Direct vs Indirect Cash Flow Methods: What’s The Difference?

The actual inflows received and the outflows paid for, and not accrued, are added and subtracted from the cash flow statement using the direct method. The accrued transactions are recorded in future cash flows when the incomes are actually received, and the payments are actually made. When it comes to cash flow forecasting, the two main methods are the direct and indirect methods. The direct method identifies payments made on specific days and weeks, as well as when you send an invoice. The indirect method is simpler to do but lacks accuracy for short to medium-term planning. In contrast, the direct method relies on actual cash transactions to derive a cash flow statement.

It will also exclude other cash-based transactions because they don’t have an impact on profit. Net profit is the result of all the transactions recorded on your profit & loss report. Here are some important considerations you can make to help determine which method you should utilize. Though it is the more popular method, there are still some potential drawbacks to keep in mind for the indirect method.

Both of these methods should leave you with the same figure, but they both take a different journey to get to that figure. It’s in fact the calculation that differs between the two as it draws upon different sources of data to reach the final figure. If your cash flow conversion is too slow, you won’t have the money you need to pay for essential expenditures, like rent or employee wages.

How To Choose Between The Direct & Indirect Cash Flow Method?

You may also have fewer non-cash assets in general, making the direct method a better way of showing your business’ true cash flow amounts. If you’re a large corporation, however, your financial health isn’t represented accurately with the direct cash flow method. The direct method, also known as the income statement method, is one of two methods utilized while crafting the cash flow statement—the other method being the indirect method, which we will examine later.

• Many accounting professionals like to use the indirect method over the direct method given how much more streamlined it is to prepare.
• In general, the two sets of standards are consistent between the statement of cash flows.
• In this article, we define cash flow statements, the different cash flow methods, cover the pros and cons of each, and explore how automation can improve cash flow.
• The indirect method for cash flow statements has some major benefits, including the following.
• As the name would suggest, the direct method (sometimes referred to as the income statement method) takes a direct approach to building the cash flow statement.

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. On the other hand, the indirect method is much easier for the finance team to create but harder for outside readers depreciation to interpret. It might be a better option for leaner teams who don’t have the time or resources to follow the direct method. You debit accounts receivable and credit sales revenue at the time of sale. For example, the bigger your company is, the more labor-intensive the direct method will become.

As you can imagine, the risk of mistakes on a direct cash flow statement is more significant than on a cash flow statement prepared using the indirect cash flow method. If you want to get started with your direct or indirect cash flow statements, grab our free 3-statement model Excel or Google Sheets template. It’s important to remember that the indirect method is based on information from your income statement, which could have certain limitations. This means you may need to take additional actions, such as accounting for earnings before taxes and interest, and making adjustments for non-operating expenses such as accounts payable and depreciation. Unsure of the difference between direct and indirect cash flow reporting?

You can use both the direct and indirect method to arrive at the same conclusion. The indirect method is more commonly used by businesses, as the statistics used in the indirect method are also used in other financial statements, which makes the method easier to calculate. Since the method isn’t directly calculating the net cash flow using the actual cash transactions during the period, the indirect method may not properly account for the timing of such outflows and inflows.

What is the Indirect Method?

The cash flow statement is the only one out of the three main financial statements that has multiple ways you can prepare it. Using each of these values, you will prepare the operating section of the cash flow statement, resulting in a net cash flow from operating activities. The indirect method uses your net income as its base and comes to a figure by the use of adjustments.

Introduction to cash flow statements

The direct method is an accounting treatment that nets cash inflow and outflow to deduce total cash flow. Notably, non-cash transactions, such as depreciation, are not accounted for using the direct method. One of the main differences between the direct and indirect method of presenting the financial statement of cash flows is the type of transactions that are used to produce the cash flow statement.

Disadvantages of Direct vs. Indirect Cash Flow

A direct cash flow statement is a simple representation of 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. Under the direct method, actual cash flows are presented for items that affect cash flow. While the direct method focuses on the cash transactions of the business, the indirect method is more accurate.

Those adjustments consider things such as depreciation and amortization, changes in inventory, changes in receivables and changes in payables. The cash generated from selling the truck would show up in the indirect cash flow forecast. Your business may earn interest on its savings account, which would help to generate extra money. Ultimately, the best approach is to choose the method that best suits your business needs. While both methods can be used to calculate the cash flow statement, the direct method is more accurate than the indirect method. Indirect cash flow requires separating cash transactions, but it does require a significant amount of preparation time.

Luckily, when using a dynamic and intuitive financial planning tool like Finmark from BILL, you can easily create and manage your cash flow statement as well as your balance sheet and income statement. The indirect method for cash flow statements has some major benefits, including the following. One of the main reasons you might prefer the direct method over the indirect method for building cash flow statements is that it can provide better accuracy. Here are some of the main benefits that you’ll find from using the direct method for cash flow statements. So therefore, your net profit is the result of all of the transactions that are recorded on your profit and loss report.

How to Calculate Cash Flow Using the Direct Method

At the same time, it can help shore up your cash flow by ensuring you’re capturing all the revenue that is owed to you. Notably, you can make your collections efforts more effective by using accounts receivable software that reduces nonpayment and encourages faster payment via a collaborative approach. Operating cash flow, financing cash flow, and investing cash flow are each detailed in separate sections in the cash flow statement. Operating cash flow is typically the first section listed in a cash flow statement. The direct method is particularly useful for smaller businesses that don’t have a lot of fixed assets, as the direct method uses only actual cash income and expenses to calculate total income and losses.