Cash flow comes from a company’s day-to-day operations, investments, and financing activities. There are two ways to show cash flow from operations. They are Direct and Indirect Cash Flow. Understanding the differences between them allows one to make the proper decisions in financial matters.
Direct Cash Flow Statement
In the Direct Cash Flow Statement, companies list the main cash received and paid. This shows all cash transactions during a set time, like loans for short-term needs. It records transactions when cash is received or spent. So, the net income will be the same as the actual cash flow from the company’s operations.
Benefits of the Direct Method
Here are some benefits of using the direct method for cash flow statements:
More Accurate
The direct method gives more accurate results because it uses actual cash payments and receipts from the period. It shows precisely how much cash was spent or earned from operating activities.
Fewer Mistakes
Since the direct method focuses on real cash transactions, it reduces the chances of mistakes, unlike the indirect method, which adjusts net income with non-cash items.
Better Insights
The direct method also offers clearer and more detailed insights than the indirect one.
In a direct method, calculations are simple and easy to understand. This makes it easier to see where cash is coming from and where it’s going, giving a better view of the company’s cash flow activities.
Indirect Cash Flow
The Indirect Cash Flow Statement starts with the company’s net profit and adjusts it for things that don’t involve actual cash. Unlike the Direct method, it changes the profit by removing things like unpaid expenses or income, non-cash costs (like depreciation), and gains or losses that aren’t from regular operations.
Benefits of the Indirect Method
The indirect method for cash flow statements has some important benefits, including:
Widely Used
Even small and large companies have started to use direct and indirect methods. Publicly traded companies must also use this method to follow Generally Accepted Accounting Principles (GAAP).
So, even if a company uses the direct method for its internal reports, it still has to prepare an indirect method statement to stay compliant, which can increase the team’s workload.
Easier to Build
Many accounting professionals like to use the indirect method over the direct method, given how much more streamlined it is to prepare. Since you only need to use information from the financial statements that were already prepared, this is a much more practical and efficient use of your team’s time.
This is in comparison to the tedious nature of the direct method, where preparers need to monitor and document each business’s cash inflow and outflow. To know more about how to manage these accounting methods, consider joining accounting professional courses that allow one to acquire more knowledge in the accounting sector.
Direct vs Indirect Cash Flow
Let’s read about some of the key differences between the Direct and Indirect Cash Flow;
| Aspect | Direct Cash Flow | Indirect Cash Flow |
| Definition | Shows actual cash payments and receipts in real-time, using only cash transactions. | Adjusts net income by factoring in non-cash transactions. |
| Use Preference | Less commonly used; often suitable for smaller businesses with fewer cash transactions. | Commonly used by public companies, especially during audits, as it draws from income statements and balance sheets. |
| Accuracy | Simple to understand but more complex to calculate due to tracking all cash movements. | Easier to calculate using a company’s ledger and accrual accounting records. |
| Accounting Standards | Accepted under GAAP in the United States. | Accepted under GAAP in the United States. |
| Effort and Time | Time-consuming as it requires tracking all cash receipts and payments individually. | Quicker and easier to prepare, as most businesses use an accrual-based system. |
| Reconciliation of Cash | Needs reconciliation to verify transactions because it reports in real-time. | Reconciles accrual accounting net cash flow with actual cash from operations, showing cash position and profit. |
| Link Establishment | Directly links to the balance sheet as it tracks real-time financial data. | Requires linking the balance sheet and income statement, offering a more complete view of the company’s finances. |
Direct vs Indirect Cash Flow offers many advantages. When choosing which method such as Direct and Indirect Cash Flow to use, focus on how it affects the operating activities section of your cash flow statement.
The investing and financing sections are prepared the same way, whether you use the direct or indirect method. For example, the investing section usually includes spending on assets, buying businesses, and money from selling property. The financing section typically shows items like dividends paid and loan repayments. To understand more properly, joining job oriented courses for commerce graduates will help you that provides knowledge as well as creates more career opportunities in the job market.
