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

Finance Insights for Professionals

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Thursday, May 21, 2020

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 3 Minutes

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.

The differences between direct and indirect cash flow reports

The direct method is perhaps the simplest to understand, though it is 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.

The indirect method, on the other hand, 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.

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

This gives the most accurate picture of the organization’s operations and there will be no need to make any adjustments to reflect money that has been earned but not yet received. It's therefore compliant with both generally accepted accounting principles (GAAP) and international accounting standards (IAS).

Cons

Because most companies keep records on an accrual basis, it makes it more complex and time-consuming to prepare reports using the direct method. For instance, it will require reconciliation to separate transaction cash flow from net income. 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. 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

On the other hand, the indirect method does lack some of the transparency that the direct method offers, which may be a particular concern for firms in highly-regulated industries.

Which should you be using?

As you've seen above, there's no definitive answer 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.

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