In the context of the indirect method for calculating net cash flow from operating activities, a decrease in inventory is added to net income.
This is because the indirect method starts with the net income as reported on the income statement and makes adjustments for non-cash items and changes in working capital accounts. When inventory decreases, it signifies that more goods have been sold than were purchased during the period. This reduction in inventory reflects an actual cash inflow since the sales result in cash being received, improving cash flow even if that wasn’t fully reflected in the net income figure.
To break it down:
- Net income includes revenues minus expenses, but it does not directly account for cash flow from changes in inventory.
- When inventory decreases, this increase in cash indicates that cash is flowing into the company from sales made.
- Thus, for the purpose of calculating cash flow from operating activities, we add the decrease in inventory to net income.
In summary, a decrease in inventory represents a positive cash flow adjustment, and hence it is added back to net income to arrive at net cash flow from operating activities using the indirect method.