Direct vs. Indirect Cash Flow Methods: Which Is Best for Your Business?
The cash flow statement is one of the most critical financial documents to get a pulse on your business’s operating, investing, and financing activities. It is something that ideally, is maintained and reviewed on a regular basis.
To effectively manage cash flow from operational activities, direct and indirect are two different methods to depict your company’s cash flow position on a statement. What are the advantages and disadvantages of direct vs. indirect cash flow methods, and how do they stack up?
Most importantly, which is the best method for assessing your business’s cash flow status?
What is the top priority? Having a clear picture of your business’s well-being at all times.
The Direct Cash Flow Method
The direct cash flow method, also known as the Direct Cash Flow Statement, looks solely at cash paid and received during a specific accounting period. It involves itemizing any payments to vendors, employees, and operations. These payments are then deducted from the cash received from customers, interest, and dividends to show the net cash flow.
This is cash-based accounting which is the method that businesses start with because it is easy and intuitive.
Pros of the Direct Method: The positives and negatives of cash payments and receipts are clearly delineated, making a direct cash flow statement easy to understand. It uses real-time figures, which is a more accurate way to monitor cash flow.
Cons of the Direct Method: The direct method does not match revenue earned and the direct cost to earn it, thus does not measure profitability. This method does not consider non-cash transactions such as depreciation and amortization which are actual cash outflows from an earlier period.
The Indirect Cash Flow Method
The indirect cash flow method is different from the direct method in that it starts with the net income taken from the income statement. Then, you add or subtract changes in assets and liabilities (non-cash transactions) from the net income to calculate implied cash flow for the accounting period.
This is accrual-based accounting which is increasingly important as businesses scale to get a handle on profitability.
Pros of the Indirect Method: The main advantage of the indirect cash flow method is that it gives a broad picture of its cash position and profitability. It also shows how non-cash transactions affect your net income.
Cons of the Indirect Method: Takes more time and effort to itemize all receipts and disbursements plus track and record non-cash items like depreciation. In addition, expenses that the business incurred but have not paid out must be estimated and recorded.
Direct vs. Indirect Cash Flow Methods: A Side-by-Side Comparison
Below is a high-level recap of the differences of direct vs. indirect cash flow methods:
Header | Direct Cash Flow | Indirect Cash Flow |
|---|---|---|
Know As | Cash-Based | Accrual-Based |
What it considers | Only cash transactions, payments received or disbursed | Starts with net income and then adjusts for all non-cash expenses such as depreciation and liabilities |
Accuracy | More accurate for cash since it uses real-time figures and does not make assumptions or rely on adjustments | Not as accurate for cash since it makes assumptions and includes non-cash items like depreciation expense |
Ease of Use | Easy to understand | Involves more time to prepare |
Other Factors | May not comply with rules, reporting, or regulatory standards | Enables profit management |
Direct vs. Indirect Cash Flow Methods: Which Is Right for Your Business?
Both direct (cash-based) and indirect (accrual-based) cash flow methods are separate ways to present your company’s cash flow status, and they each have their benefits and drawbacks.
It is ok for small businesses to stay on the direct method of cash flow management. However, using this method they will lose the benefit of measuring profitability. This may leave money on the table with the CEO managing profit using intuition.
For businesses of any size or who want to scale, the indirect method is the best way to have both cash and profit management visibility. In most cases we see, moving to the Indirect Accrual-Basis is the best choice for CEOs of privately held companies.
At Foresight CFO, our Growth CFOs are here to help you obliterate obstacles, grow your business, and achieve the financial results that you are looking for.
To gain a stronger understanding of direct vs. indirect cash flow methods or help manage your cash flow more effectively, contact Foresight CFO today to schedule a no-obligation Growth CFO Discovery call with me.