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Records the starting profit figure on the cash flow statement before adjustments, exposing the accrual-based earnings baseline from which cash flow reconciliation begins.
Net income on the cash flow statement is the starting profit figure taken from the income statement. The cash flow statement then adjusts this number to move from accounting profit to actual cash generated.
Net income on the cash flow statement is the starting profit figure taken from the income statement. The cash flow statement then adjusts this number to move from accounting profit to actual cash generated.
The indirect method of preparing the cash flow statement starts with net income because:
- Accrual accounting: Net income includes non-cash items that must be adjusted
- Reconciliation: Shows how profit converts to operating cash flow
- Transparency: Highlights the difference between earnings and cash
Common adjustments to net income:
- Add back: Depreciation, amortisation, stock-based compensation
- Subtract: Gains on asset sales, increases in receivables
- Add: Losses, increases in payables, decreases in inventory
Why it matters:
- Quality of earnings: Large adjustments may indicate aggressive accounting
- Cash conversion: Companies with high net income but low cash flow may have earnings quality issues
- Sustainable profits: Cash-backed earnings are more reliable than paper profits
Compare net income to operating cash flow over multiple periods. Persistent gaps between profit and cash generation warrant investigation.
How it relates
Net Income (CF Statement)+Depreciation & AmortizationDepreciation and amortization are non-cash expenses that spread the cost of assets over time. They reduce reported profit but do not use cash in the current period, so they are added back when calculating cash flow.+Stock-based CompensationStock-based compensation is the value of shares or options given to employees as part of their pay. It counts as an expense in profit, but it does not use cash directly in the period so it is added back in the cash flow.+Deferred Taxes (CF)Deferred taxes in the cash flow statement reflect timing differences between when tax is recorded in the accounts and when it is paid in cash. Positive amounts typically add back to cash, while negative amounts reduce cash.+Other Non-cash ItemsOther non-cash items capture adjustments that affect reported profit but not current cash, such as write-downs or unrealised gains and losses. These are added back or subtracted to get closer to real cash flow.=Operating Cash FlowOperating cash flow is the cash the business generates from its normal day-to-day operations before investing and financing. It shows how much cash is coming in from customers after paying suppliers and operating costs.