Direct vs Indirect Cash Flow Methods

Cam McIntyre

Direct and indirect are two different methods that are used in preparing the cash flow statement of your company. The main difference between the two methods relates to the cash flows from the operating activities. In the case of direct cash flow methods, changes in cash payments are reported in cash flows from the operating activities section. In the case of an indirect cash flow method, changes in assets and liabilities accounts are adjusted in the net income to replicate cash flows from operating activities.

What is the indirect cash flow method?

The indirect cash flow approach begins with the company's net income, which you may obtain from the income statement, and then incorporates depreciation. Then you should list any changes in current liabilities, assets, and other sources (e.g., non-operating losses/gains from non-current assets) on the balance sheet.

Keep in mind that an income statement is nothing more than a guide. As such, you'll need to make modifications to account for pre-tax and interest income. To determine the company's cash flow for operating expenditures, you'll also need to incorporate non-operating costs like accounts payable, inventory, depreciation, and accrued expenses.

What is direct cash flow?

The direct method is a type of accounting used to produce a full statement of cash flow that documents the changes in cash throughout the period. The direct method cash flow statement, sometimes known as the "income statement method," monitors the movement of money in and out of a firm during a certain time frame.

This technique is used to track changes in cash payments and receipts due to a company's operational activities. It allows businesses to make informed judgments and plan for the future by informing them of their financial position.

Under the direct cash flow method, you take out cash payments—such as those to suppliers, workers, and operations—from cash receipts—such as from customers—during the accounting period. The net financial flow from company operational costs is determined as a consequence of this. You may only include investing and financing activities after net cash flow from operations have been calculated for the period.

Direct vs indirect cash flow

The major distinction between the direct and indirect approaches to creating cash flow statements is cash flows from operating expenditures. You show actual cash outflows and inflows on a cash basis without starting from net income using the direct method. For both direct and indirect cash flow statement preparation, you prepare the financing and investing portions in the same way.

The direct approach affects only the cash flow statement's operations section, while the cash flow from the investing and financing sections will be similar regardless of whether an indirect or direct method is utilized.

The indirect approach is popular among accounting professionals since it is both quick and simple to generate the statement of cash flow utilizing data from the balance sheet and income statement. A credit is an amount owing to you by a company or other entity. Most businesses employ the accrual method of accounting, therefore the balance sheet and income statement reflect this approach. Income is recognized under the accrual system when it is received rather than when payment from clients is received.

Advantages and disadvantages of direct cash flow

Advantages:

Transparency

The direct cash flow technique highlights the main sources of cash financing and receipts, which might be of use to creditors and investors.

Ease of comprehension

Because this technique separates a company's transactions into two categories: negative, which includes cash outflows like employee compensation and rental payments, and positive, which includes cash inflows such as accounts receivable payouts received and money collected from customers, the direct cash flow method is the most straightforward to comprehend and read. In this manner, the direct cash flow method is very much comparable to a bank statement.  

Accuracy

When comparing cash flows using real-time data, you can be more confident in your numbers.

Disadvantages

Effort and time

The direct cash flow method, as its name implies, entails recording all of your financial receipts and disbursements. It may be time-consuming and laborious to keep track of this information.

Advantages and disadvantages of indirect cash flow

Advantages

Easier to prepare

Because most businesses operate on an accrual basis, the indirect cash flow approach is simpler to execute than the direct method.

Reconciles cash income

The indirect cash flow method compares the company's stated profitability with its accrual-based accounting net cash flow to show the difference between its cash holding position and its declared performance.

Links financial statements

The indirect cash flow approach necessitates the construction of a direct connection between a company's balance sheet and income statement, allowing you to have a more systematic viewpoint on its financial statements.

Discloses non-cash transactions

When utilizing the indirect cash flow technique, non-cash transactions are disclosed, which can help you better understand how non-cash activities contribute to a company's net income but not source of cash flows.

Disadvantage

Another disadvantage is that this technique is less transparent. This money flow technique frequently violates some accounting standards and accepted methods.

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