Cash Flow: Direct vs. Indirect Methods

Two popular ways of looking at cash flow are the direct and indirect methods.

Each comes with its own insights and advantages, so let’s explore what each method entails, their differences, and how to choose the right one for your situation.

This guide is also related to our articles on how to do cash flow forecasting, how to read a cash flow statement, and cash flow vs. revenue.

This list includes:

• Direct method cash flow
• Indirect method cash flow
• Cash flow statement preparation
• Operating activities cash flow
• Cash flow analysis

Let’s dive in!

What is cash flow? 

Cash flow measures the money that flows in and out of your business over a specific period. It’s the actual amount of cash you have available at any given time. Unlike profit, which is theoretical and includes non-cash items like depreciation, cash flow is tangible. You can touch and spend it.

Knowing your cash flow helps you manage your business’s financial health by showing you how much money is available to pay bills, reinvest in the business, or save for future use.

Cash flow and profit–what’s the difference?

It’s easy to confuse profit with cash flow, but they’re not the same. Profit is the financial gain you make after all expenses are subtracted from revenue. It’s possible to be profitable on paper, yet still struggle because cash isn’t available—maybe it’s tied up in inventory or customers haven’t paid their invoices yet.

On the other hand, cash flow is about liquidity, the actual cash available to your business at any given time. Positive cash flow means more cash is coming into your business than going out. Negative cash flow indicates the opposite, where your expenses outpace your cash intake.

The three parts of a cash flow statement: Operating, Investing, and Financing activities

A cash flow statement is divided into three parts that show where your cash comes from and where it goes, and understanding them will give you a clearer picture of how well your business manages its money. These sections are:

• Operating activities: This section reflects the cash generated or spent from your business’s core operations. It starts with your net income, adjusts for non-cash expenses like depreciation, and accounts for changes in working capital items like inventory and accounts receivable. It tells you if your day-to-day business operations are producing sufficient cash to sustain and grow your business.
• Investing activities: Here is the cash used for or generated from buying and selling assets like equipment, vehicles, or buildings. This section helps you track how much you’re investing back into the business. A negative number here might not be bad if it means you’re investing in the future growth of your company.
• Financing activities: This part records flows of cash between the company and its owners, investors, or creditors. It includes cash from loans, repayments of those loans, or money raised from selling shares. It also shows dividends paid to shareholders. This section helps you understand how your business finances its overall operations and growth with external sources of cash.

This cash flow statement is normally calculated in one of two ways. Let’s look at them more closely.

The direct method

The direct method for calculating cash flow presents a straightforward view of cash transactions. It records all cash inflows and outflows just as they occur, making it easy to see the actual cash movement within your business. You’ll list all the cash receipts (money coming in) and all the cash payments (money going out) during the reporting period.

Types of cash receipts and payments included

Under the direct method, cash receipts might include cash from customers, refunds from suppliers, or any other cash inflows directly related to your business’s primary activities.

Cash payments, on the other hand, cover all the money your business spends: expenses like salaries paid to employees, payments to suppliers, rent, and utility bills paid in cash. It also includes interest and taxes if these are paid directly in cash..

Example of a cash flow statement prepared using the direct method

Here’s a simplified example of how a cash flow statement might look when prepared using the direct method:

Cash flow from operating activities:

Cash received from customers: $150,000
Cash paid to suppliers and employees: ($95,000)
Interest paid: ($5,000)
Taxes paid: ($10,000)
Total cash from operating activities: $40,000

Cash flow from investing activities:

Cash paid for property and equipment: ($20,000)
Total cash used in investing activities: ($20,000)

Cash flow from financing activities:

Cash received from issuance of shares: $25,000
Dividends paid: ($10,000)
Total cash from financing activities: $15,000

Summary

Net increase in cash: $35,000
Cash at beginning of period: $20,000
Cash at end of period: $55,000

In this example, you can see the cash inputs and outputs from your core business operations, as well as how investments and financing activities impact your cash position. This straightforward listing of actual cash flows helps you, the business owner, see clearly where your cash is coming from and going to, allowing for better cash management and planning.

The direct method, while providing a clear and simple understanding of cash flows, does require detailed record-keeping. You need to make sure that all cash transactions are recorded accurately to prepare a true and fair view of the cash flow statement. This can be more time-consuming than using the indirect method, but it offers greater transparency for the day-to-day management of business finances.

The indirect method

The indirect method for calculating cash flow starts with net income and then makes adjustments for all non-cash transactions and changes in working capital items. Calculating your cash flow this way connects the dots between the income statement and the cash flow statement, so you can more easily understand how profits translate into cash flow. Unlike the direct method, which lists actual cash inflows and outflows, the indirect method adjusts your net income for factors that affect cash but were not cash transactions themselves.

How net income is adjusted for non-cash items and changes in working capital

Here’s how adjustments work under the indirect method:

Non-cash transactions include items like depreciation and amortization. Since these charges reduce your net income but don’t involve actual cash expenditure, they are added back to your cash flow.

Changes in working capital that affect cash flow include accounts receivable, inventory, and accounts payable. For instance, if accounts receivable increase during a period, it means sales were made on credit and cash wasn’t received, thus it’s subtracted from net income. Conversely, an increase in accounts payable represents expenses that were incurred but not yet paid in cash, so this is added to cash flow.

Example of a cash flow statement prepared using the indirect method

Let’s look at a basic example to illustrate a cash flow statement using the indirect method:

Net Income: $80,000

Adjustments for non-cash effects:

Depreciation: $5,000
Amortization of intangibles: $2,000

Changes in working capital:

Decrease in accounts receivable: $3,000
Increase in inventory: ($4,000)
Increase in accounts payable: $6,000
Total cash from operating activities: $92,000

Cash flow from investing activities:

Purchase of equipment: ($25,000)
Sale of old machinery: $10,000
Total cash used in investing activities: ($15,000)

Cash flow from financing activities:

Borrowing from bank loan: $20,000
Repayment of long-term debt: ($5,000)
Dividends paid: ($8,000)
Total cash from financing activities: $7,000

Summary

Net increase in cash: $84,000
Cash at beginning of the period: $10,000
Cash at end of period: $94,000

In this example, starting from the net income, each line item reflects an adjustment or a transaction that affects the company’s cash flow but may not have been a direct cash transaction during the period. The result is a clear view of how net income and changes to balance sheet items impact the cash available to your business.

The indirect method, with its adjustments, bridges the gap between accrued earnings and actual cash flow, so you can see beyond the income statement.

Comparing direct and indirect methods

The direct method of cash flow presents all cash transactions exactly as they occur, listing all cash inflows and outflows during the period. It shows the exact cash received from customers and paid to suppliers, employees, and for other expenses.

The indirect method, on the other hand, starts with net income from the income statement and adjusts for non-cash transactions like depreciation and changes in working capital, such as accounts receivable and payable.

Let’s look at the advantages and disadvantages of each method.

Direct method advantages:

• Clarity: Offers a clear and straightforward view of cash flows, making it easy to understand actual cash movements.
• Transparency: Provides detailed information about where cash comes from and where it goes, which can be beneficial for day-to-day management.

Direct method disadvantages:

• Record keeping: Requires meticulous recording of all cash transactions, which takes more time and effort.

Indirect method advantages:

• Convenience: Uses data already gathered in the income statement and balance sheet, making it easier and quicker to prepare.
• Popular in practice: Widely used and accepted, especially by larger companies that already prepare their financial statements on an accrual basis.

Indirect method disadvantages:

• Less intuitive: The adjustments for non-cash items and working capital can be confusing and less transparent about the actual cash flows.

Which cash flow calculation method a business chooses depends on their specific needs and the requirements of their stakeholders. Here’s why a business might choose one over the other:

Direct method: Preferred by businesses that deal primarily in cash transactions or that need detailed cash flow information for internal management.

Small businesses, particularly in retail or services that transact mostly in cash, might find this method more practical and insightful for day-to-day operations.

Indirect method: Favored by businesses that already use accrual accounting, as it’s easier to reconcile with the rest of their financial reporting.

It’s also the method preferred by many external stakeholders, like investors and financial institutions, because it connects the dots between net income and cash flow, making it easier to analyze the business’s profitability and cash generation efficiency.

Choosing between these methods depends on the nature of your business, your management needs, and sometimes the preferences of external stakeholders. While the direct method provides a clearer picture of actual cash flow, the indirect method is often more practical for those using comprehensive accounting systems and can offer insights into how operating results affect cash flow.

How to interpret cash flow statements

• Identify cash sources and uses: Look at the major categories—operating, investing, and financing activities. For the direct method, analyze specific entries for cash receipts and payments. For the indirect method, scrutinize adjustments to net income, especially non-cash items and changes in working capital.
• Evaluate operating cash flow: Positive cash flow from operations indicates your core business activities are generating more cash than they are using, a good sign of operational health. Consistently negative operating cash flow warrants a deeper look into how you’re managing receivables, inventory, and payables.
• Understand cash flow trends: Compare cash flow statements over several periods. Trends can tell you much more than a single period’s data, showing whether your cash flow is improving, declining, or remaining stable.

Key indicators in assessing the health of a business

1. Cash Conversion Cycle (CCC): Measures how quickly a company can convert its investments in inventory and other resources into cash flows from sales. A shorter cycle is generally preferable, indicating efficient management of inventory and receivables.
2. Free Cash Flow (FCF): Represents the cash a company generates after accounting for cash outflows to support operations and maintain its capital assets. A positive FCF suggests that a business has sufficient funds for expansion, dividends, debt repayment, and other investments.
3. Operating Cash Flow Margin: This ratio, calculated as operating cash flow divided by total revenue, shows how much cash is generated from sales. A higher margin is typically a sign of a well-managed business with good internal controls.

Common pitfalls in cash flow analysis

Interpreting cash flow statements requires careful examination beyond just the bottom-line figures, so keep these common pitfalls in mind:

Over-reliance on net income: For the indirect method, starting with net income might cause you to overlook underlying cash issues if net income is significantly adjusted by non-cash items like depreciation or changes in working capital.

Ignoring one-time items: Both methods can be affected by one-off transactions that don’t reflect ongoing business operations, such as cash received from selling an asset or large, unusual payments like lawsuit settlements.

Misreading cash flow for profitability: Remember that high cash flow isn’t the same as profitability. A business might show strong cash flow while losing money on its operations, or vice versa, especially if major cash flows are from financing rather than operations.

Conclusion

The direct method of  preparing cash flow statements gives a clear, transaction-by-transaction view of cash inflows and outflows, making it easier to see the actual movement of cash in your business.

On the other hand, the indirect method starts with net income and adjusts for non-cash transactions and changes in working capital, providing a bridge between your accrual accounting and cash reality.

Whether you use the direct or indirect method, understanding how cash flows through your company helps you make smarter decisions about budgeting, investing, and financing. Your choice will depend on your specific business needs and reporting requirements, but whichever you , the key is to maintain consistent and accurate records.

Next, check out our articles on operating income vs ebitda, what is a chart of accounts?, and bank reconciliation example: step by step.

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