Indirect method
The indirect method uses the company's accounting to calculate the operating cash flow. It consists of subtracting from the profit and loss account (P&L) all revenues and expenses that do not involve receipts or payments (i.e. do not involve cash flows) and adding to the other transactions not included in the P&L that do involve cash flows.
In the first case, we’ll find depreciation or amortization of fixed assets or provisions, although these amounts are registered as an expense, they do not represent a real cash outflow. In the second case, we can find some investments in fixed assets not included in the income statement that does involve a cash outflow.
Mathematically:
Operating cash flow (OCF) = Income statement + Amortization/Provisions - cash outflows due investments.
As a clarification, all items that do not imply cash outflows are added because, since they are already included in the profit and loss account as a subtracting concept, it is necessary to add them to eliminate them from the equation. This occurs with depreciation or purchases from suppliers made on credit. Similarly, credit sales that do not involve cash inflows must be subtracted from the income statement, since they are already included.
For example, imagine the following accounting of a company:
Income statement | 50.000 £ |
Items that have no impact on cash |
(+) Amortization ** | 20.000 £ |
(+) Depreciation ** | 10.000 £ |
Variation in operating expense items |
(+) Increase in accounts payable | 2.500 £ |
(-) Increase in accounts receivable | 55.000 £ |
(+) Decrease in inventories | 5.500 £ |
TOTAL OPERATING CASH FLOW IM | 33.000 £ |
