The income statement and balance sheet don't tell the whole story of a company's financial position. Net income demonstrates how much in revenue and expenses the company accrued, but sometimes managers want to know how much cash went in and out of the business. Accountants need to adjust for changes in depreciation, inventory, receivables and payables to create a cash flow statement for the period.
Accountants can create a cash flow statement using either a direct or indirect method. The direct method means starting from scratch to determine ending cash. Using the direct method, the accountant calculates cash flow from company cash payments and receipts during the period. The problem with the direct method is that this information is rarely available. Companies record transactions on an accrual basis, not a cash basis. For this reason, accountants find it easier to use an indirect method. Using the indirect method, the accountant starts with the income statement and adjusts for non-cash expenses and revenue.
If the beginning inventory balance for the month isn't the same as the ending inventory balance, the accountant needs to make an adjustment on the cash flow statement. Whenever an asset other than cash increases, the accountant must decrease the cash balance. If the ending inventory balance is higher than the beginning, that means the company bought more inventory than it sold. In this instance, the accountant should decrease cash in the amount that inventory increases. The opposite is also true; if the inventory balance decreased, the company didn't make enough purchases to replace all the inventory it sold, and cash goes up..
Because receivables is also an asset, it follows the same pattern as inventory. If accounts receivable increases, that means the company recorded revenue, but it hasn't actually been paid for it yet. The accountant should decrease cash when receivables increase. Conversely, a decrease in accounts receivable means customers paid cash to lower their account balance. The accountant should add the amount of the receivables decrease to the company's cash balance.
Accounts payable is a liability and follows the opposite pattern compared to assets. An increase in accounts payable indicates that the company owes money to vendors and it hasn't paid it yet. Since an expense was accrued but cash wasn't paid, accountants add the amount of the increase to the cash balance. Likewise, a decrease in payables means cash flowed out of the company to vendors. Accountants subtract the amount of the decrease to company cash flow. Depreciation isn't a liability, but it does represent a non-cash expense, just like accounts payable. For this reason, accountants add back increases in depreciation to the cash flow statement.