Direct vs Indirect Cash Flow Methods: Pros, Cons, and Differences
Understanding the differences between the two main methods for preparing the cash flow statement–the direct method and the indirect method–can sometimes be a challenge if you’re not a trained accountant.
While both methods will provide you with the same net cash flow calculation, they each come with their own benefits and drawbacks that may make one option better suited for your business.
Continue reading through this article where we will break down:
- The differences between direct vs indirect cash flow statements
- The pros and cons of each
- How to select the right method for your company
What is the Direct Method for Cash Flow Statements?
As the name would suggest, the direct method (sometimes referred to as the income statement method) takes a direct approach to building the cash flow statement.
When you’re utilizing the direct method, you will need to go through every cash outflow and inflow for the business during a given period of time.
Using each of these values, you will prepare the operating section of the cash flow statement, resulting in a net cash flow from operating activities.
The direct method is focused only on the transactions that made a direct impact on the business’s cash balance.
This excludes any items like accrued expenses or earned revenues that have not yet resulted in a cash outflow or inflow.
Pros of the Direct Method
Here are some of the main benefits that you’ll find from using the direct method for cash flow statements.
One of the main reasons you might prefer the direct method over the indirect method for building cash flow statements is that it can provide better accuracy.
Since the method relies on the actual cash payments and receipts that occurred over the period, this method is highly accurate and exactly calculates the amount of cash that was used or provided by operating activities for the period.
The indirect method backs into the net operating cash flow value using the calculated net income and non-cash adjustments, so there is more room for errors and redundancies.
Instead, the direct method is more clear in how it’s calculated and can give you a better idea of your current cash standing.
Another advantage of the direct method is the specificity and insights it provides compared to the indirect method.
Since the direct method simply utilizes all cash-based transactions to prepare the operating cash flow section, the calculations are simple, straightforward, and easy to follow.
In turn, this method allows for better insights because it’s clear to see exactly what activities are driving cash inflows, and where cash outflows are more concentrated.
You can use these insights to make adjustments to your operations to better optimize your net cash flows.
Tracing back what’s causing cash inflows or outflows is less transparent with the indirect method given how it’s prepared.
Cons of the Direct Method
The direct method for cash flow statements can provide a more granular and accurate view of your current financial position. However, there are some potential drawbacks to this method.
Difficult to Scale
Tracking each transaction for the business during a given period may be manageable when you’re running a small operation.
However, the more you grow and scale your business, the less feasible it may be to utilize the direct method.
Since you have to account for each cash payment and receipt during a given period, once you start making hundreds or thousands of transactions a month, this can become quite challenging, and even impossible in certain cases.
Tedious & Inefficient
Similarly, going through and documenting each transaction for the business can get tedious and inefficient for your team.
The more complex your business’s finances are, the more you’re opening yourself up to errors and complications.
If just one transaction is missed for the period, you could end up with the wrong idea of what your current cash balance is, creating problems with your decision-making and future cash flow forecasting.
What is the Indirect Method for Cash Flow Statements?
The indirect method for building cash flow statements starts with the net income provided in the income statement.
Then, you will indirectly calculate the net operating cash flow for the period after reconciling all non-cash transactions.
You do not need to go through each transaction during the period to determine its impact on the cash balance for the business.
Instead, you will utilize the changes in balance sheet items and your calculated net income to calculate the operating cash flow for the period.
Since the income statement is prepared using accrual-based accounting principles, this will typically include items that didn’t require an actual cash inflow or outflow, like:
- Depreciation expense
- Increase/decrease in accounts receivable/accounts payable
- Increase/decrease in short-term asset/liability accounts
So with this method, the only inputs you need to prepare the operating section of the cash flow statement are the other financial statements that are already completed.
Pros of the Indirect Method
The indirect method for cash flow statements has some major benefits, including the following.
The indirect method is preferred by the International Financial Reporting Standards (IFRS), making it a common choice both among small and large companies for compliance purposes.
Plus, if a business is a publicly traded company, they will be required to report an indirect method cash flow statement under Generally Accepted Accounting Principles (GAAP) requirements.
So even if the company chose to use a direct method cash flow statement for internal reporting purposes, they’d still need to prepare an indirect method statement to stay compliant–doubling their team’s workload.
For these reasons, the indirect method tends to be the industry standard over the direct method.
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 cash inflow and outflow for the business.
Cons of the Indirect Method
Though it is the more popular method, there are still some potential drawbacks to keep in mind for the indirect method.
As we discussed above, the direct method offers great granularity and detail about what activities are contributing to the business’s net cash flows.
The indirect method lacks such deep insights since the net cash flow metric is indirectly calculated from the other financial statements.
Further, the indirect method for building cash flow statements could provide a less accurate depiction of the business’s current cash positioning.
Since the method isn’t directly calculating the net cash flow using the actual cash transactions during the period, the indirect method may not properly account for the timing of such outflows and inflows.
As a result, the indirect method could provide a company with a misleading figure for their current cash position.
Direct vs Indirect Cash Flow Method: Which Is Right for Your Business?
Given the advantages and disadvantages of both direct vs indirect cash flow statements, how can you select the option that’s right for your business?
Here are some important considerations you can make to help determine which method you should utilize.
The Size of Your Business
As we discussed earlier, the size of your business can determine if the direct vs indirect cash flow method is better for you.
Smaller organizations with a limited number of transactions each month can likely manage the level of tracking and detail that the direct method requires for accuracy.
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.
The Preferences of Your Team
Something else to consider is using the method that your accounting team is comfortable with or prefers.
Since they are the ones taking the time to prepare the cash flow statement, it can be helpful to follow their lead and utilize the method they have more expertise with.
If your team hasn’t prepared a direct method cash flow statement in years but has 10+ years of experience using the indirect method, this is likely the better choice.
The Regulations You’re Subject To
Additionally, the regulations your business is subject to could determine which method you will need to utilize.
As we mentioned above, the indirect method is the required/preferred method under GAAP and IFRS accounting regulations.
Thus, many companies will choose to only utilize the indirect method to save their team the time of having to prepare the cash flow statement using both methods.
Final Thoughts on Direct vs Indirect Cash Flow Statements
The cash flow statement is the only one out of the three main financial statements that has multiple ways you can prepare it.
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.
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.
Luckily, when using a dynamic and intuitive financial planning tool like Finmark from BILL, you can easily create and manage your cash flow statement as well as your balance sheet and income statement.
Start your 30-day free trial with Finmark today to level up your financial planning.
This content is presented “as is,” and is not intended to provide tax, legal or financial advice. Please consult your advisor with any questions.