What it means
When running a business, you track profit using accrual accounting, which records sales when invoiced and expenses when billed, regardless of when cash actually changes hands. This means your net profit does not equal your actual bank balance.
The indirect method bridges this gap on your cash flow statement by starting with your net profit and working backward. First, you add back non-cash expenses like depreciation, which reduced your profit on paper but did not cost you any actual cash.
Next, you adjust for changes in working capital, such as money tied up in unpaid customer invoices or inventory. If your inventory increases, cash goes down because you bought stock, so you subtract that amount from your profit.
If your suppliers let you delay payment, your accounts payable go up, meaning you kept cash longer, so you add that amount. Business owners and managers use the indirect method because it is much easier and cheaper to prepare than tracking every single cash transaction individually.
Most accounting software generates this report automatically, making it the standard choice for small and medium-sized enterprises. By looking at this statement, managers can quickly see why a profitable business might still struggle to pay its bills, often because cash is temporarily trapped in stock or delayed customer payments.
In practice
Real-world examples.
Example
Your boutique agency reports a net profit of 50,000 pounds. However, clients owe you 15,000 pounds in unpaid invoices. Using the indirect method, you subtract this 15,000 pounds to reflect that you do not have that cash yet.
Example
Your manufacturing firm shows a profit of 80,000 pounds. You purchased 10,000 pounds of raw materials that sit in your warehouse unsold. The indirect method subtracts this 10,000 pounds because cash was spent on stock.
Example
Your software startup posts a net loss of 20,000 pounds, but your depreciation expense is 25,000 pounds. The indirect method adds back this 25,000 pounds, showing your core operations actually generated 5,000 pounds in positive cash flow.
Think of it
“Imagine your bank account is a bathtub. Net profit is the water level you hope to reach, but the indirect method looks at the actual taps and drains. It sees that profit is high, but realizes the plug is out because customers have not paid yet, meaning the real water level in the tub is low.
Formula
Calculation
Net Profit + Depreciation Expense - Increase in Accounts Receivable - Increase in Inventory + Increase in Accounts Payable = Cash Flow from Operations. Example: 40,000 pounds net profit + 5,000 pounds depreciation - 8,000 pounds unpaid invoices - 4,000 pounds new stock + 6,000 pounds unpaid bills = 39,000 pounds actual cash flow.Case study
Seen in the real world.
GreenLeaf Gardening Supplies experienced a strong trading year, reporting a net profit of 120,000 pounds in its annual accounts. The managing director was thrilled, assuming the business had plenty of cash in the bank to fund an upcoming expansion. However, when the finance manager prepared the cash flow statement using the indirect method, a different picture emerged. The company had invested heavily in stock, leading to a 45,000 pound increase in inventory, which drained cash. Furthermore, corporate clients had delayed their payments, causing accounts receivable to rise by 30,000 pounds. On the positive side, depreciation added back 10,000 pounds of non-cash expenses, and supplier credit terms allowed accounts payable to increase by 15,000 pounds. When these adjustments were calculated, GreenLeaf's actual cash flow from operations was only 70,000 pounds, well below the net profit figure. Armed with this insight, the managing director paused the expansion plans, focused the sales team on collecting overdue customer invoices, and managed inventory levels more tightly to protect the company's bank balance.
Watch out
Common mistakes.
- Assuming net profit is the same as cash in the bank.
- Forgetting to add back non-cash expenses like depreciation.
- Subtracting an increase in liabilities instead of adding it.
Questions
People also ask.
Why is it called the indirect method?
Because it does not track individual cash receipts and payments directly. Instead, it takes your profit figure and works backward indirectly by making adjustments.
Do I have to use the indirect method?
Most small and medium businesses use it because it is much simpler to prepare from standard profit and loss accounts and balance sheets.
Does a positive cash flow mean my business is profitable?
Not necessarily. You can have positive cash flow while making a loss by selling off assets or delaying payments to suppliers.
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