Direct vs. indirect cash flow accounting: What's the difference?

Determining your company's approach concerning cash flow presentation is an essential part of developing a standard financial reporting policy. There are two commonly used methods of calculating cash flow: The direct method and the indirect method.

Here’s how they differ, along with their advantages and disadvantages, to help you decide which one’s right for you and your business.

What is the direct cash flow method?

Under the direct cash flow method, the company considers only actual cash paid and received when determining operating cash flows. Accruals, such as accrued accounts payable and accounts receivable, are not considered. Changes in financing and investing activities remain the same under direct and indirect cash flow methods.

The direct cash flow method is considered the more complicated of the cash flow methods, especially for a company that utilizes accrual accounting. The accounting manager cannot use changes between assets and liabilities to measure variations in receivables and payables under the direct cash flow method. Instead, they appropriately categorize each transaction that affects cash.

Direct cash flow method example

The below represents an example of a cash flow statement using the direct cash flow method. The cash flow statement requires reconciling the net income to net cash from operating activities.

What is the indirect cash flow method?

The indirect cash flow method uses the same general classifications as the direct cash flow method.

However, the indirect method is much easier for a finance team to assemble since it uses information obtained directly from the balance sheet and income statement. The indirect method considers accruals, so all receivable transactions, including billing and invoicing, are part of the indirect cash flow statement.

Auditors and financial analysts can quickly trace the line items of an indirect cash flow statement using other financial reporting for the period. And there’s no need to reconcile cash generated from operations.

What is an example indirect cash flow?

Below is an example of a cash flow statement that utilizes the indirect method.

Key differences between the direct and indirect cash flow methods

There are several key points to keep in mind when deciding between direct vs indirect methods of cash flow:

When to choose the direct or indirect cash flow method

So, how do you choose between direct and indirect cash flow methods?

Most accountants and analysts believe the direct method of cash flow presentation is the most accurate. But calculating cash flow under the direct approach is much more complicated than under the indirect method. Complexities arise since you have to identify each source of cash inflows and outflows.

In organizations that have extensive sources of cash inflows and outflows, it may take too much time to prepare a direct cash flow statement. If an external reporting firm audits the company, auditors must thoroughly trace each line item to the source before they sign off on the financial statements.

As you can imagine, the risk of mistakes on a direct cash flow statement is more significant than on a cash flow statement prepared using the indirect cash flow method.

However, the direct cash flow method provides a better spend analysis that finance teams can use to minimize spend management mistakes. Since the direct cash flow method is much more detailed, finance teams obtain greater granularity concerning operating expenses that affect cash inflows and outflows.

Advantages and disadvantages of the direct vs. indirect cash flow methods

Preparing the cash flow statement using the direct method results in several advantages and disadvantages, summarized in the below table:

It's typically much easier for organizations with fewer types of cash in-sources and outsources to utilize the direct method of cash flow statement reporting. In addition, you'll gain more insight into spending analytics that are useful for evaluating how your organization collects and spends its money.

Other businesses prefer the indirect method of cash flow preparation. Like the direct method, it has its advantages and disadvantages.

At the heart of any business is cash flow. If your cash flow conversion is too slow, you won't have the money you need to pay for essential expenditures, like rent or employee wages. If the cycle is too fast, you may not be using available cash effectively. For example, you could use surplus cash to pay off old debts or put some excess funds into investments.

Which cash flow method is best for my business?

The direct method is most appropriate for small businesses and proprietorships that don't have significant cash transactions.

However, the direct approach can still be viable if the company has lots of transactions that affect cash. Business accounting software such as Ramp can easily categorize cash transactions so that they are quickly accessible when it comes time to prepare the cash flow statement using the direct method.

Public companies with regular audits prefer the indirect method of preparation of cash flow.

Since the indirect method utilizes information directly from the income statement and balance sheet, auditors and analysts can quickly perform calculations to determine if the information is accurate.

Companies with intangible and tangible assets amortized or depreciated over time benefit from the indirect method, which utilizes non-cash items when preparing the changes to the operating cash flow. If amortization and depreciation expense amounts are significant, the indirect method is more appropriate for evaluation purposes.

Common mistakes to avoid in cash flow reporting

Cash flow reporting is crucial for understanding the financial health of a business. However, errors in how cash flow is tracked and reported can lead to inaccurate financial statements, poor decision-making, and missed opportunities. Here are some common mistakes to avoid when preparing cash flow statements:

1. Misclassifying cash flows

This is one of the most frequent errors. Cash inflows and outflows should be categorized correctly under operating, investing, and financing activities. For example, cash from selling equipment should be classified under investing activities, not operating activities. Mixing these categories can distort the true cash flow picture and confuse decision-makers.

2. Ignoring non-cash transactions

While the direct and indirect methods focus on actual cash transactions, you have to account for non-cash transactions in the overall financial reporting. For example, depreciation and amortization are non-cash expenses that affect financial performance but do not impact actual cash flow. Failing to adjust for non-cash items can lead to a misleading picture of your company’s liquidity.

3. Not accounting for timing differences

Accrual accounting often involves timing differences between when transactions are recognized and when cash is actually exchanged. For example, accounts receivable and accounts payable can affect cash flow when payments are delayed or extended. Failing to account for these timing differences in cash flow statements can create discrepancies in reporting, leading to incorrect projections of available cash.

4. Overlooking cash flow from financing activities

Many businesses focus heavily on operating and investing activities while overlooking cash flows related to financing. Cash flows from issuing debt, repaying loans, or issuing equity can significantly impact a company’s overall cash position. Failing to track and report these activities accurately can skew your understanding of the business’s financial stability.

5. Not updating for changes in working capital

Working capital adjustments, such as accounts payable and accounts receivable, should be carefully monitored. An increase in accounts receivable or a decrease in accounts payable can reduce available cash, which may not be immediately apparent if the cash flow statement isn’t adjusted properly. Ensure that changes in working capital are correctly reflected in your cash flow calculations.

6. Underestimating the impact of taxes and interest

Cash flow statements should account for income tax payments and interest expenses. These are often overlooked or miscalculated, especially when preparing reports under the indirect cash flow method, which includes adjustments for items such as interest payments and income tax. Neglecting these adjustments can cause an overestimation of available cash and affect financial planning.

7. Failure to reconcile cash flow statements

You should always reconcile cash flow statements with your balance sheet and income statement to ensure accuracy. Discrepancies between these financial statements can signal errors in cash flow reporting. Make sure that the beginning and ending cash balances align with the cash flow reported in both operating and financing activities.

Simplify your cash flow management with Ramp

Managing cash flow is essential for ensuring liquidity and making informed decisions. You can eliminate errors, gain real-time insights into your company’s cash position, and better track net cash flow from operating activities—both inflows and outflows—by automating your cash flow reporting.

Ramp’s reporting tools streamline cash flow management, helping you efficiently track cash receipts, payables, and liabilities while offering insights into cash balance, depreciation, and amortization. Automated cash flow statements let you focus on strategic forecasting and decision-making, confident that your financial statements are accurate and up-to-date.

Simplify your cash flow accounting and unlock insights that guide your financial health with Ramp.