Welcome to the topic “Cash flow direct vs. indirect.”
A cash flow statement is one of the primary accounting statements after the income statement and balance sheet. Further, it’s a handy report that your firms and businesses use to monitor a firm’s finances. The report provides investors and other stakeholders a detailed overview of all the cash transactions taking place, and it also helps to monitor the overall business’s health.
Commonly, a cash flow statement is prepared in the two formats or methods, the direct method and indirect method, and final results may vary in both these formats. This also means that understanding the difference between direct and indirect cash flow statements is vital for accurate and relevant financial reporting. Below is the complete guide about both the methods, along with their differences.
What is a Cash Flow Statement?
It is the primary accounting statement that firms used to monitor daily cash transactions. Cash flow statements include different sections divided into three sets of activities: operating, financing, and investing. However, the operating activities section primarily deals with the direct versus indirect cash flows, while other sections have minor differences. By comparing the operating activities section with the income statement, you can easily recognize the differences in the timing of income and cash collections. These evaluations also help to identify the timing differences between a firm’s expenditures and cash payments. Major differences show that the firm is performing aggressively, or it is spending a lot of cash to purchase or maintain its assets, a fact that you will not find in the firm’s income statement. Let’s take a brief look at all the sections of cash flow statements.
Operating activities – All revenue-generating activities of a business are shown in the operating activities section of a cash flow. The operating activities include income, expenditures, gains, and losses. However, this section doesn’t contain the costs pertaining to investments or financing.
Investing activities – Investing activities in a cash flow deal with fixed or long-term assets, often referred to as plant & equipment, land or property, and other similar investments.
Financing activities – The financing activities in a cash flow include 3rd party backers of the business, such as investors or loans acquired by the business. The section also includes long-term liabilities and stockholder equity.
Now that you understand the cash flow statement and its main sections are; let’s discuss the direct method and indirect method of cash flow.
Direct Method
In the direct method, cash transactions or flows are mentioned in the operations section. These cash flows can arise because of customer collections and various cash expenses. This section also shows cash paid against taxes and interest. The major problem in cash flow’s direct method is that a firm or business might not have all the information in the appropriate form. Similarly, firms using the accrual accounting method will have to make special provisions or systems to track all the cash transactions and sales separately.
Indirect Method
In the cash flow’s indirect method, your net income is adjusted to convert it into a cash basis from an accrual basis. You will have to add back all non-cash expenditures such as depreciation, amortization, loss provisions, and all the losses on the sales of a non-current and fixed asset. Similarly, you will have to adjust net income against the changes between the starting and ending balances in all of your current assets except cash and current liabilities. You can also check this Cash Flows Indirect Method blog.
Key Differences: Direct Cash Flow vs Indirect Cash Flow Method
Here are some major differences between direct and indirect cash flow methods:
The most significant between these two methods of cash flow is the transactions used to prepare the report. In an indirect method, net income is utilized as the base, and later it is converted into the cash flow through various adjustments. However, only cash-based transactions are taken into account to produce the cash flow from operations in the direct method. In the direct method, cash transactions are recorded separately then the report is compiled.
The indirect cash flow method needs prior preparations as all the adjustments are included. But in the direct method of cash flow, there are no prior preparations as it only requires cash transactions.
In terms of accuracy, the indirect method is said to be less accurate than the direct method of cash flow, but it is suitable for most firms because it is simple to prepare than the other method. Comparatively, the direct method is said to be more accurate as there are no adjustments.
How To Choose Between Them
Now, the question is which method is recommended, or if you get the same results from both the indirect and direct cash flow methods, how will you determine which is the best for you?
For this purpose, you will have to consider various factors such as the industry, your audience or consumers, and the authorities you’re reporting for; all these factors impact the statement. Similarly, available data and insights can also affect the impacts. Apart from these, some other things you will have to consider are:
Ease of use: As it includes the information and data you’re already using in other statements such as the P&L statement and balance sheet. That is why the indirect method is said to be less complicated for large organizations as it is time savings.
Transparency: As mentioned above, the direct cash flow method only focuses on cash-based transactions without any adjustments; hence it is more transparent of your cash flow. Direct approach while preparing cash flow also gives more specific info as there are no reverse methods of backing out non-cash-based transactions or items.
Point of comparison. Unlike the direct cash flow method, the indirect method comprises net revenue and allows you to compare cash flow with net profit in a much better way. It also helps in explaining how the business receives cash and how it records its revenue.
What’s right for you mainly depends on your business type and size. Mostly, big companies prefer the indirect method as it is straightforward. Similarly, analysts also prefer it as it allows them to view all the adjustments. For small and medium enterprises, the direct method is more effective as it offers more transparency into operating details and helps them to determine their cash availability and planning needs.
The Pros and Cons of Direct and Indirect Cash Flow Reports
Both methods have their plus points and drawbacks. Let’s check them out as it will help you in deciding which is the best method for you.
Pros Of Direct Method:
This method provides a more clear and accurate picture of the business’s operations. Similarly, there are no adjustments that reflect cash that the business has earned but not received. The method is compliant with generally accepted accounting principles (GAAP) and IAS (international accounting standards).
Cons of Direct Method:
As we know that most businesses and firms maintain a record on an accrual basis; hence the direct method is more complicated and time-consuming. For example, you will have to reconcile every cash transaction separately to determine cash flow from net income.
The Pros and Cons of Indirect Cash Flow Reports
Pros
In the indirect method, the statement is simple to prepare as firms are already maintaining records on an accrual principle which offers a better overview of the adjustments and cash flow. Furthermore, the method is more popular and widely used, so investors and other stakeholders are more familiar with the indirect approach. Lastly, this method is more suitable for businesses and firms with high cash transactions.
Cons
The biggest drawback of this method, according to accounting experts, is the lack of transparency than the direct cash flow method. That is why highly-regulated industries and businesses avoid using the indirect approach.
What Else You Need To Know
No matter which method of cash flow you use, a cash flow statement is a critical requirement of your business and offers the ultimate flexibility that you will need to run your business. A cash flow statement is a strong indicator that shows that whether your company can handle the unforeseen economic downturn or market shift. It is also beneficial for investors, creditors, and others stakeholders and provides them all the information they need for decision-making and monitoring the business’s cash needs.
Conclusion
Both the direct and indirect cash flow methods are beneficial at various points, and you can use them as per your business and financial needs or as per the situation. Lastly, the indirect method of cash flow is more preferred by firms and companies. On the other hand, the cash flow’s direct method is more accurate and requires less preparation time as there are no prior adjustments.
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