One of the most important reports you can run to check the financial health of your business is the cash flow statement. There are two ways business owners can prepare their cash flow statement: the direct cash flow accounting method or the indirect cash flow accounting method. Why are there two methods, and what are their differences?
Differences Between Indirect and Direct Cash Flow Accounting Methods
There are three separate sections of the cash flow statement: operating cash flows, investing cash flows, and financing cash flows. Regardless of the accounting method used, calculating the investing and financing sections of the cash flow statement remains the same. The only difference between the indirect and direct cash flow methods appears when you calculate your cash flows from operations.
The direct method of cash-flow calculation is more straightforward, and it shows all your major gross cash receipts and gross cash payments. The indirect method backs into cash flow by adjusting net profit or net income with changes applied from your non-cash transactions. To perform this calculation, begin with net income, add back non-cash expenses, then adjust for gains and losses on the sale of assets. Next, account for changes in non-cash current assets and changes in your working capital accounts, except for notes payable and dividends payable.
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.
Advantages and Disadvantages of the Indirect Method
While most businesses like the indirect method because it’s easy to use, the folks at the International Accounting Standards Board prefer the direct method because it gives a clear view of cash flow receipts and payments. In other words, the main advantage of the indirect method is that it’s easier, while the main disadvantage of the indirect method is that it lacks the transparency necessary to be entirely compliant with some of the rules and accepted procedures of international accounting.
Advantages and Disadvantages of the Direct Method
Because the direct method is advantageous due to its clearer views and more reliable numbers, this method is perfect for preparing a cash flow statement to present to your shareholders or others who need to know reliable figures concerning your company finances. The direct method is preferred because it complies with both generally accepted accounting principles (GAAP) and the standards of international accounting (IAS). But, perhaps most importantly, the direct method of cash flow accounting is simply easier to understand and presents a clearer, more comprehensive picture of financial health.
If you own a busy retail store, for example, you have tons of transactions on any given day. In this situation, a disadvantage of the direct method is the time it takes to capture and record information necessary for the cash flow statement. Because of its labour-intensive nature, the direct method can be costly. Another disadvantage of the direct method is if, say, you’re a publicly held corporation, your cash flow statements are publicly available. Your competitors can use your cash flow information against you and potentially weaken your standing in the industry.
When to Use the Direct vs. Indirect Methods
Cash flow is all the money that comes into contact with your business. It can include money received from customers and interest payments, as well as money paid out for employee wages, supplies, and taxes. A business’ cash flow statement shows the company’s profits and losses within a given time frame.
The direct method is particularly useful for smaller business 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.
The indirect method, on the other hand, starts off with a statement of net quarterly income and adjusts for expenses and revenues by accounting for credit transactions and items that are not direct cash. The items on an indirect cash flow statement can include depreciation expenses, for example, even though such expenses do not involve actual cash changing hands.
Accounting with the direct cash flow method is ideal for small businesses, partnerships, and sometimes sole proprietors. The direct method is more ideal for small businesses because the smaller the business, the less diverse your income sources and expenses usually are. 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 requires your business be able to separate cash expenses and income records from non-cash records. If you want to use this method, you need to keep separate records for your cash transactions and for your credit or value transactions. It’s easiest to do this if your business is new and doesn’t yet have an entrenched method of accounting – but it’s not impossible to introduce separate accounting practices to an established business model.
How to Calculate Cash Flow Using the Direct Method
A direct-method cash flow statement is usually grouped into categories of expenses and losses. These can include cash collections, operating expenses, purchases, and income tax. The amount for each category is calculated using a basic formula: For example, to calculate sales income, a business would start with the total sales amount then add any monetary decrease in accounts receivable that occurred during the quarter.
The cash flow sheet generally lists sales income at the top before listing various expense amounts, leaving a total amount for cash flow at the bottom.
Because the direct method of cash flow accounting and reporting requires more information and separate accounting records, many businesses default to using the indirect method. However, if you’re a stickler for accurate accounting and want your investors to stay fully informed, the direct method could be the best option.
How to Calculate Cash Flow Using the Indirect Method
Preparing a cash flow statement using the indirect method consists of preparing three separate sections:
- Cash flows from operations
- Cash flows from investments
- Cash flows from financing
After preparing each statement, you combine them into one complete statement of cash flows to find the company’s financial health. The sum of all net cash flows from each of the three sections should be a positive. When you compare your indirect cash flow statements from year to year, you can even better prepare for future growth – or make changes where necessary – because you have a detailed picture of your current financial status.
Differences Between GAAP and IFRS Standards for Cash Flow Statements
The statement of cash flows is one of three financial statements required under both Canadian generally accepted accounting principles and the International Financial Reporting Standards. In general, the two sets of standards are consistent between the statement of cash flows. Both allow you to present cash flow from operations using either the direct or indirect method. As Canada moves to IFRS, there is one major difference you should be aware of. Under the IFRS, interest and dividends can be grouped as operating, investing, or financing. Under Canadian GAAP, if interest and dividends are shown on the income statement, they must also be shown as cash flows from operations, not investing or financing.
You can produce your cash flow statement using the indirect or direct method of cash flows, but there are pros and cons to both methods. The indirect method may be easier for you, as the direct method requires additional account information and takes more time for you to calculate, but finding the right method can help you discover your business’s rhythm. Improve your cash flow with invoices, payments, and expense tracking. See how much cash you have on hand with QuickBooks.