Cash Flow From Operating Activities Direct or Indirect Formula

The offset was sitting in the accounts receivable line item on the balance sheet. There would need to be a reduction from net income on the cash flow statement in the amount of the $500 increase to accounts receivable due to this sale. The other option for completing a cash flow statement is the direct method, which lists actual cash inflows and outflows made during the reporting period. The indirect method is more commonly used in practice, especially among larger firms. The indirect method is one of two accounting treatments used to generate a cash flow statement.

• Regardless of the method you choose, there are advantages and disadvantages to each.
• Two categories exist for direct cash flow – cash coming from customers and cash disbursements.
• Its starting point, the net income, might lead to an excessive focus on profits over actual cash movements.
• Now you know how to decide between the direct vs. indirect method of cash flow.
• The direct method provides transparency into what is driving the cash flow changes.

The articles and research support materials available on this site are educational and are not intended to be investment or tax advice. All such information is provided solely prepaid expenses examples accounting for a prepaid expense for convenience purposes only and all users thereof should be guided accordingly. The company's current assets and current liabilities on 31 March 2019 are shown below.

What is the Direct Method?

The indirect method is the more popular method of preparing a cash flow statement. Using the direct method for internal financial reporting while also providing a supplemental indirect cash flow statement in external financial filings can be a good hybrid approach. This realizes the benefits of more transparency for management through the direct method while also supplying the simplified indirect method for external stakeholders.

The indirect method uses increases and decreases in balance sheet line items to modify the operating section of the cash flow statement from the accrual method to the cash method of accounting. Whether you should use direct vs. indirect cash flow accounting will depend largely on your company’s accounting practices. Cash accounting matches up with the direct method, while accrual accounting is a fit for the indirect method. The operating section of a cash flow statement can be created using either a direct or indirect accounting method. Whether to use a direct vs. indirect cash flow statement depends on which accounting method you use.

Companies should choose the approach that best fits their financial reporting needs and resources available. Cash flow from operating activities will increase when prepaid expenses decrease. In contrast, cash flow from operating activities will decrease when there is an increase in prepaid expenses. However, the cash flows relating to such transactions are cash flows from investing activities. Operating activities are the transactions that enter into the calculation of net income.

Direct Method: Complexities of Cash Flow Method of Accounting

The direct method is one of two accounting treatments used to generate a cash flow statement. The statement of cash flows direct method uses actual cash inflows and outflows from the company's operations, instead of modifying the operating section from accrual accounting to a cash basis. Accrual accounting recognizes revenue when it is earned versus when the payment is received from a customer. This direct method of cash flow accounting is based on the cash method of accounting, so companies that use cash accounting will find it simplest to use the direct cash flow method. You don’t need to make any adjustments to translate the cash basis into operating cash flows, but you will need to manually reconcile net income to the cash provided by operating activities.

If amortization and depreciation expense amounts are significant, the indirect method is more appropriate for evaluation purposes. However, the direct approach can still be viable if the company has lots of transactions that affect cash. Accounting software can easily categorize cash transactions so that they are quickly accessible when it comes time to prepare the cash flow statement using the direct method. The below represents an example of a cash flow statement using the direct cash flow method.

The Direct Method

Although it has its disadvantages, the statement of cash flows direct method reports the direct sources of cash receipts and payments, which can be helpful to investors and creditors. The cash flow statement's direct method takes the actual cash inflows and outflows to determine the changes in cash over the period. The items need to be adjusted when calculating cash flow from operating activities because they are considered elsewhere in the cash flow statement (e.g., investing activities or financing activities). Both the direct and indirect cash flow methods tell the same story about how cash moves through your business but do so from a different starting perspective. It's important to remember that the indirect method is based on information from your income statement, which could have certain limitations. This means you may need to take additional actions, such as accounting for earnings before taxes and interest, and making adjustments for non-operating expenses such as accounts payable and depreciation.

Which method of calculating cash flow should my business use?

To perform this calculation, begin with net income, add back non-cash expenses, then adjust for gains and losses on the sale of assets. Next, account for changes in non-cash current assets and changes in your working capital accounts, except for notes payable and dividends payable. The direct method tracks the cash-specific transactions your business receives and spends on. The purpose of this is to identify changes in cash payments and company activity receipts.

Although the two methods are similar in concept, the methods have some distinct advantages and disadvantages. The direct method uses the accrual basis of accounting, while the indirect method uses the cash basis. The decision between them should hinge on a company’s specific needs, its stakeholders’ preferences, and its operational intricacies. Regardless of the choice made, consistency in application and a deep understanding of the underlying principles are paramount to ensure accurate, insightful, and actionable cash flow analysis. Investors often seek clarity on a company’s ability to generate cash, which underpins dividend payments and capital appreciation. Both methods can offer insights, but the indirect method, due to its widespread use, might be more familiar to most investors.

How does cash flow reporting and analysis impact financial planning?

Your competitors can use your cash flow information against you and potentially weaken your standing in the industry. Cash inflows from operating activities are generated by sales of goods or services, the collection of accounts receivable, lawsuits settled or insurance claims paid. Businesses may also generate cash inflows by obtaining refunds or license fees. Under the indirect method, the figures required for the calculation are obtained from information in the company’s profit and loss account and balance sheet. In the indirect method, reporting starts by stating net profit or loss (pulled from the income statement) and works backward, adjusting the amounts of non-cash revenue and expense items. These documents present a detailed narrative of the company's cash position, assets, and financial health when presented alongside the income and balance sheet statements.