What is the difference between the direct cash flow method and the indirect cash flow cash flow method? And, more importantly, how do you calculate them? And, finally, what does this have to do with my cash flow statement?
Let’s begin with the basics. Most businesses use accrual accounting as their accounting method. Accrual accounting means a company records the revenue and expenses as they occur and not when they receive payment. For those businesses which use accrual-based accounting, their income statement does not provide adequate information about the cash flow of a company. There are items that impact cash flow that does not show up in the income statement such as mortgage payments, building improvements, and the purchase of additional assets. Instead, a business needs to look at their cash flow statement to fully understand cash flow. Two methods exist to analyze operational cash flow — the direct method or indirect method.
In this article we are going to address the following:
- Definition of a cash flow statement
- Direct cash flow method calculations
- Indirect cash flow method calculations
Cash Flow Statement
Among the many financial statements business leaders rely on is the cash flow statement. At its most elemental level, the cash flow statement or sometimes referred to as the statement of cash flows, is a report that illustrates how cash flows both in and out of the business. This financial statement helps a company understand the change in cash and how it is impacted by different activities. There are three separate areas of a cash flow statement:
- Operating activities — Any revenue generating business activities are recorded in the operating activities. The operating activities create revenue, expenses, gains, and losses. Essentially, the operational activities do not include costs associated with investing or financing.
- Investing activities — Investing activities is everything that has to do with fixed assets or long-term assets, often referred to as property, plant & equipment (PP&E) and other investments.
- Financing activities — Finally, the financing activities on a cash flow statement document 3rd party backers of your company through investors or loans. And, this is also where your long-term liabilities and stockholder equity are recorded.
In reality, the only difference between direct and indirect cash flow resides in how the operational activities are calculated as illustrated in this graphic.
For both methods, the goal is to determine a company’s net cash flow. Let’s explain more thoroughly.
Direct Cash Flow Method
With the direct method, also referred to as the income statement method, you identify all sources of cash receipts plus all cash payments. The Financial Accounting Standards Board (FAS) recommends the direct cash flow method because it is a more transparent view of cash flow. However, most companies’ chart of accounts are not structured in a way to accommodate this easily. Two categories exist for direct cash flow — cash coming from customers and cash disbursements. Attached is a description of those activities that go into the direct cash flow method.
Indirect Cash Flow Method
Notably, the most commonly used cash flow method is indirect cash flow. You may also see the indirect cash flow method referred to as the reconciliation method. With the indirect cash flow, you are reconciling back to cash. If you are a QuickBooks user, QuickBooks generates their cash flow reports using the indirect method. Information for indirect cash flow is simple to compile as it comes directly from the income statement and balance sheet. Ordinarily, this information is readily available through your accounting system. With the indirect cash flow method, you begin with your net income and then add back or deduct those items that do not impact cash. Attached is a description of those activities that go into the indirect cash flow method.
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Finally, the results for either method of cash flow should get you the same results.
The important thing is to select a method and stick with it. Cash flow is necessary to manage a business successfully, so owners have sufficient cash on hand to fund operations. In short, without a regularly prepared cash flow statement, it will be difficult to see the big picture on your company’s performance.
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Originally published at STRATAFOLIO.