Direct and Indirect cash flow methods are two different methods of preparing cash flow statements of a company.
In this article we will discuss and compare both methods.
Also we will understand by example too.
So, keep an empty mind and focus on reading.
cash flow methods
Cash flow is net of cash inflow and outflow of the company. The financial world has three major statements – income statement, cash flow statement and balance sheet. Each has its own value and shows the financial data of the company.
Deep in one step, cash flow statement has three part:
- Cash flow from operating activities
- Cash flow from investing activities
- Cash flow from financial activities
For understanding the direct and Indirect cash flow methods we need to know about operating cash flow.
Operating cash flow is cash which is in and out from a company’s operations such as sales payments and paying salary.
operating activities Section include all of those activities which indicate the operations of the company.
For operating cash flow analysis and knowing the performance to use two methods.
- Direct cash flow method
- Indirect cash flow method
So let’s have some time to learn about them.
Direct vs Indirect Cash flow method
Direct cash flow method is considered only operating activities which are cash transactions such as payable and receivable cash. It avoids non transactions or non cash activities.
It includes cash received from customers and cash paid to lenders, supplier.
Here is the some examples of activities which consider when creating statement using direct cash flow method:
- Cash from customers
- Cash paid to employees
- Cash paid to suppliers
- Cash paid for interest
On The other hand, Indirect cash flow method starts from net income which is in the balance sheet. It includes non-transactional activities like decrease in inventory, Depreciation etc.
It starting point from net income and change form in cash using adjustment
When used Direct method it necessary to reconciliation of net income but in Indirect method it done automatically.
Here is the some examples of activities which consider when creating statement using indirect cash flow method:
- Adding back depreciation expense
- Adding the decrease in accounts receivable
- Deducting the increase in inventory
- Deducting the decrease in accounts payable
- Adding the increase in accrued expenses payable
Let’s do a hand to hand fight with the direct vs indirect method.
Difference between direct vs Indirect cash flow method
In this section we will compare some factors for both methods.
1. Define
Direct cash flow method is only considered cash flow factors, non cash flow ignored in this method.
Indirect cash flow takes all factors including cash flow and non cash flow of corporations.
2. Financial view
Direct method show net operating cash flow of the company it not any related to the balance sheet nor income statement. Because of these reason Reconciliation is done to separate.
In the Indirect method net income automatically converted in cash flow form. Also because of the net income base it is connected with other financial statements.
3. Factors Example
Factors are important to understand direct vs indirect cash flow method.
Direct cash flow method include these factors: paying salary to employees, payment received from customers, pay rent etc.
Indirect method include above factors with non cash factors: decrease in inventory, Depreciation etc.
4. Accuracy
Direct method has very high accuracy because it is free from any adjustments.
Indirect method start from net income and make adjustments where needed, so it has less accuracy compared to direct method.
5. Time
Direct cash flow method take more time and effort to collect all transactions receipt and disbursements data to add in the list.
Indirect cash flow method takes less time because it starts from net income and requires all data already gathered in the sheet.
6. Uses
Direct method is more accurate but very few companies use this method.
Indirect method is more popular.
7. Advantages
Because direct cash flow method include a source of cash flow in the sheet, it will be helpful to understand better to investors and analysts.
Another one advantage is that direct method is easy to understand. It shows only positive and negative cash flow in with two categories. Which indicate cash inflow and outflow.
Indirect method positive point is because of it involve non cash transactions, it’s show those factors and how it affect company’s net income.
8. Disadvantages
Both methods have disadvantages.
Direct method take lots of effort to prepare a statement.
It’s not show any information regarding non cash transactions.
Indirect cash flow method has lack of transparency.
Final thought
So, here the full comparison of direct vs Indirect cash flow method.
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