Cash Flow Statements: Direct vs. Indirect Method

December 4, 2023

Cash Flow Statements: Direct vs. Indirect Method

What is a Cash Flow Statement? 

A statement of cash flows is a financial statement that provides a summary of the cash inflows and outflows of a business or other entity during a specific period of time, usually quarterly or annually. It is one of the key financial statements used by investors, analysts, and other stakeholders to assess the financial health and liquidity of a company.

All cash flows for the business are split into three main categories:

Operating Activities: Operating cash flows refer to the cash generated or used by a company's core operating activities. These cash flows provide insights into the company's ability to generate cash from its regular business operations.

Investing Activities: Investing cash flows refer to the cash transactions related to a company's investments in long-term assets and securities. Investing cash flows provide insights into how a company is deploying its capital for long-term growth and investment opportunities.

Financing Activities: Financing cash flows involve changes in the company's capital structure and financing arrangements. The financing section of the cash flow statement provides insights into how a company raises and repays capital.

What Does a Cash Flow Statement Show?

Operating Activities on the statement of cash flows typically involves receipts from customers, payments to suppliers, payments to employees, and other operating expenses. In other words, all the cash that comes with the basic elements of running a business are captured in the operating activities section of the cash flow statement. 

Investing Activities covers cash transactions for the acquisition and disposal of long-term assets, such as property, equipment, and investments. It includes purchases and sales of assets and investments. The investing activities section of a cash flow statement assists in giving a better understanding of how a company utilizes capital in order to ensure financial stability for years to come. 

Financial Activities encompasses cash transactions with the company's owners and creditors. It includes activities such as issuing or repurchasing stock, borrowing or repaying loans, and paying dividends. This section of the cash flow statement tells investors how the company handles debt, equity, and dividends to help make informed investment decisions. 

Different Methods of Calculating Cash Flow

Direct Method: In the direct cash flow method, the statement of cash flows reports cash transactions in a way that directly lists the actual cash inflows and outflows. Each cash transaction is recorded in the appropriate section and then the three sections are summed together. While the direct method provides a more detailed and intuitive view of cash flows, it is less commonly used than the indirect method. This is primarily because preparing the statement of cash flows using the direct method requires more detailed information about specific cash transactions, and many companies find it more practical to use the indirect method

Indirect Method: In the indirect cash flow method, the statement of cash flows starts with net income from the income statement and then adjusts for changes in non-cash items and changes in working capital to derive the net cash flow from operating activities. The indirect method is more widely used than the direct method, primarily because it is generally considered easier to implement.The general process for using the indirect method is as follows: 

  1. Net Income: Begin with the net income figure from the income statement. Net income is an accounting measure and includes various non-cash items such as depreciation and amortization.

  1. Adjustments for Non-Cash Items: Add back non-cash expenses deducted in the income statement, such as depreciation and amortization. These items do not involve an actual outflow of cash.

  1. Changes in Working Capital: Adjust for changes in current assets and liabilities that affect cash. For example, an increase in accounts receivable would decrease cash flow from operating activities, while an increase in accounts payable would increase cash flow.

  1. Other Adjustments: Include other items that affect cash but are not part of day-to-day operating activities, such as gains or losses on the sale of assets.

  1. Net Cash Flow from Operating Activities: Sum up the adjustments to the net income to arrive at the net cash flow from operating activities.

After determining the net cash flow from operating activities, the statement of cash flows using the indirect method will also include the cash flows from investing activities and financing activities, similar to the direct method.

The indirect method is preferred by many companies because it is generally simpler and requires less detailed information about specific cash transactions compared to the direct method. However, both methods aim to provide a clear picture of a company's cash flows during a specific period.

Statement of Cash Flows Indirect Method Example

To put the information regarding the indirect method to use, let’s go over a quick and simple example of how an accountant may use the indirect method. If a customer has purchased a product on credit for $750, the accountant must then reduce net earnings by $750. This increase in accounts receivable cannot be captured in the cash flow statement, so it must be deducted from net earnings before we reach our net cash flow. This process must be done each time there is an increase in accounts receivable. 

Statement of Cash Flows with LiveFlow

If you are an accountant or finance professional looking to automate your financial analysis spreadsheet work, check out LiveFlow. We offer free templates that assist you in building dashboards right in Google Sheets with data from QuickBooks! With LiveFlow, the work is done for you: whether you are building a cash flow forecast, profit & loss statement, or any one of our many other dynamic templates, LiveFlow can help ensure you are able to do exactly what you need with your data. To learn more, book a demo. 

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