Direct vs Indirect Cash Flow: Key Differences Explained

Introduction to cash flow statement

But first, what is a cash flow statement?

As we explained in a previous article, 'What Is A Cash Flow Statement And How Do You Prepare One?', a cash flow statement is a record of cash movements in and out of a company during a reporting period.

Unlike an income statement that indicates revenue and overall profitability and a balance sheet that summarises a company's assets, liabilities, and equity, a cash flow statement presents businesses with a clear picture of their liquidity. This also helps stakeholders and investors assess the company's ability to fund its operations, fulfil debt obligations, and invest in growing the business.

Cash flow statements offer deep insights into the areas a business spends cash or makes it. This is essential for effective financial decision-making and accurate evaluation of the business.

Cash flow components

A cash flow statement has three main sections:

Operating activities

These are a company's core business operations, or its primary revenue-generating activities. Operating cash flow includes cash inflows from sales revenue, interest, dividends, and other cash receipts. Cash outflows or operating expenses include salaries, payments to suppliers, income tax, and utilities.

Investing activities

This section is linked to the company's long-term investments. It tracks cash spent on making business acquisitions, loan payments, investment in securities, capital expenditure, etc, and cash received from the sale of assets, divestiture of subsidiaries, collection on loans, and so on.

Financing activities

The financing activities section covers cash spent on and received from external financing. Financing cash flow examples include earnings from loans, investment, dividend payments, and stock sales, and expenses on account of debt repayment, dividend disbursal to investors, and stock buybacks.

Direct method

The direct method for calculating cash flow from operating activities only covers actual cash transactions, such as cash received from customers or paid to employees, vendors, and as interest. By deducting actual cash outflow from actual cash inflow, you arrive at net cash flow from operating activities.

The direct method uses cash-basis accounting, which records earnings and expenses only when they are received and paid, respectively. By focusing solely on cash in hand, a direct cash flow statement presents the most straightforward view of a company's cash position. It is mostly used by cash-only businesses. It also suits small businesses and start-ups, which need to know exactly how much cash is available so that they can pay their bills on time.

The greatest advantage of the direct cash flow method is that it accounts for individual transactions, allowing businesses to identify activities that are driving or draining cash.

However, the direct cash flow method is time-consuming and complicated as it requires every single transaction to be documented. This number can often run into the hundreds and thousands.

Direct cash flow statements might be viewed as inaccurate by some as they don't account for accrued accounts payable and accounts receivable. In accrual-basis accounting, earnings are documented at the moment they are owed to the company, not when they are paid. Similarly, expenses are noted at the time the company owes them, not when it pays them.

How to prepare a direct cash flow statement

Here are the steps to create a direct cash flow statement, with an example:

1. List all cash received from customers, excluding sales on credit
2. List interest and dividend payments received
3. List all cash payments to employees and suppliers
4. Calculate all loan, interest, and tax payments made
5. Separately, add up total cash paid and cash spent
6. Subtract total cash outflow from cash inflow to calculate net cash flow
7. Add up cash flow from investing and financing activities

Indirect method

Unlike the direct method, the indirect cash flow method accounts for accruals. An indirect cash flow statement is also comparatively easier to prepare because it starts with net income, which is found in the income statement and also called net profit., So, you take net income and adjust for non-cash transactions such as accounts receivable, accounts payable, depreciation, amortisation, changes in inventory, and so on. Because it is aligned with existing financial statements, an indirect cash flow statement is faster and easier to verify and audit as well.

The indirect cash flow method is widely used due to the prevalence of accrual-basis accounting, which is encouraged by the International Financial Reporting Standards.

The indirect cash flow method lacks the detailed insights provided by the direct cash flow method as it does not provide a breakdown of each transaction. Instead, it offers a broader, more strategic view of a company's financial health. Also, the non-cash adjustments on an indirect cash flow statement can give a distorted reading – for example, adding depreciation to net income might suggest healthy cash flow even when the company is facing a liquidity crunch.

Direct and indirect cash management

While the direct and indirect methods take different routes to calculating operating cash flow, they arrive at the same net cash flow. Some points on which the direct and indirect methods differ:

Cash flow analysis

The next step after preparing a cash flow statement is to interpret it. A company's financial statements hold valuable insights, which can be brought to the surface with an analysis.

An analysis reveals where money is coming from – is it from sales or from loans and investment? It indicates whether a company is in a state of growth or decline. These interpretations help companies identify areas of improvement and opportunity and make informed financial decisions on a range of subjects, from budgeting and workforce planning to operations, investments, debt, and more.

Cash flow is typically positive or negative. Positive means more money flowing in than out. It's the reverse for negative. A negative figure can deter investors while a positive number can indicate a company is on the pathway of growth. However, a proper analysis is needed to unveil the underlying causes behind the numbers. Negative cash flow, for example, might be due to heavy investments with an eye on future growth and, therefore, not necessarily bad. Similarly, a positive number might be because the business is stagnant and not making any investments.

Cash flow projections

Cash flow statements help predict cash levels in the future using anticipated outflows and inflows. This is called cash flow projection and it empowers companies to plan for the future. For example, if a company is considering entering a new market, it's a good idea to figure out the minimum liquidity it'll need to maintain for that period. Forecasting also optimises cash usage. It helps companies anticipate lean months when they need to go slow or plan ahead for cash surpluses.

Cash flow projections also help businesses respond with agility to change and unforeseen events, by planning different scenarios and flexible strategies.

Common cash flow indicators

Stakeholders, and investors use metrics to evaluate businesses on the basis of their flow of cash. Here are some common cash flow indicators:

Operating cash flow

Operating cash flow (OCF) is the amount of cash collections or expenses from core business activities. To calculate it, add the organisation's net income and non-cash items and adjust for changes in working capital. A healthy operating cash flow means the business is capable of supporting its operations from sales alone.

Net cash flow

Net cash flow is total cash inflows minus total cash outflows and is a critical indicator of liquidity, especially in the short term.

Free cash flow

Free cash flow is operating cash flow minus capital expenditures. It represents the amount left for reinvestment after accounting for operational and capital expenditures (fixed assets). Free cash flow also indicates a company's ability to generate cash that can be distributed as dividends paid to shareholders.

Operating cash flow margin

This ratio measures cash from operating activities as a percentage of sales revenue in a given period. It measures ability to convert sales into cash. It is, therefore, indicative of operational efficiency and profitability.

For the best results, cash flow indicators should be analysed together.

Which cash flow method suits my business?

When choosing between the direct or indirect method, companies must consider multiple factors, such as business size, accounting method, and financial reporting standards. The wrong selection can affect cash health and business growth.

Companies can pick the direct cash flow method if they:

• Are small in size or just starting out
• Have fewer and simpler daily transactions
• Use cash predominantly
• Need to monitor actual cash movements in real time
• Have the resources to prepare time and effort-intensive direct cash flow statements, such as extra accountants and sophisticated accounting software
• If it is demanded by financial reporting standards.

Similarly, the indirect cash flow method suits companies that:

• Are large and have substantial daily transactions, including non-cash transactions
• Have complex financial operations
• Use accrual-basis accounting
• Require a more strategic overview of company finances rather than a detailed record of cash movements.

Summing up

While understanding direct vs indirect cash flow is a simple matter, a company's financial decision-making and long-term sustainability often hinges on it. Both methods have their own advantages and disadvantages. Choosing between direct and indirect cash calculations isn't about what's more convenient to perform but what's the best fit for a company's long-term strategy and requirements.

Cash flow optimisation with Aspire

Apart from picking the right method, there's a lot more companies can do to strengthen their cash position. Partnering with Aspire is one way, and here's how we can help:

• Our invoice management tool is designed to help you get paid faster. It automatically creates and sends invoices on your behalf, sends reminders to prevent delays, and alerts you when you get paid.
• Our all-in-one receivable management offers a bird's eye view of all your cash sources as well as cash flow insights and projections for informed financial decision-making.
• Our payable management tool makes payments fast and secure with bulk payments and streamlined approvals.
• All our tools easily integrate with your accounting system, offering a seamless and highly optimised experience.