Business Courses/Accounting 101: Financial AccountingCourse
- AuthorLaura Foist
Laura has a Masters of Science in Food Science and Human Nutrition and has taught college Science.
View bio - InstructorKevin Newton
Kevin has edited encyclopedias, taught history, and has an MA in Islamic law/finance.
View bio
Learn about types of cash flow accounting. Examine the benefits of and differences between the direct method and the indirect methods of cash flow accounting.Updated: 11/21/2023
Table of Contents
- What is a Cash Flow Statement?
- Direct Method Cash Flow
- Indirect Method Cash Flow
- Comparing Cash Flow Methods
- Lesson Summary
Frequently Asked Questions
What is the difference between the direct and indirect methods of cash flow statement?
The direct method will actually add up all sales and costs to find out the total cash flow. The indirect method will start with net income, from the income statement, and take out any costs or assets that are included in the net income but are not actually cash in and out.
What is cash flow?
Cash flow refers to how money moves in a company. This includes money in (such as from sales of goods or interest earned) and money out (such as with cost of supplies, rent, and salaries).
What is the direct method of cash flow with an example?
The direct method of cash flow will add up sales and take out expenses. If a company has $500,000 in sales, $200,000 in salaries, $75,000 in inventory costs, and $50,000 in taxes then the direct method will calculate the cash flow to be: $500,000 - $200,000 - $75,000 - $50,000 = $175,000. The total cash flow is $175,000 (an increase of $175,000).
What is the indirect method of cash flow with example?
The indirect method of cash flow does not directly track cash in and out. Instead, it starts with the net income from the income statement and removes any non-cash income included. For example, if the net income is listed as $200,000, but included depreciation worth $40,000 and inventory worth $100,000, then the depreciation is added and the inventory is subtracted for a total cash flow of: $200,000 + $40,000 - $100,000 = $140,000.
Table of Contents
- What is a Cash Flow Statement?
- Direct Method Cash Flow
- Indirect Method Cash Flow
- Comparing Cash Flow Methods
- Lesson Summary
In accounting, companies use several different tools and methods to track performance. One of these tools is a cash flow statement. A cash flow statement analyzes cash or cash equivalents going out and coming into a company. Cash equivalents include items such as equipment depreciation. It is one of the three main financial statements used to determine a company's performance, the other two being a balance sheet and income statement.
The cash flow statement shows where money is going out, how businesses are spending it, and if it is being spent wisely and in a way that can repay debts. It also shows cash coming in, where that money comes from, and how much money is coming in.
There are three main sections in a cash flow statement:
- Operating — Operating expenses include sales, salary, interest, taxes, rent, and any other operating expenses and income. This is the only section that looks different using the direct versus indirect methods.
- Investing — Investing expenses and income include the initial purchase of assets or mergers. It also includes income generated from the sale of those assets or how cash from investments is utilized.
- Financing — Financing expenses include money from loans and how that money is repaid. This includes loans from banks or money from shareholders.
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The direct method for accounting operating expenses on the cash flow statement accounts for actual cash that came in for income and actual cash paid out for outgoing. This method is the preferred method for small businesses. It is fairly straightforward and very similar to many household budgeting methods. In the direct method, receipts and other documentation of money spent or earned are added up for each operating expense and income category, including sales receipts, taxes paid, and salary paid. These would be broken into categories such as:
- Cash receipt from sales
- Wages and salaries
- Cash paid to vendors
- Interest income
- Interest paid
- Taxes paid
Often the direct method is done using the accrual basis; this means that money is counted as received as soon as it is earned, instead of when it is received. In other words, if a car is sold during period one, but the payment doesn't come through until period two, the cash in would be counted in period one instead of period two, even though the money has not been physically received.
Example of Direct Cash Flow Accounting
A new bakery had the following sales during the month of June:
- 210 pies for $15/each for a total of $3,150
- 1,565 cookies for $3/each for a total of $4,695
- 329 loaves of bread for $5/each for a total of $1,645
- Total sales: $9,490
They also had the following expenses:
- $2,100 rent
- $7,200 wages
- $3,000 ingredients
- $100 interest payment
- $50 taxes
The cash flow statement would include each of these sources of income and outgoing cash.
| Operating Expenses Cash Flow | |
|---|---|
| Sales | $9,490 |
| Wages | ($7,200) |
| Inventory | ($3,000) |
| Income Before Taxes | ($710) |
| Interest Paid | ($100) |
| Taxes | ($50) |
| Net Cash | ($860) |
The total cash flow is negative, meaning the company spent more money than it earned. In some cases, this could be a red flag that businesses and investors need to be wary of. Or, such as with a new start-up business, this could indicate a time of growth for the business.
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The indirect method of cash flow doesn't directly count incoming and outgoing sales. Instead, it also accounts for liabilities, assets, and depreciation. It includes categories such as:
- Net income (as found on the income statement)
- Asset depreciation
- Worth of inventory stock
- Liabilities
Net income is not directly calculated using the indirect cash flow method; rather, it is taken from the income statement. The net income on the income statement has already subtracted any depreciation of assets or gains in assets worth. However, these were not actually cash transactions, meaning that they need to be taken out of the equation. Categories added to the net income include:
- Depreciation
- Losses (such as in asset sales or accounts receivable)
- Decrease in assets
- Increase in liabilities
- Inventory decrease (or the worth of inventory that was used)
Categories that are subtracted from the net income include:
- Gains (such as in asset sales or account payable)
- Increase in assets
- Decrease in liabilities
- Inventory increase (or the cost of inventory that is added)
Example of Indirect Cash Flow Accounting
A software company lists the net income on the income statement as $2,400,000. This net income can be adjusted to determine the cash flow of the company:
| Operating Expense Cash Flow | |
|---|---|
| Net Income | $2,400,000 |
| Depreciation | $59,000 |
| Losses on accounts receivable | $30,000 |
| Gain on sale of facility | ($79,000) |
| Decrease in inventory | $12,000 |
| Net cash | $2,422,000 |
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Businesses can use both direct and indirect cash flow methods to determine their company's cash flow. Both cash flow methods have strengths and weaknesses.
| Category | Direct | Indirect |
|---|---|---|
| Accuracy | Most accurate | Less accurate |
| Type of business | Less popular overall, best for small businesses | More popular, best for large businesses |
| Assumptions | Does not rely on assumptions such as depreciation amount | Relies on assumptions such as depreciation amount |
| Time | Takes a long time | Takes very little time, using calculations from other documents |
| Reconciliation | Requires reconciliation between cash earned and received | No reconciliation needed |
Overall, the two methods may not result in the same number generated for cash flow, and generally, the direct method is more accurate. However, what the indirect method loses in accuracy, it makes up for with how much faster it is to prepare, using numbers already calculated for other documents.
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A cash flow statement shows the flow of money in and out of a company. There are three sections in the cash flow statement: operating, investing, and financing. The operating section has two methods that can be used to calculate the cash flow: the direct method and the indirect method. The direct method is calculated using actual cash flow, with the actual receipts of sales and costs such as wages and supplies being added and subtracted from each other. The indirect method starts with the net income from the income statement and focuses on amortization and depreciation, removing these from the net income calculation. When calculating the cash flow using the indirect method, start with the net income then:
- Add depreciation
- Subtract inventory expenses
- Add decrease in assets
- Subtract decrease in liabilities
Overall, the direct and indirect methods may not come up with the same number for cash flow, and the direct method tends to be more accurate. Still, the indirect method is much easier and faster to calculate.
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Video Transcript
Reporting Operating Activities
Practically every business has to prepare a cash flow statement, which shows how money moves in and out of the organization. And if your company isn't doing this, it should! One thing people are surprised to learn is that while the cash flow statement has three different sections, only one of them is consistently different depending on the method used to prepare it.
The Operations Section
In this lesson, we're going to look at the direct and indirect methods of preparing the operations section of the cash flow statement. As we'll see, different companies choose to use different methods for their own reasons. We'll also look at an example of each method in action.
Direct Method
The direct method of preparing the operation sections of cash flow statements is the method that is preferred by both small businesses and the accounting standard-setting bodies. The reason for this is pretty simple - the direct method gives you a much more detailed image of how cash is moving through the organization. However, you don't get as good of an idea of non-cash assets, things like depreciation and amortization of assets.
So what does the direct method entail? Simply put, there's more detail to the specifics of cash itself. As a result, a direct method statement will have line items for cash paid to suppliers, cash paid as wages, and cash revenues from customers. Also, at the end of the cash flow statement, a reconciliation is given for any income from non-cash assets, like interest.
Let's look at an example of an operations section of a cash flow statement using the direct method:
| Category | Income | Expenses |
|---|---|---|
| Cash from customers | $400,000 | |
| Cash paid to suppliers | $150,000 | |
| Cash paid as wages | $125,000 | |
| Interest paid | $15,000 | |
| Income taxes paid | $10,000 | |
| Net Cash Flow | $100,000 |
Indirect Method
So what about the indirect method? This one is actually preferred by larger businesses. The reason for this is pretty simple - the indirect method can be calculated from information found in published financial statements. Investors can do the indirect method at home. The indirect method reconciles cash at the start of the year with cash at the end.
As a result, much of what is represented in the indirect method gets boiled down to one figure: net income. From there, additions for amortization and depreciation are made since they are non cash items and have already been deducted from income. So we add them back. Changes in working capital are made separately. There is also an adjustment for inventory, but we will assume this company has none. Now, let's look at an example of this in action, this time for a different company:
| Category | Amount |
|---|---|
| Yearly income | $800,000 |
| Depreciation and Amortization | $35,000 |
| Changes in working capital accounts | $15,000 |
| Cash generated from operations | $850,000 |
| Plus cash at start of the year | $40,000 |
| Cash at end of year | $890,000 |
Operating Section Only
Something that cannot be stressed enough is that the direct and indirect methods only impact the cash flow statements for the operating section. Both the financing section and the investment section are identical on each form. The only exception is that the direct method has to include some form of reconciliation for non-cash assets at the bottom. Of course, the indirect method does not require this, since it's integral to the method already.
Lesson Summary
In this lesson, we took a look at the differences between the direct and indirect methods of cash flow statement preparation for the operations section. Remember that this is the only section impacted. The direct method focuses more on understanding money moving in from customers and money moving out through costs. For that reason, many small businesses prefer direct method. Conversely, the indirect method focuses more on amortization and depreciation, treating net income as a single line item. As a result, many larger companies prefer to use the indirect method.
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