Direct vs. Indirect: Which Cash Flow Method is Better?

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Thursday, October 20, 2022

Unsure of the difference between direct and indirect cash flow reporting? Here are the key pros and cons of each to bear in mind.

Article 5 Minutes
Direct vs. Indirect: Which Cash Flow Method is Better?

A cash flow statement is one of the most important tools you have when managing your firm's finances. It offers investors and other stakeholders a clear picture of all the transactions taking place and the overall health of the business.

But there are several ways in which these can be put together, which may give different figures. Understanding the difference between direct and indirect cash flow reporting and which will be better-suited to your business is vital in ensuring your financial reporting is accurate and relevant.

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The differences between direct and indirect cash flow reports

Direct cash flow

The direct method is perhaps the simplest to understand, though it’s often more complex to calculate in practice. When reporting income, this only takes into account money that has actually been received by the firm, meaning it directly reflects the actual cash a company has to hand and when this is coming in and out of the business.

Direct method examples 

When using the direct method to calculate cash flow from operating, investing and financing activities, your statement may look something like this:

Indirect cash flow 

The indirect method focuses on net income and may include cash that is not yet in the business. For example, if a retailer sells an item on credit, the indirect method will consider this as income and reflect this in the figures, whereas the direct method won't include it until the bill has been paid.

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.

Indirect method example 

A cash flow statement prepared using the indirect method may look something like this:

Cash flow statement for year ending December 31 2021

Each method has its own advantages and disadvantages that it's important to be aware of when making your decision.

The pros and cons of direct cash flow reports 

Pros

The direct method gives the clearest and most accessible picture of the organization’s financial position in the short term, and there will be no need to make any adjustments to reflect money that has been earned but not yet received.

It's also compliant with both generally accepted accounting principles (GAAP) and international accounting standards (IAS).

If you're preparing a statement for shareholders and stakeholders who want to know where the company currently stands in terms of its cash flow, the direct method is the easiest one to understand.

In short, the key benefits of the direct method are:

  • Transparency
  • Accuracy
  • Ease of comprehension

However, this approach isn't without its drawbacks.

Cons

Because most companies keep records on an accrual basis, it can be more complex and time-consuming to prepare reports using the direct method.

Regular activities required for this system to work - such as listing all cash disbursements and receipts - can be labor intensive and may not be the best use of your time.

Furthermore, many businesses don't favor direct cash flow reporting because it can increase the amount of work they have to do to stay in compliance with certain rules. In the US, for example, the Financial Accounting Standards Board (FASB) requires businesses using the direct method to also disclose the reconciliation of net income to cash flow from operating activities - something that would have happened automatically had the company used the indirect method.

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.

The pros and cons of indirect cash flow reports 

Pros

The indirect method, by contrast, means reports are often easier to prepare as businesses typically already keep records on an accrual basis, which provides a better overview of the ebb and flow of activity.

Accountants and finance professionals tend to prefer the indirect system, because it allows greater simplicity in preparing cash flow statements using data from two easily accessible sources: the income statement and balance sheet. The widely accepted use of the accrual method of accounting means the figures on the income statement and balance sheet will be consistent with this approach.

It's also more widely used, so should be more familiar to investors, and it's better-suited to large firms with high transaction volumes.

Cons

The indirect method lacks some of the transparency that the direct method offers. This could raise concerns if you operate in a highly-regulated industry, or if you often face demands from shareholders and stakeholders to provide a clear and easily comprehensible picture of the company's financial position.

Using the indirect method could also lead to issues with the FASB and International Accounting Standards Board, which tend to prefer that companies employ direct cash flow reporting for clarity and transparency.

So while the indirect approach could be the most beneficial and time-efficient option for your business and internal teams, it can make it more complicated for you to stay in full compliance with rules and established procedures of international accounting.

Which should you be using?

As you've seen above, for which method to use, and whichever you opt for, there will be negatives that balance out the positives. However, there will be scenarios where it will be advantageous to choose one over the other.

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 larger firms, while this also gives better visibility to assist with short-term planning.

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.

Further reading:

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