The indirect method is the most used in accounting and financial practice, especially by medium and large companies that prepare their financial statements under the principle of causation (accrual). Unlike the direct method —which shows the actual cash flows—, the indirect method starts from the accounting operating profit (EBIT) and adjusts it by returning non-monetary items, such as depreciation and amortization, to reflect the true generation of cash from operations.
Thanks to this structure, the indirect method connects the income statement with the cash flow state, facilitating a comprehensive vision of financial performance. Although it does not have the level of detail of the direct method, its practicality makes it ideal for general financial analysis and for the presentation of formal reports to third parties. Cash flow is organized into three major activities.
Operational Cash Flow
It is, without a doubt, the most important section of the cash flow statement: it reflects the ability of the business to generate cash from its main activity. For its calculation, it starts from the EBIT and adjusts the accounting effects that do not affect the cash —depreciation and amortization— thus reaching EBITDA. Then the changes in working capital, the true thermometer of the use or generation of cash in daily operations are incorporated.
- If accounts receivable increase, more has been sold on credit, or there are collection problems: that money has not yet entered, it is a cash out.
- If inventories increase, more than what has been sold has been bought: it is a resource immobilization, another cash outflow.
- If accounts payable increase, more purchases with suppliers have been financed: it is a temporary cash income.
It is not uncommon to find companies with positive utility and negative cash, precisely due to an imbalance in these areas. When the operating flow is recurrently negative, it is a clear signal that the model is not sustainable and will need external financing constantly, something difficult to sustain over time. This rule does not necessarily apply to startups in early stages, which depend on investment rounds while looking for a scale that supports their future growth.
Investment Cash Flow
It reflects the movements of buying and selling assets with a long-term vision: machinery, equipment, vehicles, infrastructure or financial investments in other companies. A negative investment flow is not necessarily a bad signal: it can reflect growth and modernization, as long as it is aligned with the strategy and supported by future operating flows.
One of the most common mistakes is to invest prematurely in assets before having met basic operating cash needs, especially in the purchase of oversized assets that generate idle capacity. When the operation is not yet solid or stable, the acquisition of unproductive or sumptuous assets that do not add real value to the business growth must be avoided.
Cash flow of financing activities
It reflects the inflows and outflows of cash related to the resources that the company obtains from third parties —banks, investors— or delivers them: loans received, payment of capital and interest, issuance of shares or distribution of dividends. A positive flow usually indicates that the company is bringing resources; A negative one, which is paying back debt or distributing profits.
Indebtedness should not recurrently make up for the lack of operating cash: financing growth is valid, but covering constant deficits with debt is unsustainable. A basic principle of finance is that the long-term is financed in the long term: fixed assets with short-term loans should not be financed, since it generates liquidity pressures. An alert signal is a consistently negative operating flow accompanied by a persistently positive flow of financing: the business is surviving thanks to borrowing or capital contributions, which is unsustainable over time.
Cash reconciliation: the data that does not lie
The sum of the flow of operations, the flow of investment and the flow of financing results in the net change of cash in the period:
Initial Cash Balance + Net Variation = Final Cash Balance
This relationship must always fit, because it is about real money, not projections or estimates. If the reconciliation is not met, there are errors in the flow or unregistered movements. Cash in cash or banks does not admit subjective adjustments: that is why this financial statement must always close.
Free Cash Flow (FCF): How the actual value of a business is measured
Free cash flow represents the money that is available to owners of capital and creditors, after the company has met two needs: operating the business day by day and reinvesting what is necessary to maintain or expand its productive capacity. It is a truly free measure of money, not tied to operational commitments or mandatory reinvestment.
FCF = Operating Cash Flow − CAPEX
FCF = Net income + D&A − Δ Working capital − CAPEX
A company that generates positive and growing free cash flow can self-support without relying on debt, grow without diluting its shareholders, strongly negotiate with investors or banks, and create real economic value.
Free cash flow uses:
- Company valuation: The Cash Flow Discount Model (DCF) is part of the FFC to estimate the value of a company.
- Evaluation of strategic decisions: if there is enough box to expand, diversify or make acquisitions.
- Measurement of operational and financial efficiency: reveals how well resources are managed.
- Comparison between companies of different sizes or sectors.
Clarus Council: Don’t just look at the accounting utility: look at the box, and above all, look at the free box. That is where the story of value really begins.
At Clarus Consultores we help you build and interpret your cash flow by indirect method, connecting it with your company’s real value and strategy. Let’s talk about the cash generation of your business.