The direct method of cash flow starts with the cash inflows and outflows of your business, while the indirect cash flow method starts with your net income. We review both methods and which to choose.
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Compared to an income statement or balance sheet, the cash flow statement (CFS) does a better job of measuring how well a business manages its cash position. That’s why accounting professionals recommend preparing a CFS every month – because most billings and operating expenses (like wages and rent) are monthly.
But how do you prepare a cash flow statement? You can either use the direct or indirect cash flow method. Both approaches are standardized and will yield the same values. In this article, we break them down and help you pick the option that better suits your business.
Cash flow definition
A statement of cash flows is a budget summary that shows changes in the cash and cash equivalents of a business. It essentially displays how money moved in and out of a company over a given period of time. In doing so, a CFS acts as a bridge between the balance sheet and income statement.
The income statement doesn’t show specific cash inflows and outflows. Instead, that information goes to the cash flow statement, which is then used to compute revenues and expenses in the income statement. Both of those metrics (revenues and expenses) are used to adjust current assets and current liabilities on the balance sheet.
In short, the cash flow statement aids in the preparation of your company’s financial statements. Just as important, a CFS tracks how cash comes into and goes out of your business, helping you monitor cash movements more effectively. Stakeholders – including lenders, investors, your team, and even the government – use this information to determine where your money is coming from and how it’s being spent.
That said, a cash flow statement is more important to you as the owner of the business. You can use the data from a cash flow statement to figure if your company has sufficient money to sustain its debts and expenses, and thus keep up with operations.
The cash flow statement has three main components that help track cash movements across the board:
Operating cash flow: this covers cash flow from operating activities. It includes all the money that’s earned and spent when providing goods and services to customers.
Investment cash flow: includes all the money that your business spends on investments. Examples include equipment purchases.
Financing cash flow: this is money earned and spent on financing activities like stocks, bonds and dividend payments.
The three components of a cash flow statement make it highly intuitive. When you add them all, you get the net cash flow. I.e.,
When preparing a cash flow statement, you can either use the direct or indirect cash flow approach. The main difference between the two is that direct method cash flow starts with the cash inflows and outflows of your business. These include earnings from customers, dividends and interest, as well as payments for employee payroll, vendors, taxes and interest on credit.
On the other hand, the indirect cash flow statement starts with your net income. You then adjust it for changes in accounts that appear on the balance sheet to get the amount of money made or lost from operating activities. For example, you may adjust for changes in ending balances of inventory, accounts receivable and accounts payable. This is done to convert the company’s net income from the accrual basis of accounting to cash flow from operating activities.
In the direct method cash flow, only the operations section of the cash flow statement is affected. The investment and financing sections remain the same whether you use the direct or indirect cash flow statement. Whatever option you take, you’ll get to the same finish line, albeit while revealing varying details along the way. That said, most companies use the cash flow indirect method.
Why use the indirect method of cash flow?
Most accountants prefer the indirect cash flow statement because it’s simple to prepare since you can use information from the income statement and balance sheet. This makes sense because the cash flow indirect method uses the accrual method of accounting, which is also used in the preparation of the balance sheet and income statement.
Under this method, you recognize payments in the period that they are received rather than when customers make the actual payment. Thus, credit sales would be recognized at the time of sale, not when the customer finally pays.
How to create a cash flow statement using the indirect method
The indirect cash flow statement begins with your company’s net income then makes adjustments to finish with cash flow from operating activities. Adjustments include amortization and depreciation, as well as any changes in current assets and liabilities, including receivables, payables and inventory. After making these adjustments, you’ll get your ending cash flow position.
One advantage of using the cash flow indirect method is that you can easily pick the starting net income from your income statement. However, remember to make adjustments for earnings before interest and tax. Additionally, adjustments should include changes in non-operating expenses. These cover accounts such as accrued expenses, inventory depreciation, payables and receivables.
Since it’s based on adjustments, the indirect cash flow statement doesn’t provide enough insight into cash transactions. It doesn’t even break down sources of cash, which can be disadvantageous if you want to analyze your sources of cash. On the upside, the indirect method makes it simpler to figure out the cause should there be a difference between your net profit and closing bank position.
How to calculate operating cash flow using the indirect method
Here are the steps to follow when creating the cash flow statement using the indirect method:
Begin with the business’s net income. You can pick it directly from the company’s income statement.
Pick out any gains and losses from investment and financing activities (e.g., gain from sale of land or loss from sale of equipment).
Determine non-cash changes to income, then subtract non-cash revenues.
Finally, look at operating assets and liabilities. Subtract any increases in operating assets and add any decreases in those same accounts. As far as operating liabilities, add increases and subtract decreases.
In short, the formula for finding the cash flow indirect method is:
Cash flow = Net Income + Gains & Losses from financing & investments + non-cash charges + changes in operating accounts
Cash flow example statement
Assume that in a particular year, your business records:
Net income of $250,000
Depreciation of $30,000
Inventory adjustments of -$20,000
Accounts receivable adjustments of $80,000
Accounts payable adjustments of -$50,000
To find operating cash flow using the indirect method, take net income, add inventory adjustment, add depreciation, less accounts receivable adjustments and finally less accounts payable adjustments.
This means that your company had $170,000 left over after paying all the bills and expenses.
Why use the direct method of cash flow?
The case for the direct method cash flow is that the Financial Accounting Standards Board (FASB) recommends it. That’s primarily because it provides a clearer picture of cash inflows and outflows. However, you’ll still need to reconcile your cash flow to the balance sheet.
Another advantage of the cash flow direct method is that it’s easier to understand. It divides transactions into negative and positive. Negatives include cash outflows like rent and payroll payments while positive includes cash inflows like cash from customers and accounts receivable. This simplicity, coupled with the fact that the direct cash flow method reports exact sources of cash payments, makes it very helpful to stakeholders – particularly lenders and investors who want to see where your money is coming from.
How to create a cash flow statement using the direct method
When using the direct method cash flow approach, itemize cash inflows and outflows, and ignore all non-cash items. Specifically, subtract cash payments from cash receipts of the same fiscal period. Cash payments include money paid out to employees, suppliers and operations. On the other hand, cash receipts are primarily money paid in by customers.
Once you’ve calculated the net cash flow from operating activities, you can now add cash flow from investing and financing activities. This should give you the same closing position as you would get if you used the indirect method.
How to calculate operating cash flow using the direct method
When the cash flow statement is based upon the direct method, you can follow the following steps to find your ending cash position:
Start with cash receipts from customers. This includes revenue from sales after adjusting accounts receivable.
Subtract cash payments to suppliers. This is your cost of goods and should be adjusted to changes in inventory as well as changes in accounts payable.
Subtract cash expenses, which may include R&D, administrative costs etc.
Subtract the sum of interest paid in cash.
Subtract the sum of taxes paid in cash.
With that in mind, here’s the formula when the cash flow statement is based upon the direct method:
This means your business had $159,000 left over after paying bills and expenses.
Why a cash flow statement matters
Regardless of the cash flow statement format you choose, it’s important to prepare the document in the first place. Below are the advantages of a cash flow statement:
Verifies liquidity position: whether your cash flow statement is based upon the direct or indirect format, it will tell you the profitability and liquidity position of your business. You can use the information to determine whether the company can pay its debt obligations.
Helps with investment planning: when properly prepared, a cash flow statement accurately portrays your capital cash balance. This information can help you know how much idle cash you have to reinvest in the business or invest in other things.
Easier cash management: a cash flow statement can show your cash inflows and outflows. Such knowledge is helpful when you need to figure which processes are bringing in more money and which ones are taking out more of it. Once you’re equipped with that information, you can easily make future plans to increase efficiency.
Future planning: it’s possible to estimate future incomes and expenses based on the current cash flow. You may need this for proper planning and coordination.
Access to financing: most lenders and creditors will want to see your financial statements – including the cash flow statement – before extending credit to your company. Specifically, the CFS will show your sources or income, your revenues and whether or not you have enough money left to take up a new debt.
The bottom line
Ultimately, the choice between direct vs. indirect cash flow boils down to what you prefer. If you would rather prepare your cash flow statement using information that you pick from the balance sheet and income statement, then it makes sense to use the indirect method.
On the other hand, the direct method makes more sense if you usually itemize your revenues and expenses. Either way, both methods will accurately tell you your company’s cash position when applied correctly.
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