A cash flow statement is one of the most important financial reports to determine a business’s success. It shows how changes in balance sheet accounts and income affect cash and cash equivalents, giving clear visibility of cash flowing in and out of the business. The analysis is broken down into three areas: cash from operating activities, cash from investing activities and cash from financing activities.
Before you start creating a cash flow statement, you need to decide how to record cash flows from operating activities – either the direct method or the indirect method.
The direct method
Using the direct method, you list cash flow in the operating activities section, based on actual cash the business has received or paid during the period. Unlike an income statement, where income and expenses are recorded on an accrual basis – that is, at the moment of sale – a cash flow statement records when the cash is physically received or paid. In short, cash from all sales and all payments are directly reported on the cash flow statement, without any adjustments.
Examples of cash receipts and payments used in the direct method include:
- Receipts from customers
- Payments to suppliers
- Payments to employees
- Interest payments
- Tax payments
The advantage of this line-by-line breakdown of cash transactions is that investors, owners and their advisors have a clear understanding of the business’s ability to generate and manage cash, ignoring non-cash transactions.
The indirect method
The indirect method is generally easier to use, as it relies on information already gathered in the income statement and balance sheet. Net income is adjusted to convert it from an accrual to a cash basis by:
- Adding back non-cash transactions, like depreciation, provisions made for losses or bad debts, and losses recorded on the sale of an asset.
- Adjusting for changes in balances of current assets (excluding cash) and current liabilities between the start and end of the period. Current assets include inventory and accounts receivable (or debtors).
Calculating cash flow using the indirect method utilises figures taken directly from existing reports, which is why most businesses prefer the indirect method.
When should you use either method?
The best method will depend on the information you need from the cash flow statement.
The indirect method is simpler – it uses readily available information from a business’s accounting software to show profits converted into cash. However, even after you’ve made the necessary adjustments, you won’t have the precise overview of cash flows that the direct method provides.
While the direct method requires more work, it is typically preferred by investors and creditors – it shows where the business is collecting money from and who it is paying it to, as well as the exact cash amounts for each transaction.
Regardless of the method you choose, both are useful in providing a clear and accurate view of a business’s liquidity.
Read more about preparing your cash flow statement here.