Indirect Cash Flow: Why Net Income Is Not Cash
Norwick Traders reports net income of $210,000 for the year. Additional data: depreciation expense $48,000; a gain of $15,000 on the sale of equipment; accounts receivable increased $30,000; inventory decreased $22,000; accounts payable decreased $18,000; and accrued liabilities increased $9,000. The company also purchased equipment for $120,000 cash and paid $40,000 of cash dividends. The owner asks the accountant, "We earned $210,000 - why is our cash lower than that?" The accountant is preparing the operating activities section using the indirect method.
1. Compute cash provided by operating activities using the indirect method, and explain the logic behind each adjustment.
Read the worked answer
Start with net income and adjust to cash basis:
| Item | Amount |
|---|---|
| Net income | $210,000 |
| + Depreciation expense | +$48,000 |
| − Gain on sale of equipment | −$15,000 |
| − Increase in accounts receivable | −$30,000 |
| + Decrease in inventory | +$22,000 |
| − Decrease in accounts payable | −$18,000 |
| + Increase in accrued liabilities | +$9,000 |
| Cash from operations | $226,000 |
Logic:
- Depreciation is a noncash expense added back (it reduced income but not cash).
- Gain is subtracted because the cash proceeds belong in investing, not operating; leaving the gain in operating would double-count.
- AR increase means sales exceeded collections → subtract.
- Inventory decrease means purchases were less than cost of goods sold → add.
- AP decrease means the company paid more than it purchased on credit → subtract.
- Accrued liabilities increase means expenses exceeded cash paid → add.
2. The owner is confused because cash from operations ($226,000) exceeds net income. Explain in plain terms why this can happen, and identify where the equipment purchase and dividends appear.
Read the worked answer
Why cash exceeds net income: Net income includes noncash items (depreciation) and is affected by timing of collections and payments. Here, adding back $48,000 of depreciation and benefiting from working-capital shifts (inventory down, accruals up) more than offsets the drag from receivables growing and payables shrinking. It is entirely normal for operating cash flow to differ from net income - the statement of cash flows exists precisely to bridge that gap.
Equipment purchase ($120,000): an investing outflow - cash paid to acquire a long-term asset.
Dividends ($40,000): a financing outflow - a distribution to owners.
So the $226,000 operating inflow does not equal the change in total cash; the $120,000 investing outflow and $40,000 financing outflow must also be netted. Net change in cash = $226,000 − $120,000 − $40,000 = +$66,000. The gain's cash proceeds from the equipment sale also belong in investing and are excluded from operating, which is why the gain was subtracted above.