Preparing your cash flow statement thoroughly is key in managing your business finances. When developing the statement, there are two main methods: direct method or indirect method. While they both produce the same result, their methodology differs. This is why we've compiled this short guide on the direct method vs. indirect method of cash flow.
Direct and indirect method - explained
The indirect method of creating a statement of cash flow entails using changes in your balance sheet accounts to calculate cash flow from operating activities. Changes in asset and liability accounts that are capable of affecting your cash balances in a defined reporting period are added or subtracted from your net income at the beginning of the period. This then identifies your operating cash flow. The direct method, on the other hand, describes listing all your business’s cash inflows and outflows during the defined period. This then helps you identify your business's net cash flow from operating activities.
Building a cash flow statement with the indirect method
Set up the statement
First, record the net income for your defined period. Then, subtract or add any non-cash expenses, losses, and gains. Non-cash expenses can include various items, such as depreciation, amortization, and depletion.
Adjust your net income
In a second step, you adjust your company's net income changes in asset accounts that may have affected your company’s cash generated. This can include things like inventory, prepaid expenses, and accounts receivable. Identify how these changes influence cash in your business to calculate which way your net income has to be adjusted. This could, for instance, be an asset increasing in the recorded period, which means that cash has left your business, so the increase needs to be subtracted from your net income.
Account for liabilities
In the last step, you adjust your net income to reflect any changes in your company's liability accounts. Accounts to be considered can include accounts payable and accrued expenses. This site the indirect method can prove challenging, as liabilities have a credit balance, rather than a debit balance. This means that any liabilities should be added back to your income, not subtracted. After having done these steps and adjustments, you are left with your business's total amount of cash from operating expenses.
Use Excel for operating cash flow statements
Excel is a great tool to use for producing a cash flow statement. It holds a number of templates including a cash flow statement indirect method format. Download the template, simply enter your company's financial information and calculate cash inflows and outflows using the indirect method.
Direct method vs. indirect method of cash flow
When looking at the different methods for creating a statement of cash flows, it is key to understand that neither method provides a more reliable or in-depth outcome than the other. Which method you choose for your cash flow statement reflects your personal preferences. For example, many accounting professionals choose to go down the route of the indirect method because it can be prepared relatively easily using information from your balance sheet and income statement.