Direct vs. Indirect: The Best Cash Flow Method (2024)

It may not always get the most love, but your cash flow statement is a vital part of your reporting story. That's why, in this post, we're going to talk all about choosing the best cash flow method for your business. Direct, or indirect.

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. But as a view into your company's liquidity, it provides an important piece of the puzzle.

And extracting the information you need? This begins with putting the right process in place to build the best cash flow statement for your business--in whatever time you have. That starts by choosing between the direct and indirect cash flow methods.

The Direct Method vs. Indirect Method

So what's the difference between direct and indirect?

While both are ways of calculating your net cash flow from operating activities, the main distinction is the starting point and types of calculations each uses.

The indirect method begins with your net income.

Alternatively, the direct method begins with the cash amounts received and paid out by your business.

Each uses a separate set of calculations from there to get to the same finish line, revealing different details along the way.Let's look at each in turn.

The Indirect Cash Flow Method

The indirect cash flow method starts with your organization's net income. It then makes adjustments to get to the cash flow from operating activities. Those adjustments consider things such as depreciation and amortization, changes in inventory, changes in receivables and changes in payables.

Once you're done with the adjustments, you end up with a final closing bank position.

The benefit of the indirect method is that it lets you see why your net profit is different from your closing bank position. But because it's based on adjustments, one of its disadvantages is that it doesn't offer the same visibility into cash transactions or break down their sources.

Without that fine detail, there are insights you may be missing out on.

The Direct Method

The direct method individually itemizes the cash received from your customers and paid out for supplies, staff, income tax, etc. Non-cash transactions are ignored. And again, a closing bank statement emerges--the same closing bank statement you'd get using the indirect method.

An advantage of the direct method is that it gives you more visibility of your cash inflow and outflow--something that can benefit your short-term planning, enabling you to identify and analyze any potential challenges or opportunities that might exist for future cash flow.

Mastering cash flow management is something every business will benefit from.

A better view of the past helps you forecast for the future.

But it's also more time-consuming for your team because it requires looking beyond the balance sheet and income statement account activity you already know so well.

How To Choose Between The Direct & Indirect Cash Flow Method?

In the end, both the indirect and direct cash flow methods get you to the same number. So how do you decide which method will work best for you?

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.

But there are a few other factors to consider as well:

Ease of use:Since it draws on data you're already using in your profit and loss (P&L) statement and balance sheet, the indirect method is less complicated for teams to prepare, meaning it offers significant time savings.
Transparency and granularity:As it focuses only on cash transactions that have been received or paid out, the direct method offers a more transparent view of your cash flow. It also allows for more specific details rather than using the reverse method of backing out non-cash items.
Point of comparison:Unlike the direct method, the indirect method includes your net profit, letting you better compare cash flow with net profit to explain how your business receives cash compared to how it records income.

What's right for your team will be up to you. Most larger companies choose the indirect method, at least in part because of the lower time investment, while analysts often prefer it as well because it lets them see for themselves what adjustments have been made.

The direct method, on the other hand, is often the best choice for smaller businesses, as the transparency into operating cash flow details helps them better determine their short-term cash availability planning needs.

What Else You Need To Know

Your cash flow statement tells a critical part of your financial story, no matter which approach you use. It can also give you the ultimate flexibility to run your business responsibly.

A negative cash flow statement can be a strong indicator that your company's not in a good position for a potential economic downturn or market shift. It can also mean you need to look into other financing options.

It also empowers your investors, creditors, and stakeholders with the information they need to understand whether you have the cash available to pay off your loans if you can pay your employees, or how you measure up to your peers.

Whether you choose to use the indirect or direct method will affect the way you operate your cash flow and the story you tell around it. So make sure you choose the method that puts you in the best place to help your business succeed.

Do you want to talk more about choosing the right financial solutions for your business? Take a look atVena's financial reporting solutions here, orreach outto discuss what's right for you.

Did you learn a lot about the different cash flow methods in this post? Here are three more posts to read next:

Why Are Dashboards Important to Performance?
How To Overcome 6 Horrors of Financial Reporting
Cash Management: 3 Questions to Ask When Planning for Today and Tomorrow

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FAQs

Direct vs. Indirect: The Best Cash Flow Method? ›

There are two ways to prepare cash flow statements: direct and indirect. Generally, larger companies with more complex accounting and reporting will use the indirect method for efficiency, and smaller businesses will use the direct method since it's more straightforward.

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Which is better direct or indirect method of cash flow? ›

The indirect cash flow method makes reporting cash movements in and out of the business easier for accruals basis accounting. It's faster and better aligned with the way this accounting method works. Accountants overwhelmingly prefer it for reporting cash movement.

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Which method of cash flow statement is better? ›

While both the direct and indirect cash flow statement format provides you with the same end result, it's important to note that the International Accounting Standards Board (IASB) favours the direct method, as it provides more useful information.

What is the most effective cash flow techniques require? ›

The most effective cash flow techniques require Multiple Choice budgeting for both the amount and timing of required cash flows. reconciling bank statement each day. taking advantage of prompt payment discounts. trusting customers to pay on time.

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Do most companies use the direct or indirect method? ›

Whenever given a choice between the indirect and direct methods in similar situations, accountants choose the indirect method almost exclusively. The American Institute of Certified Public Accountants reports that approximately 98% of all companies choose the indirect method of cash flows.

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What is the preferred method of cash flow? ›

For example, the indirect method may be used for a company's regular cash flow statements and reports, while the direct method may be used for specific small-scale analyses or short-term projections. In general, the indirect method is preferred by most organizations.

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What is the best type of cash flow? ›

Operating cash flow

A company's operating cash flow offers a portrait of its day-to-day operating activities: namely, the income from sales and outflows from salaries, vendor fees, lease payments, taxes, and interest payments. A company whose sales exceed its operating expenses is cash flow positive.

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Which cash flow method is easier? ›

Businesses can generate cash flow statements using either the indirect or direct method. The indirect method, starting with net income and adjusting for noncash items and balance sheet changes, is simpler and more commonly used, especially by larger firms, because it's efficient and easy to prepare.

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Which method results in the highest cash flow? ›

Highest Cash Flow: While all methods result in the same cash flow from operations (since depreciation is a non-cash expense), the Diminishing-Balance Method using double the straight-line rate can indirectly lead to higher cash flow after taxes in the early years due to lower taxable income.

Which cash flow is most important? ›

Positive cash flow indicates that a company's liquid assets are increasing. This enables it to settle debts, reinvest in its business, return money to shareholders, pay expenses, and provide a buffer against future financial challenges. Negative cash flow indicates that a company's liquid assets are decreasing.

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Which type of cash flow should always be positive? ›

Investing cash flow- The cash flow from investing activities depicts a company's cash to buy or sell investments, such as property or stocks. A positive investing cash flow means that a company generates more cash from its investments than it is spending.

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Which method of cash flow is easiest and fastest to prepare? ›

The indirect method of cash flow is generally considered easier and faster to prepare compared to the direct method. Here's why: The indirect method starts with net income from the income statement, which is likely already prepared. It then makes adjustments for non-cash items to arrive at cash flow from operations.

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What cash flow method does FASB prefer? ›

According to FASB, that information can be presented within the statement of cash flows by either of two approaches: the direct methodA mechanical method of reporting the amount of cash flows that a company generates from its operating activities; it is preferred by FASB because the information is easier to understand ...

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Which is better, direct or indirect cash flow? ›

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.

Which one is better direct or indirect? ›

Context and Formality

Direct speech is often used in informal conversations, while indirect speech is more common in formal settings or when reporting information.

Should you use direct or indirect approach? ›

Use a direct approach for straightforward, non-sensitive communication that needs to be delivered immediately. Opt for an indirect approach when conveying sensitive or potentially upsetting information, providing context and explanations to soften the impact.

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Which is better direct or indirect cost? ›

As we can see, direct costs are those that are directly involved with bringing your product to market, while indirect costs are those incurred during the processes that support this. Both are important, as they are part of your bottom line, and provide an insight into your company's profitability.

What is the main disadvantage of the direct method of reporting cash flows? ›

In this situation, a disadvantage of the direct method is the time it takes to capture and record information necessary for the cash flow statement. Because of its labour-intensive nature, the direct method can be costly.

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