This post was first published in 2020 and updated on December 8, 2021.
It may not always get the most love, but your cash flow statement is a vital part of your reporting story. That’s why, in this post, we’re going to talk all about choosing the best cash flow method for your business.
Among the main trifecta of financial reports—the balance sheet, income statement and cash flow statement—it’s often the statement of cash flow that gets the least attention and time. But as a view into your company’s liquidity, it provides an important piece of the puzzle.
And extracting the information you need? This begins with putting the right process in place to build the best cash flow statement for your business—in whatever time you have. That starts by choosing between the direct and indirect cash flow methods.
Calculating Cash Flow
A mandatory part of your organization’s financial reports, the cash flow statement tracks cash movement for stakeholders of all kinds. This includes investors and creditors, as well as your own team.
It must eventually be reconciled to the bank to make sure you’ve covered all cash transactions. It also provides critical knowledge on how your money is being spent, where it’s coming from and whether there’s enough available to keep up with operating expenses and ongoing debt repayment.
Primary components of a cash flow statement
To accomplish all of that, the cash flow statement includes three main components:
- Investment cash flow: Cash spent on investments your business has made, including equipment purchased.
- Financing cash flow: Cash spent and earned on financing activities, such as bonds, stocks and dividend payments.
- Operating cash flow: Cash spent and earned on operating activities.
(Here’s another post you don’t want to miss next: Cash Management: 3 Questions to Ask When Planning for Today and Tomorrow)
There may be some disclosure of non-cash activities included as well. But it’s those three components that allow your stakeholders to infer whether your company is paying dividends, paying down their debt or accruing more, investing in capital and so on.
Investors or lenders can also identify whether your company’s operating cash flow is smaller than your net income or whether you’re paying dividends to your investors from your operating cash flow or by accruing more debt. All of which is important if they’re trying to determine the overall health of your business.
Operating Cash Flow
While financing and investment cash flow are calculated using a standardized approach, methods vary for the third section of your cash flow statement: operating cash flow.
There, reporting guidelines require you use one of two methods: direct or indirect.
Either is acceptable according to the generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS) guidelines. That being said, the direct method is encouraged. Still, each method has its pros and cons.
Visit this post next to learn about balancing GAAP and IFRS with other reporting needs.
The Direct Method vs. Indirect Method
So what’s the difference between direct and indirect?
While both are ways of calculating your net cash flow from operating activities, the main distinction is the starting point and types of calculations each uses. The indirect method begins with your net income.
Alternatively, the direct method begins with the cash amounts received and paid out by your business. Each uses a separate set of calculations from there to get to the same finish line, revealing different details along the way.
Let’s look at each in turn.
The Indirect Cash Flow Method
The indirect cash flow method starts with your organization’s net income. It then makes adjustments to get to the cash flow from operating activities. Those adjustments consider things such as depreciation and amortization, changes in inventory, changes in receivables and changes in payables.
Once you’re done with the adjustments, you end up with a final closing bank position.
The benefit of the indirect method is that it lets you see why your net profit is different from your closing bank position. But because it’s based on adjustments, one of its disadvantages is that it doesn’t offer the same visibility into cash transactions or break down their sources.
Without that fine detail, there are insights you may be missing out on.
The Direct Method
The direct method individually itemizes the cash received from your customers and paid out for supplies, staff, income tax, etc. Non-cash transactions are ignored. And again, a closing bank statement emerges—the same closing bank statement you’d get using the indirect method.
An advantage of the direct method is that it gives you more visibility of your cash inflow and outflow—something that can benefit your short-term planning, enabling you to identify and analyze any potential challenges or opportunities that might exist for future cash flow.
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A better view of the past helps you forecast for the future.
But it’s also more time-consuming for your team because it requires looking beyond the balance sheet and income statement account activity you already know so well.
(Check out The Ultimate Guide to Financial Reporting to help you better understand your company's financial performance.)
How To Choose Between Them
In the end, both the indirect and direct cash flow methods get you to the same number. So how do you decide which method will work best for you?
Factors like the industry you’re working in and the audience you’re reporting for (whether management or banks, auditors or shareholders) will make a difference. And so will the data you have available and the insights you hope to generate.
But there are a few other factors to consider as well:
- Ease of use: Since it draws on data you’re already using in your profit and loss (P&L) statement and balance sheet, the indirect method is less complicated for teams to prepare, meaning it offers significant time savings.
- Transparency and granularity: As it focuses only on cash transactions that have been received or paid out, the direct method offers a more transparent view of your cash flow. It also allows for more specific details rather than using the reverse method of backing out non-cash items.
- Point of comparison: Unlike the direct method, the indirect method includes your net profit, letting you better compare cash flow with net profit to explain how your business receives cash compared to how it records income.
What’s right for your team will be up to you. Most larger companies choose the indirect method, at least in part because of the lower time investment, while analysts often prefer it as well because it lets them see for themselves what adjustments have been made. The direct method, on the other hand, is often the best choice for smaller businesses, as the transparency into operating cash flow details helps them better determine their short-term cash availability planning needs.
What Else You Need To Know
Your cash flow statement tells a critical part of your financial story, no matter which approach you use. It can also give you the ultimate flexibility to run your business responsibly.
A negative cash flow statement can be a strong indicator that your company’s not in a good position for a potential economic downturn or market shift. It can also mean you need to look into other financing options.
It also empowers your investors, creditors, and stakeholders with the information they need to understand whether you have the cash available to pay off your loans if you can pay your employees, or how you measure up to your peers.
Whether you choose to use the indirect or direct method will affect the way you operate your cash flow and the story you tell around it. So make sure you choose the method that puts you in the best place to help your business succeed.
Did you learn a lot about the different cash flow methods in this post? Here are three more posts to read next:
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- How To Overcome 6 Horrors of Financial Reporting
- Cash Management: 3 Questions to Ask When Planning for Today and Tomorrow