In the indirect method, how is net income converted to net cash provided by operating activities?

• A. Start with net income, add back non-cash expenses (such as depreciation and amortization), and adjust for changes in working capital.
• B. Start with cash flow from operating activities.
• C. Subtract all non-cash expenses.
• D. Ignore non-cash items.

Answer: (A)

In the indirect method, you start with net income and adjust for items that affected net income but not cash, to arrive at net cash provided by operating activities. The key is to reverse non-cash effects and reflect changes in working capital. Non-cash expenses like depreciation and amortization reduce net income without using cash, so you add them back. Then you examine how operating assets and liabilities changed during the period—such as accounts receivable, inventory, and accounts payable—and adjust for those changes since they tie directly to cash flows. When receivables rise, cash collected is lower than revenue and you subtract the increase; when payables rise, cash outlays are deferred and you add. Collectively, starting with net income, adding back non-cash expenses, and adjusting for working capital changes converts accrual earnings into cash from operating activities.