Net income, plus what was not cash, plus what working capital did

Starting from net income

The indirect method does not list the operating receipts and payments. It starts from net income — which already contains them, mixed with accruals — and undoes the accruals in three steps until only cash is left:

1. Add back non-cash expenses. Depreciation, amortisation and impairment losses reduced net income but moved no cash.
2. Remove non-operating items. A gain on selling equipment raised net income, but the cash from the sale sits in investing; subtract the gain (add a loss) so it is not counted twice.
3. Adjust for working-capital changes. Where revenue was earned but not yet collected, or expenses incurred but not yet paid, net income and cash differ by the change in the related current asset or liability.

The sign rules

The third step is where the marks are lost, so learn the two rules rather than twelve cases:

• A current asset increases → cash decreases → subtract the increase (subtract an increase, add a decrease). Receivables rose because customers have not paid; inventory rose because cash was spent on stock not yet sold; prepaids rose because cash was paid ahead of the expense.
• A current liability increases → cash increases → add the increase (add an increase, subtract a decrease). Payables rose because suppliers have not yet been paid; accrued liabilities rose because an expense was recorded before the cash left.

The working-capital lines are the operating ones only. The current portion of long-term debt is financing (its repayment is a principal payment), and dividends payable pairs with dividends paid in financing; neither is an operating adjustment.

Tamarack 2025

From the two balance sheets: receivables 480 → 600 (+120), inventory 560 → 720 (+160), prepaids 40 → 60 (+20), payables 400 → 480 (+80), accrued liabilities 100 → 120 (+20). Depreciation for the year was 180, and there was no disposal.

Net income                                   480
Add: depreciation                            180
Increase in accounts receivable             (120)
Increase in inventory                       (160)
Increase in prepaids                         (20)
Increase in accounts payable                  80
Increase in accrued liabilities               20
                                            ----
Cash from operating activities               460

Tamarack turned 480 of profit into 460 of cash. The 180 of depreciation is the largest reconciling item, as it usually is; the working-capital lines net to −200 because a 20 % growth year tied up 300 in receivables, inventory and prepaids while suppliers financed only 100 of it. Read that way, the section is already telling the story lesson 10.4 makes explicit.

With a gain on sale

Suppose a company reports net income of 200 after depreciation of 50 and a gain of 15 on selling a truck for 35 that had a carrying amount of 20. Receivables rose 30, inventory fell 10 and payables rose 20.

Net income                                   200
Add: depreciation                             50
Less: gain on sale of truck                  (15)
Increase in receivables                      (30)
Decrease in inventory                         10
Increase in payables                          20
                                            ----
Cash from operating activities               235

The 35 of proceeds appears in investing. Had the gain been left in, the 15 would have been counted in operating and inside the 35 in investing. A loss on sale is the mirror: added back, with the proceeds still in investing.

The direct method (lesson 10.3) reaches the same 460 or 235 by listing receipts and payments. The indirect method is what nearly every Canadian company publishes and what the final asks you to build.