Indirect method of calculating the cash flow
Hi all,
I have a question regarding the indirect way of calculating the companies cash flow. So looking at the operating cash flow, I understand why we have to deduct increases in inventory (so because they are cash expenses), but why do I add the decrease of inventories (so my problem is I don't understand why because we don't get any money right from a decrease, only when we sell our stuff for cash)?
Thanks for your help
PS: I hope you understand my english (it is not my native language)
Whenever, we try to answer a technical we want to think about the big picture of what we are doing not how we do it.
So for operating activities cash flow adjustments we are trying to reconcile net income to cash flows. This means adding back non-cash expenses and subtracting out non-cash operating expenditures that will be recognized as cash flows in future periods.
For inventory, when inventory increases (or any current asset increase) we are recognizing that we are spending cash to gain an asset that we have not yet used, so has ont yet been recognized as an expense. We thus subtract increases.
When it decreases, it has lowered our net income via COGS..Since this is our starting line on cash flows it essentially is recognizing this expenditure as a cash outflow. However, due to the above rationale it was already recognized as a cash outflow and we thus want to make sure we don't recognize it as a cash outflow twice (since we aren't paying out cash this time) so we add it back.
The same rationale applies to current liabilities, but it is the opposite.
Many thanks, man! This helped me massively!
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