Direct or Indirect Cash Flow: Which Is the Right Fit for Your Business?

Factors like the industry you’re working in and the audience you’re reporting for (whether management or banks, auditors or shareholders) will make a difference. And so will the data you have available and the insights you hope to generate. Once you’re done with the adjustments, you end up with a final closing bank position. For public firms, it also means there will be an open record of their exact cash flow available, which competitors could use to their advantage. Each method has its own advantages and disadvantages that it’s important to be aware of when making your decision.

It can also give you the ultimate flexibility to run your business responsibly. Larger, more complex firms, on the other hand, may find it too inefficient to devote the necessary resources to the direct method, so the indirect alternative becomes faster and simpler. This option may also be more beneficial for long-term planning, as it gives a wider overview of the firm’s overall cash flow.

While the two methods only apply to the operating section of the cash flow statement, the method you choose to utilize will have important implications for your business. However, larger corporations often select the indirect method because of the efficiency it provides since you only need the information that’s already provided on the other financial statements. As a result, the indirect method could provide a company with a misleading figure for their current cash position. Depending on the depth of reporting you’re looking for, you may want to commit the work to a direct reporting method.

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So make sure you choose the method that puts you in the best place to help your business succeed. Under the accrual method of accounting, revenue is recognized when earned, not necessarily when cash is received. If a customer buys a $500 widget on credit, the sale has been made but the cash has not yet been received. The indirect method lacks some of the transparency that the direct method offers. The direct method focuses on operating assets while the indirect method focuses on liabilities.

One of the main differences between the direct and indirect method of presenting the financial statement of cash flows is the type of transactions that are used to produce the cash flow statement. The indirect cash flow method makes reporting cash movements in and out of the business easier for accruals basis accounting. Among the main trifecta of financial reports–the balance sheet, income statement and cash flow statement–it’s often the statement of cash flow that gets the least attention and time.

While most businesses like the indirect method because it’s easy to use, the folks at the International Accounting Standards Board prefer the direct method because it gives a clear view of cash flow receipts and payments. The indirect cash flow method works by taking your net profit figure from your profit and loss statement. As you can imagine, the risk of mistakes on a direct cash flow statement is more significant than on a cash flow statement prepared using the indirect cash flow method. Most accountants and analysts believe the direct method of cash flow presentation is the most accurate. While this may be true, calculating cash flow under the direct approach is much more complicated than under the indirect method. Complexities arise since each source of cash inflows and outflows must be appropriately identified.

For example, the bigger your company is, the more labor-intensive the direct method will become. Smaller firms with fewer sources of income will find it easier to work with the direct method than the role of accounting in business and why its important larger firms, while this also gives better visibility to assist with short-term planning. The problem with the indirect method is it doesn’t offer a clear picture of the origins of your cash.

The indirect method is the more popular method of preparing a cash flow statement. If you manage grants, you know that allocating costs for shared services can be challenging. Shared services are activities or functions that benefit more than one grant or program, such as accounting, human resources, or IT. How can you distribute these costs fairly and accurately among your grants, without violating the rules and regulations of your funders? In this article, we will explain some common methods of grant cost allocation, and how to choose the best one for your situation. More broadly, the cashflow from operations is prepared by accounting for cash receipts and payments of the cash in case of the direct method.

13: Introduction to Direct Method versus Indirect Method

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. Direct technique presents operating cash flows as a list of incoming and departing cash flows.

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The direct cash flow method is considered the more complicated of the cash flow methods, especially for a company that utilizes accrual accounting. The accounting manager cannot use changes between assets and liabilities to measure variations in receivables and payables under the direct cash flow method. Instead, each transaction that affects cash is appropriately categorized. Using the differences we laid out here between direct vs indirect cash flow statements, hopefully you have a better idea of when each method is more appropriate, and what the potential advantages and drawbacks are of each.

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The cash flow statement is a critical statement as it helps the stakeholder evaluate the cash flow position of the business. Generally, a cash flow statement is composed of cash flow from operating activities, financing activities, and investing activities. For the direct and indirect methods of cash flow, the cash flows arising from the financing activities and investing activities tend to be the same. However, the approach utilized for the cash flow from the operating activities differs for both the direct method of cash flow statement and the indirect method of the cash flow statement.

Indirect Method vs. Direct Method

Further, the indirect method for building cash flow statements could provide a less accurate depiction of the business’s current cash positioning. Because the cash flow statement is more conducive to cash method accounting, one can think of the indirect method as a way for businesses using the accrual method to report in terms of cash on hand. As such, it requires additional preparation and adjustments after the fact. In the accruals basis of accounting, revenue, and expenses get recorded when incurred—not when the money is collected or paid out. This delay makes it challenging to collect and report data using the direct cash flow 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.

While both methods can be used to calculate the cash flow statement, the direct method is more accurate than the indirect method. Indirect cash flow requires separating cash transactions, but it does require a significant amount of preparation time. The direct method can be used at different points in the business cycle, including the end of a quarter or the beginning of the year. This means that you use a combination of direct and indirect allocation methods, depending on the nature and purpose of each shared service cost. This method allows you to tailor your cost allocation to your specific circumstances and needs, but it may be more complex and confusing than the other methods.

The popularity of the indirect way of cash flow generally outnumbers that of the direct cash flow method. The indirect approach displays operating cash flows as a profit-to-cash flow reconciliation, and it signifies that you consider depreciation in your computations. The direct method of the cashflow and indirect method of cashflow are variants of the cashflow statements.

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