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The cash flow statement shows all cash flowing in and out of your business. It’s divided into three categories, including operating, financing, and investing activities. A vital component of your company’s financial documents, it can be prepared using your choice of the direct or indirect method. So, what is a direct method cash flow statement, and how does it compare to the indirect method? Here’s what you need to know.
What is the statement of cash flows direct method?
The direct cash flow method uses real cash inflows and outflows taken directly from company operations. This means it measures cash as its received or paid, rather than using the accrual accounting method. Accrual accounting recognises revenue as it’s earned, rather than when you receive payment.
To prepare a cash flow statement using the direct method, you’ll need to rely on cash receipts and other documentation to find out when payment exchanged hands. It creates a straightforward, reader-friendly document with a list of cash receipts and payments. Total cash payments are subtracted from total cash receipts to arrive at net cash flow.
Cash flow direct method example
While the specific cash flow direct method format might vary, it’s usually a simple list of payments and receipts. Items associated with operational cash flows include things like:
Cash paid to suppliers and vendors
Cash received from customers
Income received from interest and dividends
Tax and interest payments
Here’s a simple cash flow direct method example to show what this document might look like:
Cash Flow from Operating Activities
Employee wages and salaries
Cash received from customers
Cash paid to suppliers
Income from interest
Income taxes paid to HMRC
Net cash from operating activities
Under each category, such as cash paid to suppliers, you can then provide a more detailed list of each individual payment for clarity.
Understanding indirect vs direct method cash flow
The differences between the direct and indirect methods only concern the operations section of the cash flow statement. The financing and investing sections of the cash flow statement will be identical under both methods.
With the indirect method, you use accrual accounting beginning with the income statement’s net income section. This is adjusted as needed using information from the asset and liability accounts on the balance sheet to arrive at cash flow. The direct method looks at individual cash receipts and payments, rather than relying on the more general net income figure.
Pros and cons of using the cash flow direct method
At first glance, the direct cash flow method might seem easier. You simply list and add together all the various cash inflows and outflows as they occur. However, pulling together and listing every single cash disbursement and receipt can be time consuming. It also leaves greater room for error if even a single receipt is missed. Furthermore, most businesses use the accrual accounting method which is compatible with the indirect method.
Yet there are many advantages to using the direct method as well. By listing all payments on the financial statement, a reader has access to highly specific information. Managers and investors can see exactly where money is flowing in and out of the business. By comparison, the indirect method is lower in detail.
Whichever method you opt for, maintaining an accurate cash flow statement helps keep your business on track. You can also improve cash flow using systems like GoCardless that reduce late payments. With automated invoice collection and integration with over 300 partners including top accounting software like Xero and others, we make accurate record keeping easier than ever.
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