The cash flow statement is crucial for a company’s finances and for understanding the overall health of the business. Creating a cash flow statement involves using either the direct or indirect cash flow method and setting up the right processes.
In this article we will guide you through the process and help you understand the details and differences between the direct and indirect cash flow method.
Cash Flow Statement Definition
The cash flow statement is one of the three important financial reports that show a company’s financial health – along with the balance sheet and income statement. Even though the cash flow statement often receives less attention, it’s crucial because it shows how money comes in and goes out of the business.
The cash flow statement is divided into three categories:
- Operating: Money earned and spent in the core business operations.
- Financing: Cash related to activities like selling stocks, bonds, or paying dividends to investors.
- Investment: Cash used for long-term items like equipment and assets.
There are two methods to prepare the cash flow statement (direct and indirect). Both methods tell the same story about how cash moves around in the business, but from different perspectives.
Direct vs. Indirect Cashflow: What’s the Difference?
What sets apart direct and indirect methods in calculating net cash flow from operating activities?
The key difference lies in their starting points and the kinds of calculations they involve.
With the indirect method, you start with your net income.
With the direct method you begin with the actual cash your business received and paid out.
Both methods use distinct calculations to reach the same end result, but they use different details during the process.
Let’s explore each method separately.
Indirect Cash Flow Statement
The indirect cash flow method begins with your organization’s net income and adjusts it to find the cash flow from non-cash transactions. These adjustments consider things like depreciation, changes in inventory, receivables, and payables. After adjustments, you get your final bank balance.
This method is useful because it shows why your profit differs from your closing bank balance. However, it lacks detailed insights into specific cash transactions and their sources, which means you might miss important information about your finances.
Here is a simple example of an indirect cash flow statement:
Note how it always starts with the net income and then adjusts the numbers based on non-cash transaction.
| Net Income | $400,000 |
| Add (or deduct) items not affecting cash | |
| Depreciation expense | $7,500 |
| Net gain from sale of equipment | $3,300 |
| Decrease in accounts receivable | $26,000 |
| Increase in accounts payable | -$6,000 |
| Net cash from operating activities | $430,800 |
Benefits and Drawbacks of Indirect Cash Flow
Benefits:
- Widely Used
The indirect method is commonly used by both small and large companies to comply with International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP) requirements. Publicly traded companies must use this method, even if they use the direct method internally.
- Simpler Preparation
Many accountants prefer the indirect method because it’s easier to prepare. It uses information from existing financial statements, saving time and effort compared to the direct method.
Drawbacks:
- Limited Insight
Unlike the direct method, the indirect method provides less detailed information about specific cash flow activities. It doesn’t offer a deep understanding of what contributes to the company’s net cash flows.
- Possible Errors
The indirect method might not accurately represent the company’s current cash position. It indirectly calculates net cash flow from other financial statements, meaning the numbers might not be up to date if the previous financial statements aren’t accurate or updated. This could lead to misleading information about the company’s cash situation.
Direct Cash Flow Statement
The direct method tracks the cash-specific transactions your business receives and spends on. The purpose of this is to identify changes in cash payments and company activity receipts. As opposed to the indirect cash flow statements that focuses on non-cash transactions, direct cash flow is meant for finding changes in cash payments.
The direct cash flow statement method lists every transaction on the company’s cash flow statement. Examples of these are cash from customers, cash to pay employees, and cash to pay suppliers. It provides a clear picture of your cash flow, aiding short-term planning and helping you identify future challenges or opportunities.
Although beneficial for understanding cash flow, it requires extra time as it involves examining detailed account activities beyond balance sheets and income statements. Mastering cash flow management is crucial for any business, as it provides insight into the past and helps in forecasting future financial situations.
Here is a simplified example of what a direct cash flow statement might look like:
| Cash receipts from customers | $745,000 |
| Wages and salaries | -$315,000 |
| Cash paid to vendors | -$92,000 |
| Income before taxes | $480,000 |
| Interest paid | -$2000 |
| Income taxes paid | -$125,000 |
| Net cash from operating activities | $665,000 |
Benefits and Drawbacks of Direct Cash Flow
Benefits:
- Increased Accuracy
This method is very precise because it uses real cash payments and receipts from the given period. It accurately calculates the cash used or received through business activities.
- Clearer Understanding
The direct method uses all cash transactions, making the calculations simple and easy to grasp. It provides straightforward insights into the cash flow from operating activities.
Drawbacks:
- Hard to Expand
Managing individual transactions for a small business is doable. But as your business grows, using the direct method becomes less practical.
- Time-Consuming and Ineffective
The more complicated your finances, the more likely errors will occur. Missing even one transaction could mess up your cash balance, leading to problems in decision-making and future financial planning.
Choosing the Right Method for Your Business
Considering the benefits and drawbacks of direct and indirect cash flow statements, how do you choose the best one for your business? Here are three key factors to help you decide.
1) Business Size
Smaller businesses with fewer transactions can handle the detailed tracking of the direct method. Larger corporations often prefer the indirect method for its efficiency, as it uses data already available in other financial statements.
2) Technology
Having the right technology and automation can play a big role in your decision of whether to use the direct or indirect method. Although the direct method can be time consuming and tough for large businesses, with the right technology it can be done fast with a very low risk of errors.
3) Regulations
Your choice might be influenced by accounting regulations. Under GAAP and IFRS, the indirect method is preferred or sometimes required, so many companies opt for it to save time and comply with regulations.
Conclusion
The cash flow statement is an important financial tool for any business. It shows how money moves in and out of the company. With this, the direct and indirect methods respectively offer different perspectives on cash flow calculation.
The indirect method is widely used and simpler to prepare, though it lacks detailed insights into specific transactions. Meanwhile, the direct method provides a precise and clear understanding but can be time-consuming and challenging for businesses with extensive transactions. Businesses must weigh the pros and cons of each method to make an informed decision, ensuring accurate financial reporting and aiding effective financial management and planning.
Using Datarails to automate your cash flow statements
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By automating cash flow reports, businesses can gain instant insights into cash movements between months, and quickly equip decision-makers with the numbers they need to make the best business decisions.