What are the common adjustments when converting net income to cash flow from operations using the indirect method?
I understand the concept -- start with net income and adjust for non-cash items and working capital changes. But I keep messing up the signs. When do I add and when do I subtract? A clear framework would help.
The indirect method starts with net income and adjusts for (1) non-cash items included in income and (2) changes in operating working capital accounts. The goal is to arrive at cash actually generated from operations.
Framework: Three Categories of Adjustments
Category 1: Add Back Non-Cash Expenses
These reduce net income but do not use cash:
- Depreciation and amortization (+)
- Impairment charges (+)
- Stock-based compensation expense (+)
- Amortization of bond discount (+) / premium (-)
- Deferred tax expense (+) / benefit (-)
- Loss on asset disposal (+) / Gain on disposal (-)
Category 2: Remove Non-Operating Items
Items that belong in investing or financing sections:
- Gain on sale of equipment (-) -- already in investing cash flow
- Loss on sale of investments (+)
Category 3: Working Capital Changes
The sign depends on whether the change freed or consumed cash:
| Account | Increase | Decrease |
|---|---|---|
| Accounts receivable | (-) Cash not collected | (+) Cash collected from prior sales |
| Inventory | (-) Cash spent on stock | (+) Cash freed |
| Prepaid expenses | (-) Cash paid in advance | (+) Benefit consumed |
| Accounts payable | (+) Cash retained | (-) Cash paid to suppliers |
| Accrued liabilities | (+) Expense recognized, cash not yet paid | (-) Cash paid |
| Unearned revenue | (+) Cash received in advance | (-) Revenue earned |
Quick Rule: Current asset increase = subtract. Current liability increase = add. Reverse for decreases.
Example: Silverline Consulting reports:
- Net income: $450,000
- Depreciation: $65,000
- Gain on sale of office furniture: $12,000
- Increase in accounts receivable: $38,000
- Decrease in inventory: $15,000
- Increase in accounts payable: $22,000
- Decrease in accrued wages: $8,000
CFO Calculation:
| Item | Adjustment |
|---|---|
| Net income | $450,000 |
| + Depreciation | $65,000 |
| - Gain on sale | ($12,000) |
| - Increase in A/R | ($38,000) |
| + Decrease in inventory | $15,000 |
| + Increase in A/P | $22,000 |
| - Decrease in accrued wages | ($8,000) |
| = CFO | $494,000 |
Exam Tip: The sign convention trips up most students. Remember: if a current asset grew, the company spent cash (subtract). If a current liability grew, the company delayed paying cash (add). Gains are subtracted because they inflate net income but the actual cash is in CFI.
Practice more indirect method problems in our CFA Level I FRA question bank.
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