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

Cash flow statements reveal the true health of a business—where your money is coming from and where it's going. Cash flow is what keeps your business alive, regardless of how profitable it appears on paper. The two most commonly used methods of calculating cash flow are the direct method and the indirect method.

In this post, we'll cover how these two methods 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?

The direct cash flow method reports actual cash receipts and cash payments during a specific period, showing exactly where cash came from (e.g., customer payments) and where it went (e.g., payments to suppliers and employees). This method provides a straightforward view of operating cash flows by listing the major categories of gross cash receipts and payments.

Accruals, such as accrued accounts payable and accounts receivable, are not considered in the direct method, but changes in financing and investing activities remain the same under both the direct and indirect cash flow methods.

Businesses use the direct cash flow method when they want to provide stakeholders with a clear, intuitive view of actual cash transactions, as it's easier to understand than the indirect method. But most companies avoid it because it requires more detailed recordkeeping, and the indirect method is simpler to prepare using existing financial statement data.

The direct cash flow method is especially complicated if you use accrual basis accounting. Your team can't 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.

How the direct cash flow method works

The direct method focuses primarily on operating activities because these represent your business's core cash-generating activities. Major cash inflows include payments from customers, interest received, and dividends received, while major outflows cover vendor payments, employee salaries, interest payments, and tax payments.

This approach gives stakeholders visibility into exactly how your business operations impact cash movement, making it easier to assess your company's ability to generate cash from its primary business activities.

What's an example of the direct cash flow method?

Here's an example of a cash flow statement using the direct cash flow method:

The direct method shows actual cash receipts and payments without starting from net income or making reconciliation adjustments.

What is the indirect cash flow method?

The indirect cash flow method uses the same general classifications as the direct cash flow method, but it starts with net income and adjusts for non-cash items and changes in working capital.

Companies tend to use the indirect method more often than the direct method. It's much easier for a finance team to assemble because it uses information obtained directly from the balance sheet and income statement. The indirect method also considers accruals, so all receivable transactions, including billing and invoicing, are part of the indirect cash flow statement.

Auditors and financial analysts often prefer the indirect method because they 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.

How the indirect cash flow method works

The indirect method works by reconciling net income to actual cash generated from operations through a series of adjustments. Key adjustments include adding back depreciation and amortization since these are non-cash expenses that reduce net income but don't require cash payments.

Changes in working capital accounts also require adjustment because increases in accounts receivable or inventory tie up cash, while increases in accounts payable provide additional cash.

This reconciliation approach emphasizes how accounting profits differ from actual cash generation, helping stakeholders understand why a profitable company might still face cash flow challenges or why cash flow might exceed reported profits.

What's an example of the indirect cash flow method?

Here's an example of a cash flow statement that uses the indirect method:

The indirect method efficiently transforms accounting profits into actual cash flows, helping stakeholders understand the critical difference between earnings and available cash.

Components of a cash flow statement

The cash flow statement breaks down into three distinct sections, each telling a different part of your company's financial story. These sections help you see exactly where your cash comes from and where it goes throughout the year.

1. Operating activities

This captures the cash flows from your core business operations. It includes cash received from customers, payments to suppliers, employee salaries, rent, utilities, and other day-to-day expenses.

Both the direct and indirect methods focus heavily on this section, though they present the information differently. The direct method shows actual cash receipts and payments, while the indirect method starts with net income and adjusts for non-cash items like depreciation.

2. Investing activities

This covers cash flows related to buying and selling long-term assets. It includes purchasing or selling equipment, buildings, investments in other companies, or any other assets that will benefit your business for more than one year.

When you buy new machinery, that cash outflow appears here. When you sell an old building, that cash inflow shows up here as well. Both the direct and indirect methods handle investing activities the same way since these transactions already involve actual cash movements.

3. Financing activities

This part focuses on how you raise money and pay it back. It includes cash from issuing stock, borrowing money, paying dividends to shareholders, or repaying loans. Essentially, it shows how you finance your business operations and growth.

Whether you choose the direct or indirect method, financing activities are reported identically because they represent clear cash transactions with investors and lenders.

The beauty of this three-part structure is that it gives you a complete picture of your cash management. You can see whether your operations generate enough cash to fund growth, how much you're investing in future success, and how you're balancing debt and equity financing.

How to prepare a cash flow statement

At the heart of business finance is cash flow. If your cash flow conversion is too slow, you won't have the money you need to pay for essential expenditures, such as rent or employee wages. If the cycle is too fast, you may not be using available cash effectively.

Creating a statement of cash flows might seem complex, but following a clear process makes it straightforward. Let's walk through the step-by-step approaches for both methods.

Direct cash flow statement

You'll create a cash flow statement using the direct cash flow method by tracking and reporting actual cash receipts and payments during a specific accounting period.

Here are the steps for preparing a cash flow statement using the direct method:

• Gather cash transaction data: Collect detailed records of all cash receipts and payments from accounting systems, bank statements, and transaction logs
• Categorize operating cash flows: Separate cash flows into operating, investing, and financing activities, with primary focus on operating activities
• Calculate major cash inflows: Determine cash received from customers, interest received, dividends received, and other operating income sources
• Calculate major cash outflows: Determine cash paid to suppliers, employees, for interest, taxes, and other operating expenses
• Compute net operating cash flow: Subtract total operating cash outflows from total operating cash inflows
• Add investing and financing activities: Include cash flows from asset purchases/sales and debt/equity transactions to complete the statement

The direct method provides visibility into actual cash movements, making it easier to assess a company's ability to generate cash from core operations.

Indirect cash flow statement

The indirect cash flow method starts with net income and makes adjustments to reconcile it to the actual cash generated from operating activities.

Here are the steps for preparing a cash flow statement using the indirect method:

• Start with net income: Begin with the net income figure from the income statement as the foundation for operating cash flow calculations
• Add back non-cash expenses: Add depreciation, amortization, and other non-cash charges that reduced net income but didn't involve actual cash outflows
• Adjust for changes in current assets: Subtract increases in accounts receivable, inventory, and prepaid expenses; add decreases in these accounts
• Adjust for changes in current liabilities: Add increases in accounts payable, accrued expenses, and other current liabilities; subtract decreases in these accounts
• Include other operating adjustments: Add losses on asset sales or subtract gains, and make other necessary operating activity adjustments
• Calculate net cash from operating activities: Sum all adjustments to arrive at the final operating cash flow figure
• Add investing and financing sections: Complete the statement by including cash flows from investing activities and financing activities

The indirect method efficiently converts net income into operating cash flow through systematic adjustments, making it the preferred approach for most businesses.

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 cash flow methods:

Both methods deliver the same bottom line for operating cash flow, so choose based on your reporting needs, available resources, and stakeholder preferences.

Advantages and disadvantages of direct vs. indirect cash flow

Both the direct and indirect cash flow methods come with their own set of benefits and drawbacks. Weighing these trade-offs helps you choose the approach that best fits your business needs.

Direct cash flow method:

Indirect cash flow method:

It's typically much easier for organizations with fewer types of cash inflows and outflows to use 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.

Which cash flow method is best for my business?

The direct method is most appropriate for small businesses and sole proprietorships that don't have significant cash transactions. However, the direct approach can still be viable if the company has a lot of transactions that affect cash.

Public companies with regular audits prefer the indirect method of cash flow preparation. Since the indirect method uses information directly from the income statement and balance sheet, auditors and analysts can perform quick calculations to determine whether the information is accurate.

Companies with intangible and tangible assets amortized or depreciated over time benefit from the indirect method, which uses 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.

Your choice depends on business size, transaction volume, audit requirements, and stakeholder needs. Consider these factors alongside your available resources and reporting objectives to select the one that best suits your needs.

Common mistakes to avoid in cash flow reporting

Cash flow reporting is crucial for understanding the financial health of your business. 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 financial 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. Make sure 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 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. Try an interactive demo to learn more.