HOW TO DETERMINE NET CASH PROVIDED BY OPERATING ACTIVITIES?
- October 22, 2021
- Posted by: Marek Niedzwiedz, Your CFO
- Category: Scaling Cash 4 eCommerce
Companies, including eCommerce businesses, adjust net income in numerous ways to determine net cash provided by operating activities under the method called Indirect.
A helpful starting point is understanding why net income must be converted to net cash provided by operating activities.
Under Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) most companies use the accrual basis of accounting. This basis requires that a company records revenue when the performance obligation is satisfied and record expenses when incurred. Revenues include credit sales for which the company has not yet collected cash. Expenses incurred include some items that it has not yet paid in cash. Thus, under the accrual basis of accounting, net income is not the same as net cash provided by operating activities.
Therefore, under the “indirect” method, companies adjust net income to convert certain items to the cash basis. The indirect method (or “reconciliation” method) starts with net income and converts it to net cash provided by operating activities.
Net Income +/− Adjustments = Net Cash Provided/Used by OperatingActivities.You need to add back non-cash expenses, such as depreciation and amortisation.You need to deduct gains and add losses that resulted from investing and financing activities.And finally, you need to analyse changes to non-cash current assets and current liability accounts.
Let me explain the 3 types of adjustments.
1. Depreciation (and amortisation) expense.Say your income statement reports depreciation of 10,000. Although depreciation reduces net income (by 10,000), it does not reduce cash. In other words, depreciation expense is a non-cash charge. The company must add it back to net income to arrive at net cash provided by operating activities.
2. Loss on disposal of plant assets.Cash received from the sale of plant assets is reported in the investing activities section. Because of this, companies eliminate from the net income all gains or losses resulting from investing activities to see what is the net cash provided by operating activities.Say your income statement reports a 5,000 loss on the disposal of plant assets (e.g. book value 9,000, less cash received from sale of equipment 4,000). The company’s loss of 5,000 is eliminated in the operating activities section of the statement of cash flows. It is eliminated by adding 5,000 back to net income to arrive at net cash provided by operating activities.
3. Changes to non-cash current asset and current liability accounts (this is a big one).A final step to reconcile net income to net cash provided by operating activities involves checking all changes in current asset and current liability accounts. The accrual-accounting process records revenues when the performance obligation is satisfied and expenses in the period incurred. For example, Accounts Receivable reflects amounts owed to the company for sales that have been made but for which cash collections have not yet been received. Prepaid Insurance reflects insurance paid for but has not yet expired and therefore has not been expensed. Similarly, Salaries and Wages Payable reflects salaries expense that has been incurred but has not been paid.As a result, we need to adjust net income for these accruals and prepayments to determine net cash provided by operating activities. Thus, we must analyse the change in each current asset and current liability account to assess its impact on net income and cash.
CHANGES IN NON-CASH CURRENT ASSETS.The adjustments required for changes in non-cash current asset accounts are as follows: deduct from net income increases in current asset accounts and add to net income decreases in current asset accounts to arrive at net cash provided by operating activities.Say your accounts receivable decreased by 10,000 (from 30,000 to 20,000) during the period. This means that cash receipts were 10,000 higher than sales revenue. To adjust net income to net cash provided by operating activities, your company would add to net income the decrease of 10,000 in Accounts Receivable.When the Accounts Receivable balance increases, cash receipts are lower than revenue recorded under the accrual basis. Therefore, the company deducts from net income the increase in accounts receivable to arrive at net cash provided by operating activities. Phew! It sounds complex, but it is not that bad, really.
INCREASE IN INVENTORY.Say your inventory increased by 5,000 (from 10,000 to 15,000) during the period. The change in the Inventory account reflects the difference between the amount of inventory purchased and the amount sold. This means that the cost of the stock purchased exceeded the cost of goods sold by 5,000. As a result, the cost of goods sold does not reflect 5,000 cash payments made for stock. The company deducts from net income this inventory increase of 5,000 during the period to arrive at net cash provided by operating activities. If inventory decreases, the company adds to net income the amount of the change to arrive at net cash provided by operating activities.
INCREASE IN PREPAID EXPENSES.Say your prepaid expenses increased during the period by 5,000. This means that cash paid for expenses is higher than expenses reported on an accrual basis. In other words, the company has made cash payments in the current period but will not charge expenses to income until future periods (as charges to the income statement). To adjust net income to net cash provided by operating activities, the company deducts from net income the 5,000 increase in prepaid expenses.If prepaid expenses decrease, reported expenses are higher than the expenses paid. Therefore, the company adds to net income the decrease in prepaid expense to arrive at net cash provided by operating activities.
Are you still there? There is a few more I am afraid 😉
CHANGES IN CURRENT LIABILITIES.The adjustments required for changes in current liability accounts are as follows: add to net income increases in current liability accounts, deduct from net income decreases in current liability accounts, and arrive at net cash provided by operating activities. Easy-peasy.
INCREASE IN ACCOUNTS PAYABLE.Say your accounts payable increased by 11,000 (from 12,000 to 23,000). That means the company received 11,000 more in goods than it actually paid for. So, to adjust net income to determine net cash provided by operating activities, your company adds to net income the 11,000 increase in the Accounts Payable account.
DECREASE IN INCOME TAXES PAYABLE.When a company incurs income tax expense but has not yet paid its taxes, it records income taxes payable. The Income Taxes Payable account change reflects the difference between income tax expense incurred and income taxes actually paid.Say your Income Taxes Payable account decreased by 2,000. That means that e.g. 47,000 of income tax expense reported on the income statement was 2,000 less than the amount of taxes paid during the period of 49,000. To adjust net income to a cash basis, the company must reduce net income by 2,000.
Voila! That’s it.