billy-russell

Billy Russell - FP&A Strategist

June 2022 - min to read

Cash flow: What's the difference between the direct vs indirect method?

Cash flow: What's the difference between the direct vs indirect method?

It's no surprise that cash flow is one of the most important parts of running a business.

But keeping track of cash gets trickier as your business grows. To complicate matters, there are two big methods of reporting cash flow—direct and indirect reporting.

Each method has its own pros and cons. In this post, you'll learn exactly when and how to use the direct vs. indirect cash flow method. 

Keep reading.

Key Takeaways

  • A cash flow statement is one of the three major financial statements. It summarizes the cash flowing into and out of your business. 
  • Cash flow statements are built using two methods: direct or indirect cash flow. 
  • While one method of cash flow reporting is more widely used, both methods have advantages.
  • Both methods of cash flow reporting meet Generally Accepted Accounting Practices (GAAP) and International Financial Reporting Standards (IFRS), though these guidelines encourage the direct cash flow method.
  • Direct and indirect cash flow methods use different techniques to report operating cash—the cash generated from your main source of revenue. Investment cash and financing cash are handled the same way in both methods.

Contents

  1. What is a cash flow statement?
  2. What is the direct cash flow method?
  3. What are the advantages and disadvantages of the direct cash flow method?
  4. Direct method example
  5. What is the indirect cash flow method?
  6. What are the advantages and disadvantages of the indirect cash flow method?
  7. Indirect method example
  8. How to choose a reporting method
  9. Conclusion: direct vs. indirect cash flow

What is a cash flow statement?

A cash flow statement is one of three documents that make up a company’s total financial statements. 

When presented alongside the income and balance sheet statements, these documents present a detailed narrative of the company’s cash position, assets, and financial health. 

The cash flow statement is used to report the movement of cash from all sources into and out of the business. 

The cash flow statement provides a detailed account of the three sources of cash flow:

  • Operating: This is revenue and expenses generated from your main line of business. 
  • Financing: Revenue earned and cash spent on financing activities. This includes stocks, bonds, and dividend payments to investors.
  • Investment: Cash spent on the business for long-term items such as supplies, equipment, and fixed assets.

The direct and indirect cash flow methods tell the same story about the movement of cash but do so from a different starting point. 

Now let’s take a closer look at each method.

What is the direct cash flow method?

The direct cash flow method looks at a simplified version of how cash comes into and out of your business. Cash movement is presented with actual items that change the flow of cash, such as:

  • Cash from customers
  • Interest and dividends received
  • Salaries
  • Vendor payments
  • Interest payments
  • Income taxes

To build a direct cash flow statement:

  1. Start by stating cash flow from revenue.
  2. Subtract any cash payments for expenses. This number is your pre-tax income.
  3. Subtract the cash payments made for income taxes. The remainder is your net cash flow from operating activities.

What are the advantages and disadvantages of direct cash flow statements?

As we mentioned before, a direct cash flow statement provides a simple way to represent cash movement. The layout of the direct cash flow method makes it easy for the reader to understand how cash comes into and out of the business. 

…so, what’s the catch?

Direct cash flow reporting takes a lot of time to prepare. This is because most businesses work on an accrual basis. 

In the accruals basis of accounting, revenue and expenses are recorded when they’re incurred—not necessarily when the money is collected or paid out. 

This makes it difficult to collect and report data using the direct cash flow method. For this reason, most businesses use the indirect method, as the information needed for reporting is readily available in the general ledger.

Direct method example

Below is a quick example of how the direct method might look: 

Cash flow from operating activities:

Cash receipt from customers

$2,000,000

Wages and salaries

(600,000)

Cash paid to vendors

(400,000)

Interest income

$10,000

Income before income taxes

$750,000

Interest paid

(7,000)

Income taxes paid

(253,000)

Net cash from operating activities

$1,500,000

To simplify this example, we've rolled up expenses and incomes from a couple of different categories. 

If you're a Cube user, you can alleviate the "messiness" of direct method reporting by using the drilldown and rollup features. So it comes down to preference.

What is the indirect cash flow method?

On the other side of the coin, we have the indirect cash flow method. 

In the indirect method, reporting starts by stating net profit or loss (pulled from the income statement) and works backward, adjusting the amounts of non-cash revenue and expense items. 

To build an indirect cash flow report:

  1. Start with your net income. 
  2. Build non-cash expenses back in. These are items such as depreciation and amortization.
  3. Subtract out gains or losses from the sale of long-term assets. You do this because long-term assets show up under the “investing” portion of cash flows.
  4. To adjust for current assets and liabilities, subtract out accruals from operating activities.

After these non-cash adjustments, the remaining number is your cash generated through operations. 

Important: No matter which method you use, you should arrive at the same operating cash amount.

What are the advantages and disadvantages of indirect cash flow?

The indirect cash flow method makes it easier to report cash movements in and out of the business for accruals basis accounting. 

It’s faster and better aligned with the way this accounting method works. Accountants overwhelmingly prefer it for reporting cash movement.

The drawback here is the opposite of the direct reporting method. It’s harder for outside readers to understand how cash moves in and out of the business. This means investors and lenders don’t find this method as useful.

Indirect method example

Accrual method accounting recognizes revenue when earned, not when cash is received. If you're reporting month-on-month, a $30,000 sale that closes at the end of the month but which isn't paid until the next month can complicate your reporting. 

You recognize the revenue, but you don't yet have the cash.

The indirect method provides an out. At the time of sale, a debit is made to accounts receivable and a credit is made to sales revenue. 

So while no cash has been received, revenue has been recognized. This means net income was overstated, so we correct it by balancing accounts receivable and sales revenue.

On the balance sheet, this might read as "Increase in Accounts Receivable (30000)."

How to choose a reporting method

To decide on the best reporting method for your needs, consider a few questions:

What are your desired outcomes for reporting? If you are a smaller business simply looking for clarity in your financials, the direct cash flow method may be best. If you’re looking for comparison data, indirect may be the way to go. 

Who are you creating reports for? If reports are for internal use, use the method that best aligns with your audience’s level of understanding. If you report to investors, banks, or prospective buyers, the direct method will make more sense to readers. 

How detailed do you need to be? Depending on the depth of reporting you’re looking for, you may want to commit the work to a direct reporting method. While it takes longer to compile, the direct method gives a more transparent view of your cash inflows and outflows. 

Once you’ve considered what you’re trying to do with your cash flow statement, one method will make more sense.

Conclusion: direct vs indirect cash flow

Now you know the basics of direct and indirect cash flow statements.

In short, the direct method is helpful when you need to make it easy for other people—like investors and stakeholders—to understand your cash flow. But it's harder for you as the finance person to create. 

On the other hand, the indirect method is much easier for the finance team to create, but harder for outside readers to interpret. It might be a better option for leaner teams who don't have the time or resources to follow the direct method.

If you're looking to get started with your own direct or indirect cash flow statements, grab our free 3-statement model Excel or Google Sheets template.