Definition of the Indirect Method for Calculating Cash Flows

The indirect method is one of the approved methods for preparing the cash flow statement, and relies on starting with net income from the income statement and then making adjustments to it to arrive at net cash flow from operating activities. These adjustments include adding non-cash expenses such as depreciation and provisions, subtracting non-cash revenues, in addition to adjusting changes in working capital such as accounts receivable, accounts payable, and inventory. This method is considered more common and widely used than the direct method because it is easier to apply and relies on data available in the basic financial statements.

Steps for Implementing the Indirect Method for Calculating Cash Flows

The indirect method follows a set of systematic steps to convert from accounting net income to net cash flow from operating activities:

1. Start with Net Income - Take net income from the income statement as a starting point
2. Add Non-Cash Expenses - Add depreciation, amortization, provisions, and impairment losses
3. Subtract Non-Cash Revenues - Subtract any revenues not received in cash such as gains on sale of fixed assets
4. Adjust Changes in Current Assets - Subtract increases in accounts receivable, inventory, and prepaid expenses, and add decreases in them
5. Adjust Changes in Current Liabilities - Add increases in accounts payable and accruals, and subtract decreases in them
6. Arrive at Final Result - Obtain net cash flow from operating activities

Advantages and Benefits of the Indirect Method for Calculating Cash Flows

The indirect method is characterized by ease of application and reliance on data available in basic financial statements without the need for complex additional information, making it less costly and faster to prepare. It also clearly shows the relationship between accounting net income and operating net cash flow, helping users understand the differences between profitability and liquidity. This method is considered the most common and widely used by companies and accountants around the world, and provides useful information about changes in working capital and their impact on cash flows, in addition to facilitating the review and audit process for external auditors.

Disadvantages and Challenges of the Indirect Method for Calculating Cash Flows

The indirect method faces several disadvantages, most notably not showing actual cash inflows and outflows, making it less detailed and transparent than the direct method in clarifying sources and uses of cash. It may also be confusing for non-specialist users who find difficulty in understanding the reconciliation processes and adjustments required to convert from the accounting basis to the cash basis. This method lacks precise details about sources of cash collections and destinations of operating payments, limiting analysts' ability to assess the company's real ability to generate cash from its core operations. Additionally, it may hide important information about cash flow patterns and requires complex reconciliation processes that may lead to application errors.

Comparison Between the Indirect Method and Direct Method for Calculating Cash Flows

The indirect method differs from the direct method in several important aspects that affect companies' choice of one of them:

Direct Method	Indirect Method	Comparison Aspect
Actual cash flows	Net income + adjustments	Starting point
Complex and needs additional information	Simple and relies on existing statements	Ease of application
More detailed and clear	Less detailed	Level of detail
Higher in cost and time	Lower cost and time	Cost
Less usage	Most common	Practical usage
Shows actual cash sources	Shows relationship with net income	Type of information
Preferred by analysts	Preferred by accountants	User preference

Summary: The direct method is more detailed but the indirect method is easier and more widely used.

Comprehensive Practical Example of the Indirect Method for Calculating Cash Flows

Al-Noor Trading Company - Financial Data for 2024

Given Data:

• Net income from income statement: 500,000 SAR
• Depreciation of equipment and buildings: 80,000 SAR

Changes in Current Assets and Liabilities:

• Accounts receivable: Increased from 150,000 to 210,000 (increase of 60,000)
• Inventory: Decreased from 200,000 to 160,000 (decrease of 40,000)
• Prepaid expenses: Decreased by 15,000
• Accounts payable: Increased from 120,000 to 150,000 (increase of 30,000)

Calculation of Net Cash Flow from Operating Activities:

Explanation	Amount (SAR)	Item
Starting point	500,000	Net income
		Adjustments for non-cash expenses:
Non-cash expense (added)	80,000	+ Depreciation
		Adjustments for working capital changes:
Asset increase (subtracted)	(60,000)	- Increase in accounts receivable
Asset decrease (added)	40,000	+ Decrease in inventory
Asset decrease (added)	15,000	+ Decrease in prepaid expenses
Liability increase (added)	30,000	+ Increase in accounts payable
Final result	605,000	Net operating cash flow

Analysis:

The company achieved operating cash flow of 605,000 SAR, which is 105,000 SAR higher than net income, reflecting the strength of the financial position and efficiency of working capital management.