Subtract it from net income in the operating section. The gain is already inside net income, and the full cash proceeds from the sale are reported in the investing section.
- What is the direction of the conversion?
- Net income is converted from an accrual basis to a cash basis.
- Which items require adjustments to net income?
- Adjust for noncash income and expenses, gains or losses whose cash effects belong in investing or financing activities, and changes in operating assets and liabilities. For example, add back depreciation, subtract a gain on an equipment sale, and subtract an increase in accounts receivable.
- What information is needed for the indirect method?
- The current year’s income statement, comparative balance sheets, and selected transaction data must all be analyzed.
Practice: check your adjustments
1. Net income is $35,000; depreciation is $5,000; receivables decrease $2,000; operating payables decrease $3,000. What is operating cash flow?
Answer: $39,000. Calculate $35,000 + $5,000 + $2,000 − $3,000. A receivable decrease adds cash relative to revenue; a payable decrease uses cash relative to expense.
2. A $4,000 loss on equipment sold is included in net income. Should you add it back?
Answer: yes. Remove the loss from net income because the sale’s cash proceeds belong in investing. The add-back is not a separate cash receipt.
3. Cedar acquires another $12,000 machine by issuing a note directly to its seller. Does ending cash change?
Answer: no. The transaction is noncash. Disclose it separately; the example’s $51,000 cash balance stays the same.
Want more practice like this? CPA candidates can keep going with lectures, multiple-choice questions, and simulations in the FAR supplemental course. CMA candidates will find the statement of cash flows in CMA Exam Part 1. Both courses include free sample lessons.
Frequently asked questions
Why is an increase in receivables subtracted?
In a basic example, some recognized revenue has not yet been collected. Subtracting the increase removes that uncollected portion from accrual profit.
Can net income be positive while operating cash flow is negative?
Yes. Large increases in receivables or inventory can consume more cash than the period’s earnings provide. Investigate collection patterns, growth, and payment timing.
Does the indirect method change the amount of cash generated?
No. It changes how operating cash flow is presented. The direct method lists operating receipts and payments and reaches the same operating total.
What is the indirect method of cash flow in simple terms?
It is a way to calculate operating cash flow by starting with net income and adjusting it. You add back expenses that did not use cash, remove gains and losses that belong in other sections, and adjust for changes in operating assets and liabilities.
Why is depreciation added back under the indirect method?
Depreciation lowers net income, but no cash is paid when it is recorded. The cash went out when the asset was purchased, which is an investing activity. Adding depreciation back removes a noncash expense. It does not create cash.
Which is better, the direct method or the indirect method?
Neither one changes the answer. Both give the same net cash provided by operating activities. The FASB encourages the direct method because it shows actual cash receipts and payments. Most companies use the indirect method because it is easier to prepare from the income statement and balance sheet.
Do the investing and financing sections change under the indirect method?
No. Only the operating section is different. Investing and financing activities are reported the same way under both methods.
Sources and learning context
The rules in this article come from FASB Accounting Standards Codification Topic 230, Statement of Cash Flows. Paragraph 230-10-45-28 describes the indirect method, paragraph 230-10-45-25 encourages the direct method, and paragraphs 230-10-50-2 through 50-6 cover the related cash flow disclosures. For income taxes paid, paragraph 230-10-50-2A refers to the requirements in ASC 740-10-50-22 through 50-23. The SEC staff resource linked above provides a public introductory illustration.
About the author: Mansour Farhat, CPA, CIA, DBA, is the instructor behind Farhat Lectures, where he teaches accounting, CPA Exam, and CMA Exam topics through video lectures and practice questions. Read more about Professor Farhat.
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