Cash Flow Statement Direct Method: What Is It & Should You Use It? (2024)

FAQs

Cash Flow Statement Direct Method: What Is It & Should You Use It? ›

The direct cash flow method uses real cash inflows and outflows taken directly from company operations. This means it measures cash as its received or paid, rather than using the accrual accounting method. Accrual accounting recognises revenue as it's earned, rather than when you receive payment.

The direct method of accounting for cash flows uses real cash inflows and outflows from a business's operations. This process records cash as it comes in or is paid out. Conversely, the accrual accounting method records revenues and expenses as they occur, rather than when money comes in or out.

There are two ways to prepare cash flow statements: direct and indirect. Generally, larger companies with more complex accounting and reporting will use the indirect method for efficiency, and smaller businesses will use the direct method since it's more straightforward.

While both the direct and indirect cash flow statement format provides you with the same end result, it's important to note that the International Accounting Standards Board (IASB) favours the direct method, as it provides more useful information.

Whenever given a choice between the indirect and direct methods in similar situations, accountants choose the indirect method almost exclusively. The American Institute of Certified Public Accountants reports that approximately 98% of all companies choose the indirect method of cash flows.

Salaries/Cash Paid to Employees

We need to factor the wage expense (as we have to pay our employees), but SUBTRACT the change in accrued wages from period to period. Just like Accounts Payable, or Accounts Receivable, the change in accrued wages indicates the amount we doled out in cash.

The indirect method is more common and easier to prepare, as it uses the data from the income statement and the balance sheet, which are readily available. The indirect method also highlights the relationship between the net income and the cash flow, and the impact of non-cash items and working capital on cash flow.

Businesses can generate cash flow statements using either the indirect or direct method. The indirect method, starting with net income and adjusting for noncash items and balance sheet changes, is simpler and more commonly used, especially by larger firms, because it's efficient and easy to prepare.

Context and Formality

Direct speech is often used in informal conversations, while indirect speech is more common in formal settings or when reporting information.

To calculate cash flow from operating activities using the direct method, first, sum up cash receipts from customers and then subtract cash payments to suppliers, employees, and operating expenses. You also need to adjust for any other cash inflows or outflows directly related to core business operations.

What is the advantage of using the direct method to present the statement of cash flows? ›

The direct method of preparing a cash flow statement has several advantages over the indirect method. It offers more detailed and transparent information about the sources and uses of cash from operating activities, allowing users to better understand the cash cycle and profitability of the business.

The indirect method and direct method are two ways of preparing the statement of cash flows. The key difference is: Indirect method: Starts with net income from the income statement, then adjusts for non-cash items to arrive at cash flows from operations. This is the most common method used.

Direct Cash Flow Method

It is presented in a straightforward manner. Most companies use the accrual basis accounting method. In these cases, revenue is recognized when it is earned rather than when it is received.

Cash flow direct method example

Cash paid to suppliers and vendors. Cash received from customers. Income received from interest and dividends. Tax and interest payments.

The indirect method adjusts net income with changes applied from non-cash transactions. Not commonly used. It is most appropriate for small businesses without significant cash transactions. Commonly used by public companies with regular audits.

While both are ways of calculating your net cash flow from operating activities, the main distinction is the starting point and types of calculations each uses. The indirect method begins with your net income. Alternatively, the direct method begins with the cash amounts received and paid out by your business.

Direct cash forecasting is a method of forecasting cash flows and balances used for short term liquidity management purposes. Direct cash forecasting, sometimes called the receipts and disbursem*nts method of forecasting, aims to show cash movements and positions at specific future points in time.

Classification of cash flows

The first is the direct method which shows the actual cash flows from operating activities – for example, the receipts from customers and the payments to suppliers and staff. The second is the indirect method which reconciles profit before tax to cash generated from operating profit.

Both methods arrive at the same total operating cash flow amount, but the direct method provides a more granular breakdown while the indirect method is easier to derive from financial statements.