Note: this article is part of our guide to cash flow management.
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.
The two methods differ in their approaches, which are explained below. You can take a look at how they differ as well as their advantages and disadvantages to help you decide which is right for 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 payables and receivables, 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, each transaction that affects cash is appropriately categorized.
The direct cash flow method
The below represents an example of a cash flow statement using the direct cash flow method. You'll note that 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 the other financial reports for the period. In addition, there is no need to reconcile cash generated from operations.
The indirect cash flow method
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 should I choose one cash flow reporting method over another?
Most accountants and analysts believe the direct method of cash flow presentation is the most accurate. While this may be true, calculating cash flow under the direct approach is much more complicated than under the indirect method. Complexities arise since each source of cash inflows and outflows must be appropriately identified.
In organizations that have extensive sources of cash inflows and outflows, the time to prepare a direct cash flow statement may be unrealistic. 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 there is much greater detail required in the direct cash flow method, finance teams obtain greater granularity concerning operating expenses that affect cash inflows and outflows.
Advantages and disadvantages of each method
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, there are both advantages and disadvantages to this method.
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 method of calculating cash flow should my business use?
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. Accounting software 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 and organizations 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.