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Learn about the difference between the direct and indirect method.
A cash flow statement is a very important financial report that helps determine your business’s success. The statement shows how changes in balance sheet accounts and income affect cash, allowing you to see cash flowing in and out of your business. However, before you start creating a cash flow statement, you must decide how to record cash flows from operating activities- the direct method or the indirect method. Continue reading to learn about the differences between the two methods.
The Direct Method
When using the direct method, you will list cash flow in the operating activities section, based on cash the business has received or paid during the period. A cash flow statement records when the money is physically received or paid, rather than an income statement that records income and expenses on an accrual basis.
A few examples of cash receipts and payments used in the direct method include receipts from customers, tax and interest payments, and payments to suppliers and employees. The advantage of the direct method is that investors and owners have a clear understanding of the business’s ability to manage cash.
The Indirect Method
The indirect method is typically easier to use since it relies on information that has already been gathered in the income statement and balance sheet. The net income is adjusted to convert it from an accrual to a cash basis in two ways. The first way is to add back non-cash transactions, such as depreciation, provisions made for bad debts and losses, and losses record on the sale of the asset. The second way is by adjusting for changes in balances of current assets (including inventory and accounts receivable) and current liabilities between the beginning and end of the period. Many businesses prefer the indirect method for calculating cash flow, as it uses figures taken from existing reports.
When To Use Each Method
To decide which method is best to use, you must think about the information you need from the cash flow statement. The indirect method is more straightforward, but on the other hand, you won’t have the same precise overview of cash flows that the direct method provides. The direct method does require more work, but it is often preferred by investors, as it shows more information about where the business is collecting money from, who it is paying it to, and the exact cash amount for each transaction.
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