indirect method

Imagine you know your profit for the month from your accountant — say 5,000 — but you want to know how much actual cash you gained. You start from that 5,000 and adjust it: 'My profit counted a 1,000 sale a customer hasn't paid yet, so subtract that; it subtracted 800 of wear-and-tear on my van that didn't cost me cash, so add that back.' Step by step you turn the profit figure into the real cash figure. That conversion process is the indirect method.

Under the indirect method, the operating section starts from net income and works back to operating cash flow by making three kinds of adjustments. First, add back non-cash expenses that reduced profit but used no cash (such as depreciation and amortization). Second, remove gains and losses that belong to other sections (like a gain on selling equipment, which is investing). Third, adjust for changes in working capital — for example, a rise in accounts receivable means sales were recorded but cash not yet collected, so subtract it; a rise in accounts payable means expenses were recorded but not yet paid, so add it.

This method dominates real-world reporting because the inputs — net income, depreciation, and the changes in balance-sheet accounts — are already sitting in the books, so it is cheaper to prepare. Its great virtue is that it doubles as a reconciliation: it shows exactly why cash differs from profit. Its drawback is that it is harder for a newcomer to read, because a long list of add-backs and subtractions looks nothing like a simple cash in / cash out statement.