No. 84 Indirect Method of Operating Cash Flow

There are two ways to prepare a cash flow statement: the "direct method" and the "indirect method."
The direct method is a way of calculating the total cash flow for each major transaction, such as operating income and expenditures from the purchase of raw materials or products.
The indirect method is a way of calculating based on the figures recorded in the "balance sheet" and "income statement."
Since individual transactions are generally not made public, investors cannot determine the figures using the "direct method."
Therefore, while the "indirect method" is basically used to determine the figures, knowing this "indirect method" allows you to understand the problems inherent in "cash flow."

For example, "Operating CF" can be calculated using the following formula.

(1) Net income (+) or loss (-) amount
(2) Non-cash expenses such as depreciation (+)
(3) Increase (-) or decrease (+) in trade receivables
(4) Increase (-) or decrease (+) in inventories
(5) Increase (-) or decrease (+) in other current assets
(6) Increase (+) or decrease (-) in accounts payable
(7) Increase (+) or decrease (-) in other liabilities

In other words, to increase the positive (+) "Operating CF," the following conditions must be met.

(1) The higher the net income (+), the better.
Since net income can simply be rephrased as an increase in cash, it can be said that the higher the profit amount, the more cash accumulates.

(2) The higher the non-cash expenses such as depreciation (+), the better.
Here, "non-cash expenses" refers to accounting expenses that do not involve cash expenditures.
As you can see when considering depreciation and goodwill, depreciation and the like reduce asset value, so they are calculated as a minus (-) on net income.
However, since they are not actually paid and cash does not decrease, the amount subtracted in the calculation becomes a plus on the cash side.

(3) The lower the trade receivables, the better.
Trade receivables are classified as accounts receivable.
In other words, it is money that has been sold but not yet received, so it is calculated in net income, but has not yet been collected as cash.
Therefore, if trade receivables increase, cash becomes negative (-), so the lower they are, the better.

(4) The lower the inventory, the better.
Inventory refers to stock, which is items purchased for the purpose of sale or consumption that still remain within the company.
In other words, inventory is what has been made as a product but remains unsold; if it sells, it turns into cash, but if it doesn't sell, it becomes dead stock and turns into trash.
Therefore, if inventory increases, cash becomes negative (-), so the lower it is, the better.

(5) The lower the other current assets, the better.
Other current assets are assets other than cash equivalents and inventory that will be converted into cash within one year. This includes advance payments, short-term loans, accounts receivable, suspense payments, and temporary payments.
As explained in the case of trade receivables, all of these can be considered as accounts receivable.
Therefore, although they are calculated in net income, they have not yet been collected as cash, so the lower they are, the better.

(6) The higher the accounts payable, the better.
Accounts payable are the exact opposite of trade receivables; they are things that have been bought but for which payment has not yet been made.
Therefore, they are calculated in net income, but have not yet been paid as cash.
In other words, if accounts payable increase, cash becomes positive (+), so the higher they are, the better.

(7) The higher the other liabilities, the better.
Think of other liabilities mainly as borrowings from banks.
Since "an increase in debt = an increase in cash on hand," if other liabilities increase, the cash on hand increases by that much.
Accounts payable are also included.
Remember that accounts payable are the opposite of accounts receivable.

Therefore, when there is a large change in "Operating CF," you can read the impact depending on which of these subdivided conditions has changed.
If "Operating CF" is small even though operating profit is large, and "inventory" has increased significantly, it indicates that unsold goods are increasing rapidly and there is a "risk" of recording a loss in the near future.
Similarly, if "trade receivables" have increased rapidly, you need to confirm whether they are actually selling.
For example, there might be a case where a contract is signed with a free three-month trial, and that is being recorded as sales.
In this way, for companies you are considering investing in, you should check the subdivided "Operating CF" figures to "risk hedge."