Direct vs Indirect Cash Flow

Both of these methods should leave you with the same figure, but they both take a different journey to get to that figure. It’s in fact the calculation that differs between the two as it draws upon different sources of data to reach the final figure. If your cash flow conversion is too slow, you won’t have the money you need to pay for essential expenditures, like rent or employee wages.

You may also have fewer non-cash assets in general, making the direct method a better way of showing your business’ true cash flow amounts. If you’re a large corporation, however, your financial health isn’t represented accurately with the direct cash flow method. The direct method, also known as the income statement method, is one of two methods utilized while crafting the cash flow statement—the other method being the indirect method, which we will examine later.

Your cash flow statement tells a critical part of your financial story, no matter which approach you use. It can also give you the ultimate flexibility to run your business responsibly. On the other hand, the indirect method is much easier for the finance team to create but harder for outside readers to interpret. It might be a better option for leaner teams who don’t have the time or resources to follow the direct method. You debit accounts receivable and credit sales revenue at the time of sale. For example, the bigger your company is, the more labor-intensive the direct method will become.

Auditors and financial analysts can quickly trace the line items of an indirect cash flow statement using the other financial reports for the period. In addition, there is no need to reconcile cash generated from operations. Among the main trifecta of financial reports–the balance sheet, income statement and cash flow statement–it’s often the statement of cash flow that gets the least attention and time. But as a view into your company’s liquidity, it provides an important piece of the puzzle. The indirect cash flow method makes reporting cash movements in and out of the business easier for accruals basis accounting. But there are several ways in which these can be put together, which may give different figures.

While favored by financial guides, the direct method can be difficult and time-consuming; the itemization of cash disbursements and receipts is a labor-intensive process. To add to the complexity, the Financial Accounting Standards Board (FASB) requires a report disclosing reconciliation from all businesses utilizing the direct method. While the two methods only apply to the operating section of the cash flow statement, the method you choose to utilize will have important implications for your business. If your team hasn’t prepared a direct method cash flow statement in years but has 10+ years of experience using the indirect method, this is likely the better choice.

Which method of calculating cash flow should my business use?

If the cycle is too fast, you may not be using available cash effectively. For example, you could use surplus cash to pay off old debts or put some excess funds into investments. You can take a look at how they differ as well as their advantages and disadvantages to help you decide which is right for your business. Do you want to talk more about choosing the right financial solutions for your business? Take a look at Vena’s financial reporting solutions here, or reach out to discuss what’s right for you. Factors like the industry you’re working in and the audience you’re reporting for (whether management or banks, auditors or shareholders) will make a difference.

• It’s important to remember that the indirect method is based on information from your income statement, which could have certain limitations.
• It’s also compliant with both generally accepted accounting principles (GAAP) and international accounting standards (IAS).
• The indirect method is preferred by the International Financial Reporting Standards (IFRS), making it a common choice both among small and large companies for compliance purposes.
• On the indirect cash flow you’ve got to work through these cash inclusions and exclusions adjusting the top net profit figure to get to the cash figure at the bottom.

The cash flow statement is the only one out of the three main financial statements that has multiple ways you can prepare it. Using each of these values, you will prepare the operating section of the cash flow statement, resulting in a net cash flow from operating activities. The indirect method uses your net income as its base and comes to a figure by the use of adjustments.

What is a cash flow statement?

As you can imagine, the risk of mistakes on a direct cash flow statement is more significant than on a cash flow statement prepared using the indirect cash flow method. If you want to get started with your direct or indirect cash flow statements, grab our free 3-statement model Excel or Google Sheets template. It’s important to remember that the indirect method is based on information from your income statement, which could have certain limitations. This means you may need to take additional actions, such as accounting for earnings before taxes and interest, and making adjustments for non-operating expenses such as accounts payable and depreciation. Unsure of the difference between direct and indirect cash flow reporting?

Direct or Indirect Cash Flow: Which Is the Right Fit for Your Business?

Conversely, the cash flow direct method measures only the cash that’s been received, which is typically from customers and the cash payments or outflows, such as to suppliers. The direct method individually itemizes the cash received from your customers and paid out for supplies, staff, income tax, etc. And again, a closing bank statement emerges–the same closing bank statement you’d get using the indirect method.

The direct method is an accounting treatment that nets cash inflow and outflow to deduce total cash flow. Notably, non-cash transactions, such as depreciation, are not accounted for using the direct method. One of the main differences between the direct and indirect method of presenting the financial statement of cash flows is the type of transactions that are used to produce the cash flow statement.

What you’ll learn to do: Distinguish between the Direct and Indirect methods of preparing a statement of cash flow

The accounting manager cannot use changes between assets and liabilities to measure variations in receivables and payables under the direct cash flow method. Instead, each transaction that affects cash is appropriately categorized. The difficulty and time required to list all the cash disbursements wave community and receipts—required for the direct method—makes the indirect method a preferred and more commonly used practice. Since most companies use the accrual method of accounting, business activities are recorded on the balance sheet and income statement consistent with this method.

Direct method cash flow vs indirect method cash flow: How they’re different

It will also exclude other cash-based transactions because they don’t have an impact on profit. Net profit is the result of all the transactions recorded on your profit & loss report. Here are some important considerations you can make to help determine which method you should utilize. Though it is the more popular method, there are still some potential drawbacks to keep in mind for the indirect method.

Introduction to cash flow statements

This type of statement is highly detailed, and helps you determine whether or not you need to plan for short-term cash availability. The indirect method is relatively complex method as compared to the direct method as it utilizes net income as the base and performs necessary cashflow adjustments. One of the adjustments can be regarded as the treatment of non-cash expenses. In indirect method, depreciation which is a non-cash expense is generally added back to the net income followed by additions and deductions arising from the changes in liabilities and assets. If you just look at one figure at the bottom of an indirect cash flow, you can see what has happened, but this needs to be broken down to understand why.