Indirect vs. direct method of cash flow: which is better?

Prophix ImageProphix Jul 3, 2024, 8:00:00 AM

A cash flow statement is a financial document that shows how cash moves in and out of a business during a specific period. It covers inflows and outflows, aiding stakeholders in understanding a company's liquidity and financial health. In addition, cash flow statements may be used over time to create cash forecasts. A strong understanding of a company’s cash situation and reliable forecasts are both crucial for making strategic decisions.

There are two methods for generating cash flow statements: direct and indirect. Each has its advantages and disadvantages. Knowing the strengths of both the direct method and indirect method will allow financial and accounting teams to use the right tool for the right job, and leverage what each method is best at.

What is a cash flow statement?

In financial accounting, a cash flow statement presents the changes in cash and cash equivalents due to shifts in associated accounts and income. A cash flow statement identifies the source of the cash and describes how it was used over a certain period. These statements will often be used for reporting, internal decision-making, and forecasting, meaning that reliable and accurate financial data in your cash flow statement is essential.

Cash flow from operating activities

Operating Cash Flow (OCF) represents the following formula:

Net Income + Non-Cash Expenses - Increase in Working Capital = Operating Cash Flow

OCF is the cash generated by normal business activities and operations within a given time frame. This is one of the key calculations that FP&A analysts will use when determining the profitability of a company.

Cash flow from investing activities

Cash Flow from Investing (CFI) is the combined change in cash due to losses and gains linked to investments a business has made. These include investing and selling securities or assets. CFI is calculated with this formula:

Capital Expenditures (or Capex) + Purchase of Long-Term Investments + Business Acquisitions – Divestitures = Cash Flow from Investing

Each of these, except for Divestitures, should be a negative value. For most organizations this, especially Capex, will be the largest outflow of cash for the company.

Cash flow from financing activities

Cash Flow from Financing (CFF) is the movement of cash between owners, investors, creditors, and the company. This includes debt, equity, and dividends. CFF is represented by this formula:

Issue/Repurchase equity + Issue/Repurchase debt + Dividend payments = Cash Flow from Financing = CFF

Additional items may be added to the third part as well. Some investors may pay closer attention to these statements. Though they may appear cash flow positive, that may also indicate that the business is not generating enough cash itself and is leaning too heavily on financing.

Pro forma cash flow statement

A pro forma cash flow statement is a predictive report that uses available financial data to project a company’s expected cash flow. These statements present expected or planned future expenditures and investments. These are often used by startups and new businesses to consolidate and communicate plans to stakeholders and potential investors. A pro forma cash flow statement can be created using either the direct or indirect method, depending on goals, scope, and available financial data.

Cash flow formulas

Direct vs. indirect cash flow

There are two ways to prepare cash flow statements: direct and indirect. Generally, larger companies with more complex accounting and reporting will use the indirect method for efficiency, and smaller businesses will use the direct method since it’s more straightforward.

Direct cash flow

In the direct method, all cash transactions are noted directly. All cash movements, both inflow and outflow, are combined to create the statement. This becomes labor intensive as the number of transactions grows. However, despite the extra effort, the resulting statement provides easily understood details on a company’s cash flow.

Indirect cash flow

This method starts with net income and adjusts it for changes in the cash accounts. Beginning with net income from the income statement, adjusted for non-cash transactions and changes in working capital. This method does not use cash receipts for its results, so there is no need to list all individual transactions. Because there is no need for all cash transactions to be listed, this method is much faster for handling large accounts.

That’s a quick overview of the direct vs. indirect method for cash flow. Let’s dive into the details.

What is the indirect cash flow method?

The indirect cash flow method begins with the organization’s net income and adjusts that amount for any non-cash transactions that happened within a given period.

Indirect method advantages

  • Indirect cash flow statements are faster and easier to calculate because they don’t require all cash transactions to be individually tracked and included.
  • This speed makes the indirect method more appropriate for larger organizations with frequent reporting, or where tracking every transaction accurately may be prohibitive.
  • Abides by GAAP (Generally Accepted Accounting Principles)
  • Easily calculated from a company’s general ledger.
  • Uses the accrual method of accounting which is likely already in use elsewhere in the organization’s accounting and financial processes.
  • Reconciliation, which is required by the FASB for reporting, is generated using this method.
  • Less clarity and detail for individual cash transactions.

Indirect method disadvantages

  • Less clarity and detail for individual cash transactions.

What is the direct cash flow method?

The direct cash flow method results in a statement that shows all cash transactions made by a business during a specific period. It lists all cash receipts and payments in detail.

There are pros and cons to this. In short, the main advantage is providing a detailed view of the actual cash flow, with each individual transaction clearly listed and identified. However, the main drawback is that this level of tracking becomes difficult to maintain accurately at scale. Aggregating all transactions and reviewing them for the final statement can also be especially time-consuming.

Direct cash flow method complexities

This method won't be efficient for most organizations. Indirect is often preferable because it is faster, and the method matches the accrual accounting system which is likely in use elsewhere in the organization.

Accrual accounting records sales when made and whether the payment has been received. This makes it challenging to track actual cash transactions since payments have to be reconciled with invoices after the fact. Additionally, the Financial Accounting Standards Board (FASB) requires a reconciliation report alongside the direct method. This report adjusts net income for non-cash items and changes in balance sheet accounts, adding extra work. This reconciliation is done as part of the indirect method.

For many organizations, the advantages of the direct method and the improved detail and clarity of the final statement are overshadowed by the additional time, work, and reporting necessary.

Direct method advantages

  • Provides a clearer picture and greater detail of cash flow from operating activities.
  • Easier to understand for the end user because it shows the actual cash transactions and not an extrapolation.
  • GAAP accepted.

Direct method disadvantages

  • Challenging and time-consuming to calculate.
  • Supplementary reconciliations must be generated for reporting and verification.
  • Impractical for many organizations.

Indirect cash flow method example

Here is a quick step-by-step for the indirect cash flow method. Keep in mind that additional steps may be needed based on the accounting or reporting requirements of your organization or industry.

Step 1: Net income and non-cash expense adjustment

Begin with the net income for the period, which is your total revenue minus expenses, operating costs, and taxes. Adjust this net income for non-cash expenses.

Step 2: Asset adjustment

Referencing the balance sheet, adjust the net income for changes in assets like accounts receivable, cash, property, inventory, and stock. Increases in assets other than cash reduce cash flow, while decreases in these assets will increase it.

Step 3: Liabilities adjustment

Adjust net income for changes in liabilities such as accounts payable, expenses, and debt. Paying off liabilities decreases cash flow; while taking on more liabilities can increase or maintain cash flow.

Step 4: Include cash flow from investing and financing

Add cash flows from investing activities (e.g., buying/selling property or equipment) and financing activities (e.g., debt repayments, selling stock). The net change in your cash flow is the sum of cash flow from operating, investing, and financing activities.

For an excellent video breakdown of the indirect method, we recommend Accounting Stuff’s video on the indirect method of cash flow statements.

Direct cash flow method example

Here’s how the direct cash flow method would look for a small business. This method works best on smaller scales where the necessary receipts are easily accessible and few enough that they can be quickly accounted for.

Cash receipts:

Cash from Sales: $20,000

Interest Received: $200

Total Cash Receipts: $20,200

Cash payments:

Payments to Suppliers: $8,000

Salaries and Wages: $4,000

Rent: $2,000

Utilities: $500

Marketing Expenses: $300

Repairs: $200

Total Cash Payments: $15,000

Net cash flow from operating activities:

Total Cash Receipts: $20,200

Total Cash Payments: $15,000

Net Cash Flow from Operating Activities: $20,200 - $15,000 = $5,200

Common mistakes made in cash flow statements

Creating cash flow statements can be challenging, and there are several common issues that you might encounter. Here are ten of the most common mistakes made in cash flow statements:

  • Incorrect classification: Mislabeling cash flows between operating, investing, and financing activities can distort the statement and mislead people using the statement for forecasting and decision-making.
  • Omitting non-cash transactions: Failing to account for non-cash transactions, such as depreciation and amortization, results in inaccurate net income adjustments.
  • Timing differences: Incorrectly matching cash flows to the correct reporting period will lead to errors in the cash flow statement.
  • Incomplete data collection: Missing or incomplete data on cash receipts and payments can result in an incomplete cash flow statement, especially when using the direct method.
  • Errors in adjusting net income: When using the indirect method, errors while adjusting for changes in working capital items like accounts receivable, inventory, and accounts payable will lead to errors in the cash flow from operating activities.
  • Double counting: Double counting cash inflows or outflows by recording them in more than one category creates inaccurate and misleading final balances.
  • Inconsistent accounting policies: Inconsistencies in accounting policies or practices across different periods or organizations will complicate the preparation and comparison of cash flow statements. Maintaining clear and consistent methods across organizations and periods keeps reporting and forecasting streamlined and accurate.
  • Complex transactions: Complex transactions, such as mergers, acquisitions, or large financing arrangements, can be difficult to classify and report accurately.
  • Currency conversion: For businesses operating internationally, converting foreign currency transactions to the reporting currency can introduce errors if not handled correctly.
  • Lack of reconciliation: Failing to reconcile the cash flow statement with the cash balances reported on the balance sheet can lead to discrepancies and inaccuracies.

Indirect vs. direct method: which is better?

Both methods of calculating cash flow have appropriate use cases. When choosing a method to use, consider the end goal of the cash flow statements and the amount of financial data needed to create the statements. It is also possible to use both methods for different goals. For example, the indirect method may be used for a company's regular cash flow statements and reports, while the direct method may be used for specific small-scale analyses or short-term projections.

In general, the indirect method is preferred by most organizations. Larger organizations benefit most from the indirect method due to its speed and efficiency alongside reporting and other accounting and financial activities. Though it does sacrifice some detail and accuracy for this speed, over a long period of time it is accurate and reliable.

Smaller businesses will likely prefer the direct method because of the ease of understanding the resulting statement and the granular accuracy and clarity it provides. For a smaller business, the data that the direct method requires is less cumbersome to manage and will be less restrictive.

Indirect vs. direct method for creating pro forma cash flow statements

Pro forma cash flow statements can provide valuable foresight into a company’s expected performance. Depending on a projection's requirements, a pro forma statement can be generated using the direct or indirect method.

An indirect pro forma cash flow statement is most valuable when looking at long-term forecasts. This is best suited for larger companies with more historical financial data available.

A direct pro forma cash flow statement is best suited to short-term, detailed forecasts, particularly if past financial data is unavailable. This is especially valuable for new businesses that do not have substantial historical financial data to use.

FAQs about the indirect vs. direct method

What is the difference between the direct and indirect method?

The direct method shows all cash transactions directly, calculating cash flow from these transactions.

The indirect method starts with net income and adjusts for non-cash items and changes in working capital. Cash flow is inferred from these larger amounts, with no need to collect each individual cash transaction.

Why is the indirect method preferred over the direct method?

The indirect method is preferred because it is faster and easier to use, it uses the accrual method of accounting, and it generates a cash reconciliation as part of its production, which is required for reporting.

What are the advantages of indirect method over direct method?

The advantages of the indirect method are:

  • Better synergy with existing accounting procedures and reporting requirements
  • Faster to produce
  • Easier to manage larger, more complex cash flow situations

What is the difference between the direct method and the accrual method?

The accrual method is an accounting method that records revenue when a sale is made, no matter if the cash has been received or not. In the same way, a payment is recorded when a purchase is made, not when the actual cash is sent. This method is typically used in the indirect method of measuring cash flow.

The direct method of measuring cash flow uses cash basis accounting, which records revenue and expenses when the cash is moved. Generally, the direct method is simpler. This method is used when there can be a long period of time between a purchase and the payment.

Is the direct method allowed under GAAP?

Yes, GAAP approves and encourages the use of the direct method because of its increased accuracy and clarity.

Is the direct method allowed under IFRS?

Yes, IFRS accepts the direct method, and encourages it for the same reasons GAAP does, clarity and accuracy.

What are the three methods of accounting?

Accrual Accounting (used with double-entry), Cash-Basis (used with single-entry), and Modified Cash-Basis (also used with double-entry).

Conclusion: Direct vs indirect cash flow

Both methods of cash flow provide value for different business contexts. Though indirect is often viewed as the preferable method, direct cash flow can be extremely valuable for some organizations. Each method is important to keep in mind since there is no single correct answer for every cash flow need.

Learn more about how Prophix One can help you project and analyze your cash flows with confidence.

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