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 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.
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 aren't direct cash. The items on an indirect cash flow statement can include depreciation expenses, for example, even though such expenses don't 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 to 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.
