Plain definition
The indirect cash-flow method starts with a profit measure and reconciles it to cash from operating activities. It adds back expenses that reduced profit without using cash, such as depreciation, and adjusts for changes in operating working-capital balances. An increase in receivables usually reduces operating cash because customers have not yet paid; an increase in payables usually preserves cash because suppliers have not yet been paid.
Illustrative example
Monetary examples use Saudi riyals (SAR). The same principles apply in other currencies.
A manufacturer reports profit before the relevant adjustments. The figure includes depreciation, which is an accounting expense but no April cash payment. Receivables rise by as customers take longer to pay, while trade payables rise by because supplier invoices remain unpaid. The indirect reconciliation is + − + = operating cash flow.
Profit and operating cash happen to match in this case, but for different reasons. The finance director should not infer that collections are healthy: the receivables increase is a concrete claim on cash that needs a collection date in the forecast.
| Profit before relevant adjustments | |
|---|---|
| Depreciation added back | |
| Increase in receivables | |
| Increase in trade payables | |
| Operating cash flow |
Why it matters
Without the bridge, a manager may blame “cash conversion” in general and miss the actual driver. The method distinguishes a non-cash expense from a collection delay or a supplier-credit change, so the response can target the right process.
Practical consequence
Prepare the reconciliation from a controlled trial balance and identify the account behind every material adjustment. Compare the receivables and payables movements with aging reports and bank payments, then ask the commercial and procurement owners whether the movement will reverse and when. Do not use a balancing line called “other” to force cash to agree; describe the account and verify its classification.