In an indirect cash flow statement, what adjustments are made to net income to arrive at cash from operating activities?

• A. Subtract all non-cash items
• B. Only adjust for changes in inventory
• C. Add back non-cash items (D&A, impairment, stock-based comp), adjust for changes in working capital, and reflect taxes and interest payments as applicable.
• D. Ignore cash taxes

Answer: (C)

In the indirect method, you convert net income to cash from operating activities by accounting for items that affected reported earnings but not actual cash flow. You start with net income and add back non-cash charges such as depreciation and amortization, impairment, and stock-based compensation, since these reduce net income without using cash. You also adjust for changes in working capital—accounts like accounts receivable, inventory, accounts payable, and other current assets and liabilities—because increases or decreases in these balance sheet items affect cash even though they don’t show up as expenses or revenues in the period. Finally, you reflect cash taxes and cash interest payments as applicable, since the cash outflows for taxes and interest influence operating cash but aren’t captured the same way in net income. This combination—adding back non-cash items, adjusting for changes in working capital, and incorporating cash taxes and interest—produces the cash flow from operating activities.

Substitute options miss the point: subtracting all non-cash items is incorrect because these items are added back, not subtracted; adjusting only for inventory ignores other working capital changes that impact cash; and ignoring cash taxes would omit real cash outflows.