When you need to prepare a cash flow statement, there are two options – direct method or indirect method. Both methods provide you with the same result, but their methodology differs in several significant ways. Check out our comprehensive guide to find out more about the cash flow statement indirect method and get a little more information about the direct method vs. indirect method of cash flow.
What is the indirect method of cash flow?
There are two ways to generate a cash flow statement: the direct method and the indirect method. The indirect method uses changes in your balance sheet accounts to calculate cash flow from operating activities. Put simply, any changes in asset and liability accounts that may affect your cash balances throughout the reporting period are added or subtracted from your net income at the beginning of the period, providing your operating cash flow. By contrast, the direct method lists all your business’s cash inflows and outflows during the reporting period, thereby allowing you to calculate your net cash flow from your business’s operating activities.
How to prepare a cash flow statement using the indirect method
It’s much easier to understand the indirect method of cash flow by looking at how to prepare a cash flow statement in depth:
Set up the statement – When you’re calculating cash flow using the indirect method, you’ll start by recording the net income for a given period, before subtracting or adding non-cash expenses, losses, and gains. Non-cash expenses can include items like depreciation, amortization, and depletion.
Adjust your net income – Then, you’ll need to adjust your net income for changes in asset accounts that may have affected your company’s cash. Some of these accounts include inventory, prepaid expenses, and accounts receivable. At this point, you’ll need to calculate how these changes affect cash to work out which way your net income should be adjusted. For example, if an asset increases during the recording period, cash has left your business, so the increase needs to be subtracted from your net income.
Account for liabilities – Finally, you’ll need to adjust your net income for changes in your liability accounts. Some of the accounts that you’ll need to consider include accounts payable and accrued expenses. This step can be especially tricky, as liabilities have a credit balance, rather than a debit balance. In short, increases in liabilities must be added back into income, not subtracted. After you’ve made all these cash flow statement indirect method adjustments, you’ll have the total amount of cash from operating expenses.
To see what the indirect method of cash flow looks like when you put all that information together, AccountingTools have produced an example of a statement generated using the indirect method, and there are many other examples and templates available online that you can explore at your leisure.
Cash flow statement indirect method format in Excel
There are a broad range of online tools that can help you produce a cash flow statement. For example, there are many different templates that include a cash flow statement indirect method format in Excel. After you’ve downloaded the template, all you need to do is enter your business’s financial information to calculate cash inflows and outflows according to the indirect method.
Direct method vs. indirect method of cash flow
When it comes to the direct method vs. indirect method of cash flow, you should remember that neither method is more effective than the other – they both provide the same result. Ultimately, it all comes down to personal preference. Many accountants prefer using the indirect method because it can be prepared relatively easily using information from your balance sheet and income statement. Having said that, the Financial Accounting Standards Board (FASB) favours the direct method, as it provides a clearer picture of the cash flows moving in and out of your business.
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