Difference Between Direct and Indirect Cash Flow Methods
The direct and indirect methods are two ways of preparing the cash flow statement, which is one of the main financial statements of a company. They differ in how they report cash flows from operating activities.
- Direct Method: This method presents the specific cash flows associated with items that affect cash income. It requires a company to report cash receipts (incoming cash) and cash payments (outgoing cash) from each of its operating activities. Examples include cash received from customers, cash paid to suppliers, cash paid to employees, etc. Although the direct method provides a more detailed view of cash flows, it is more complex and requires more detailed records, which is why it is not used as frequently as the indirect method.
- Indirect Method: This method starts with net income and then adjusts it for non-cash transactions, changes in operating assets and liabilities, and other items. Essentially, it reconciles reported net income to the actual cash provided by or used in operating activities. Non-cash items that are added back to net income can include depreciation, amortization, and deferred taxes, while changes in operating assets and liabilities can involve accounts receivable, inventory, accounts payable, and others. The indirect method is more straightforward to prepare and is the most commonly used method.
Regardless of the method used for the operating activities, the investing and financing sections of the cash flow statement are presented identically.
While both methods will result in the same amount of cash flow from operating activities, they offer different perspectives on the business. The direct method provides a clearer picture of the flow of cash in and out of a company, whereas the indirect method shows the link between net income and cash flow.
Example of the Difference Between Direct and Indirect Cash Flow Methods
Let’s consider a hypothetical company, “BizCo”, and compare how the cash flow from operating activities might be calculated under both methods.
Assume the following for a given year:
- Net Income: $15,000
- Depreciation: $3,000
- Increase in Accounts Receivable: $1,000
- Increase in Accounts Payable: $2,000
Indirect Method: The indirect method starts with the net income and adjusts it for non-cash transactions and changes in operating assets and liabilities:
- Start with Net Income: $15,000
- Add back Depreciation (a non-cash expense): +$3,000
- Subtract Increase in Accounts Receivable (an increase in assets uses cash): -$1,000
- Add Increase in Accounts Payable (an increase in liabilities provides cash): +$2,000
- Total Cash Flow from Operating Activities: $19,000
Direct Method: In the direct method, we would need additional information about actual cash received and paid out for various activities. Assume that during the year, BizCo had the following cash flows:
- Cash received from customers: $40,000
- Cash paid to suppliers: -$15,000
- Cash paid for salaries: -$6,000
- Total Cash Flow from Operating Activities: $19,000
With both methods, the resulting cash flow from operating activities is the same ($19,000), but as you can see, the path to get there is quite different. The indirect method adjusts net income for changes that affected reported income but didn’t involve actual cash, while the direct method directly records cash received and paid out.
