When it’s time to prepare your company’s cash flow statement, there are two main methods to choose from: direct and indirect. Both offer certain advantages and disadvantages using a slightly different approach. We’ll discuss the main difference between indirect and direct cash flow below, so that you can choose the best preparation method for your business.
Understanding the cash flow statement
To get started, it’s helpful to understand what the cash flow statement is and how it’s used. Along with your income statement and balance sheet, the cash flow statement is one of a company’s primary financial statements. It summarises all the cash that flows in and out of your business, so that you can view a quick snapshot of working capital over a certain period.
The cash flow statement measures how well a company can generate cash to pay off its debts and fund daily operations. It’s divided into three main sections:
1. Operating activities
This includes inflows from sales revenue, dividends, interest payments, and other cash receipts. Outflows under this category include everyday operating expenses like taxes, vendor payments, salaries, and wages.
2. Investing activities
The second section of the cash flow statement includes any gains or losses related to investments. This could include things like sales of business assets or loan payments.
3. Financial activities
Additional cash inflows and outflows raised externally would be included under financial activities. This would include the sales of your company’s securities, outgoing dividend payments to investors, or servicing debt.
Direct method cash flow
When it comes time to prepare your cash flow statement, your first option is to use the direct method. The statement of cash flows direct method is the most straightforward, focusing on the cash amounts received and paid. It uses the operating section of the cash flow statement as a basis for this calculation, subtracting all cash outflows (money spent) from all cash inflows (money received).
What types of transactions are included in a direct method cash flow process? Generally, this will be anything impacting daily operations, such as:
Cash payments from customers
Cash paid out to employees
Cash paid to vendors and suppliers
Interest paid out
Income tax payments
Rather than using net income as a starting point for calculations, the statement of cash flows direct method uses cash inflows alone. After subtracting outflows from inflows, the leftover value reveals either a positive or negative cash flow.
Indirect method cash flow
By contrast, the cash flow statement indirect method is a bit more complicated. It uses the accrual method of accounting and factors depreciation into the equation. To measure indirect method cash flow, you must reconcile profits, recognising that revenue and expenses take place at different times than when the cash is received.
The cash flow statement indirect method begins with net income as its starting point. You must then adjust this figure according to changes in the balance sheet to reconcile with cash inflows and outflows. Examples of typical adjustments include:
Adding a decrease in accounts receivable
Adding in depreciation expenses
Deducting decreases in accounts payable
Factoring in accrual entries
Difference between indirect and direct cash flow
As you can see, there are a few key differences between direct and indirect cash flow methods. The information from the operating activities is presented differently with each method. While the indirect method uses net income as its starting point and the accrual basis of accounting, the direct method uses the cash basis instead.
Either method is valid, but it’s important to note that most organisations choose to use the indirect method because it closely correlates to the general ledger. This makes it easier to prepare the cash flow statement. Ultimately, the best method will depend on your current accounting practices and preferences.
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