What is a cash flow statement?
Before we explain the differences between direct and indirect cash flow statements, let’s go over the basics of a cash flow statement:
A cash flow statement is a financial statement that reports the inflow and outflow of cash in a business over a specific period. It presents information about the company’s cash receipts and payments during that period, which provides a detailed picture of the company’s financial health and liquidity.
The cash flow statement is divided into three sections:
- Operating activities- This reports the cash inflows and outflows from the company’s primary operations. It includes cash received from customers and cash paid to suppliers, employees, and other operating expenses.
- Investing activities- This section reports the cash inflows and outflows related to the company’s investments in assets such as property, plant, and equipment, as well as investments in other companies.
- Financing activities- This is the cash inflows and outflows from the company’s financing activities, such as borrowing and repaying loans, issuing and buying back shares, and paying dividends.
Like most financial ratios and statements, analyzing the cash flow statement allows investors and analysts to assess a company’s ability to generate cash from its operations, and understand how it’s investing its money and how it’s financing its operations.
A positive cash flow means that the company is generating more cash than it’s spending, indicating that it’s in good financial health. In contrast, a negative cash flow suggests that the company is spending more cash than it’s generating, which can be a sign of financial trouble.
Overview of Direct Cash Flow and Indirect Cash Flow
Direct and indirect cash flow are two methods used to prepare the cash flow statement, which is one of the essential financial statements used in accounting.
The primary difference between direct and indirect cash flow lies in the way the operating activities section of the cash flow statement is presented.
In the direct method, the operating section lists all the cash inflows and outflows directly associated with the company’s operations, such as sales receipts, payments to suppliers, and employee salaries. The direct method shows the actual cash flows of a company’s operating activities in a clear and concise manner.
On the other hand, the indirect method starts with net income and adjusts it for non-cash transactions and changes in balance sheet accounts to arrive at the net cash provided by operating activities. This method indirectly calculates the cash flows from operating activities.
While both methods can provide the same result for the cash flow from the operating activities section of the cash flow statement, the biggest difference is in time and complexity.
The direct method is generally preferred because it provides more detailed information and is easier to understand for non-accounting professionals. However, preparing the cash flow statement using the direct method can be more time-consuming and costly than the indirect method because it requires more detailed data and analysis.
What is the direct cash flow method?
The direct cash flow method is a way to prepare a cash flow statement that shows the actual cash inflows and outflows related to a company’s operating activities during a specific period.
To prepare the cash flow statement using the direct method, the company needs to analyze its cash transactions and determine how much cash has been received from customers and how much cash has been paid to suppliers and employees.
The direct method reports these cash inflows and outflows in the operating activities section of the cash flow statement, providing a detailed picture of the company’s actual cash flows.
This method is more straightforward and easier to understand for non-accounting professionals than the indirect method, which starts with net income and adjusts it for non-cash transactions and changes in balance sheet accounts to arrive at the net cash provided by operating activities. However, the direct method can be more time-consuming and costly to prepare because it requires more detailed data and analysis.
Advantages of Direct Cash Flow Statements:
- Provides more detailed information- The direct cash flow statement provides a more detailed breakdown of a company’s cash inflows and outflows related to operating activities, which can be helpful for investors and analysts in assessing the company’s financial health.
- Easier to understand- The direct method presents cash flows in a straightforward manner, making it easier for non-accounting professionals to understand.
- Highlights the impact of operating activities- The direct method highlights the impact of operating activities on a company’s cash flow, which is particularly important for companies that have significant operating cash flows.
Disadvantages of Direct Cash Flow Statements:
- Time-consuming and costly to prepare- The direct method requires more detailed data and analysis, which can be time-consuming and costly to prepare.
- Limited flexibility- The direct method is less flexible than the indirect method, making it harder for companies to adjust their cash flow statements in response to changes in their operations.
- Requires accurate data- To prepare a direct cash flow statement accurately, a company must have accurate and reliable data on its cash transactions, which may not always be readily available.
What is the indirect cash flow method?
The indirect cash flow method is a way of preparing a cash flow statement that starts with the net income and then adjusts it for non-cash transactions and changes in balance sheet accounts to determine the net cash provided by operating activities during a specific period.
To prepare the cash flow statement using the indirect method, a company adds back non-cash expenses like depreciation and amortization to its net income and then adjusts for changes in current assets and liabilities that affect cash flows. For example, an increase in accounts receivable means the company is owed more money, which reduces the cash available, and hence must be subtracted from net income to arrive at the net cash provided by operating activities.
The indirect method can be more straightforward and less time-consuming to prepare than the direct method, but it is less detailed, and it can be less helpful for investors and analysts who want to understand the actual cash inflows and outflows related to a company’s operating activities.
Despite its limitations, the indirect method is widely used by companies because it requires less detailed data and analysis and is considered more flexible in adjusting for changes in operations. Additionally, many accounting software and bookkeeping tools use the indirect method by default.
Advantages of Indirect Cash Flow Method:
- Less time-consuming- The indirect cash flow method is generally less time-consuming and less costly to prepare than the direct method.
- Requires less detailed data- The indirect method requires less detailed data and analysis, which makes it easier to prepare the cash flow statement.
- More flexible- The indirect method is more flexible than the direct method, making it easier for companies to adjust their cash flow statements in response to changes in their operations.
Disadvantages of Indirect Cash Flow Method:
- Less detailed- The indirect method is less detailed than the direct method, making it harder for investors and analysts to understand the actual cash inflows and outflows related to a company’s operating activities.
- Not accurate for some industries- The indirect method may not accurately reflect the cash flows for certain industries where non-cash transactions and balance sheet changes play a significant role in the company’s operations.
- Non-standardized adjustments- The adjustments required for the indirect method are not standardized and can vary between companies, which can make it difficult to compare cash flow statements between companies.
Which one is better for your company?
There is no standard for which type or size companies the direct or indirect cash flow method is better for. Rather it depends more on who the reports are for and how detailed they need to be.
The direct method is helpful when you need to make it easy for other people—like investors and stakeholders—to understand your cash flow. But its downside is that it is harder for the finance person to create.
The indirect method is much easier for the finance team to create but harder for outside readers to interpret. Therefore, it might be a better option for teams who don’t have the time or resources to follow the direct method, or for those who don’t need to report to stakeholders or investors in the near future.
