Indirect Method

Hi, can someone plz explain to me why a loss on sale and depreciation and all the other things you’d normally expect to be taken away, are actually added back onto the indirect method for Cash Flow statement ? i understand it’s to do with the flow of cash, but i need someone to explain the deprecation thing to me in simple terms. Thanks

Reply 1

MindMax2000

Universities Forum Helper

21

Original post by Madman11

Hi, can someone plz explain to me why a loss on sale and depreciation and all the other things you’d normally expect to be taken away, are actually added back onto the indirect method for Cash Flow statement ? i understand it’s to do with the flow of cash, but i need someone to explain the deprecation thing to me in simple terms. Thanks

Depreciation and loss on sale (to an extent) doesn't affect your cash position; but it does affect your equity and profitability.
Profit is an abstract concept. Cash is a very real concept.

It's not like if you had £3000 depreciation, someone would be running to your door demanding £3000 in payment. It affects your profitability (and equity), because it affects the value of your company, so to get a real measure of how well your company has performed or how much it's worth, you need to deduct depreciation. However, just because you had £3000 depreciation it doesn't mean your cash is down by £3000, so you add it back on to get an idea of how much cash has actually gone in and went out of your business.

As a side note, if the company is financially managed properly, whatever the company is charged for depreciation the company should set to one side to save up money to replace the depreciating asset at a later date. For example, if you had a machine initially worth £1000 and is depreciated by £200 each year for 5 years, by the end of the 5th year, you would need £1000 to buy another machine to replace the old one (due to wear, tear, general malfunction, etc.). However, this is only a side note.

Reply 2

Madman11

OP

13

ah thank you. in the second para, you mentioned how to get a real measure of the company we need to deduct depreciation. that’s the thing i’m confused on, as everywhere i’ve seen, depreciation is actually added on. i’m trying to wrap my head around this, as I understand depreciation doesn’t actually result in cash outflow, but it doesn’t result in cash inflow either, so why add it on ?

Reply 3

MindMax2000

Universities Forum Helper

21

Original post by Madman11

ah thank you. in the second para, you mentioned how to get a real measure of the company we need to deduct depreciation. that’s the thing i’m confused on, as everywhere i’ve seen, depreciation is actually added on. i’m trying to wrap my head around this, as I understand depreciation doesn’t actually result in cash outflow, but it doesn’t result in cash inflow either, so why add it on ?

It's to get a more precise picture of what your financial position (value of the company) and financial performance (profits) are.

Let's say I have a door that someone initially bought for £100, but it's now 80 years old, in complete disrepair, and practically falling apart. Should it be worth £100? What do you think the value of this door is to me?
A more relevant example would be a car. Cars depreciate like crazy. You would not buy the same car second hand at the same price as you would brand new. It makes sense; older and more used cars would need more maintenance work, possibly replace a number of parts, or can be so obsolete that it's no longer is useful (you wouldn't have a fleet of cars made in the 1920s on the road for example).
The value you attribute to the product/asset needs to reflect that, because the value of your business and the value of your financial performance will be directly affected. Keeping the asset at book value will give you an inaccruate picture of what the vompany is worth and how well you have performed.

Indirect Method

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