USA SCF Indirect Method and Inventory

[Adrien]

Can someone explain why we subtract inventory increases from Net Income in the Indirect Method of calculating SCF?

I understand why we subtract Accounts Receivables: an increase in A/R is a non-cash increase in revenue and therefore a non-cash increase in Net Income. So, we subtract A/R from NI to get operations cash flow. But an increase in inventory does not affect the net income; it could increase A/P, but we are already including A/P in the Indirect Method separate from inventory!

To summarize, I can clearly see the relationship between A/R, A/P, Depreciation to Net Income and their place in the Indirect Method, but not Inventory.


Thanks,

Adrien

 

[Triest123]

Can someone explain why we subtract inventory increases from Net Income in the Indirect Method of calculating SCF?

I understand why we subtract Accounts Receivables: an increase in A/R is a non-cash increase in revenue and therefore a non-cash increase in Net Income. So, we subtract A/R from NI to get operations cash flow. But an increase in inventory does not affect the net income; it could increase A/P, but we are already including A/P in the Indirect Method separate from inventory!

To summarize, I can clearly see the relationship between A/R, A/P, Depreciation to Net Income and their place in the Indirect Method, but not Inventory.


Thanks,

Adrien

Remeber that (gross) profit is in line with the goods which is actually sold out (i.e. the costs of goods)

For example, If you purchase 10 units of goods at $10 each, and 6 units of goods is sold at $15 each.

Assumed there is no opening inventory, you earn the profit is $30 ($15 x 6 units - $10 x 6 units), that means you have a cash inflow of $30.

However, you, in fact, get a cash outflow of $10 (i.e. Purchase $100 - Sales $90), that making the difference of -$40 (i.e.-$10 - $30), which is exactly equal to costs of closing stock ($10 x 4 units) = $40 (i.e. the increase in inventory of $40)

Therefore, you must consider the change in inventory level as it has a impact on cashflow under indirect method, otherwise you would understate / overstated
the operating cash flow. As a result, the cash flow would not match with the cash balance as shown on the balance sheet.

The change in "Account Payable" is also consider
as the "purchase" need to be converted from Accrual basis to Cash basis