Cash flow statement: Direct versus indirect cash flow accounting methods

Cash flow statements are crucial for assessing a company’s financial health and summarizing cash inflows and outflows across three main activities: operations, investments, and financing. The operational activities section reflects cash generated from core business operations, which is crucial for understanding day-to-day viability and potential growth. Investing activities indicate cash flows from asset investments and sales, providing insights into a company’s future capabilities and expansion efforts. Financing activities track cash exchanges between the company, its shareholders, and creditors, highlighting how a business finances its growth or returns value to shareholders. This statement is essential for investors and analysts to gauge a company’s ability to manage cash, fund operations, and fulfill debt obligations.

Cash flow statements can be prepared via direct or indirect cash flow methods. Each provides distinct clarity on financial activities and is critical for accurately interpreting a company’s financial status and making informed investment decisions.

Apart from the balance sheet and the income statement, the direct method and indirect method of cash flow statement are two of the three top financial statements that disclose the cash generated and spent during a specific period (for instance, a month, quarter, or year). The cash flow statement connects the income statement and balance sheet by indicating how cash has moved in and out of the company.

An organization’s financial statements allow analysts and investors to examine all the transactions that occur within the business, where every transaction contributes to its growth. The cash flow statement tracks the money made by the company in three main ways: operations, investing, and financing. The total of these three sections is known as net cash flow. 

The three segments of the cash flow statement—operations, investments, and financing—allow investors to determine the value of a business’s stock or the organization as a whole.

Let’s take a detailed look at the three segments of the cash flow statement:

1. Cash flow from operating activities – This is the first section of the cash flow statement, which comprises cash flows from operating activities and transactions from all operational business activities. The cash flows from the operations segment start with net income, after which it reconciles all noncash elements to cash items that involve business operational activities. 

The cash flow from operating activities reports cash outflows directly from the business’s core activities, including paying its staff members salaries and buying and selling inventory and supplies. Other types of cash outflows, such as debts, investments, or dividends, are not included. 

Usually, organizations can generate ample positive cash flow for operational growth. However, if enough cash flow cannot be generated, they may have to raise money to finance projects that help them grow or expand. 

For instance, accounts receivable do not have cash value. But if accounts receivable increase during a specific period, it implies that sales are up. Still, no cash came into the business at the time of sale. The cash flow statement, in this case, deducts receivables from the net income because it is a noncash account. Therefore, the cash flows from the operations section can also cover amortization, depreciation, accounts payable, and several prepaid items booked as expenses or revenue but with zero related cash flow.

2. Cash flow from investing activities – This segment of the cash flow statement considers cash flows from investing; it is the outcome of investment profits and losses. Cash flow from investing activities also encompasses money spent on plant, property, and equipment. Analysts use this segment to measure capital expenditures (CAPEX).

When CAPEX goes up, it typically means a decrease in cash flow. However, it suggests that a business is investing in its future operations. Organizations with high capex are often considered to be expanding or growing.

That said, even though positive cash flows in this segment can be viewed as positive, investors prefer firms that give rise to cash flow from business operations — not through financing and investing activities. Businesses can generate cash flow in this segment by selling property or equipment.

3. Cash flow from financing activities – Cash flow from financing provides an overview of money used in business financing. It calculates cash flow between an organization, its owners, and its creditors, and its source is usually equity or debt. These amounts must be reported to shareholders on the firm’s 10-K report.

Analysts use the cash flows from this section to ascertain how much cash the business has paid out via share buybacks or dividends. Cash flow from financing activities can also help establish how a firm raises money for operational growth.

This section includes cash obtained or paid back using capital fundraising efforts, such as debt or equity, as well as loans taken out or paid back. 

A positive cash flow from financing activities indicates that more cash is coming into the organization than going out. But when the same number is negative, it may mean the business is making stock buybacks and/or dividend payments or is paying off debt.

How to calculate operating cash flow

An organization’s operating cash flow is its first cash flow statement segment. Operating cash flow indicates how much net cash a company generates from its everyday business operations, which is usually an apt indicator of the business’s profitability. 

Positive operating cash flow shows the company is bringing in more cash from its core operations than is going out. On the other hand, negative operating cash flow could indicate that a business may need to reduce its expenses, readjust its pricing model, or even apply for funding. 

Operating cash flow, an essential financial KPI, can be calculated using the following formula:

Operating cash flow = net income + non-cash expenses + change in working capital

Steps to prepare a cash flow statement using the indirect method

Before building a cash flow statement, the first thing to ensure is to have the latest income statement and balance sheet on hand to obtain data. With these two documents in hand, follow these four steps to create a cash flow statement using the indirect method. 

Step 1: Document net income and accommodate noncash expenses – The first step is to document the net income for the period for which the cash flow statement is being prepared. Arriving at the net income involves deleting the company’s operating costs, expenses and taxes from total revenue. 

Then, adjust the net income to accommodate noncash expenses such as depreciation of assets.

Step 2: Fine-tune for assets – Keeping the balance sheet in mind, the next step is to adjust the net income for additions and reductions to company assets. Assets include inventory, accounts receivables, property, cash, and stock. Any asset increase (except for cash) lowers the overall cash flow. In contrast, any decrease in assets increases the total cash flow. 

For example, when purchasing a commercial property, your business adds an asset to its arsenal, but this decreases its total cash flow. 

Step 3: Fine-tune for liabilities – After accounting for assets, it is essential to regulate the net income for any liability changes, such as expenses, accounts payable, and debt. Do note that any reduction in liabilities, such as paying off a loan payment, can lower the overall cash flow. 

On the other hand, any increase in liabilities in the form of credit, such as adding a vendor payment to accounts payable, may either keep the cash flow steady or increase it. 

Step 4: Include cash flow from investing and financing activities – The last step is to add direct cash flow from all investing and financing undertakings. Investing activities could include issuing or buying back common stock or buying or selling equipment or property. On the other hand, the financing segment considers activities like the sale of company stock and making debt repayments. 

The net change in cash flow is the total of all three sections of the cash flow statement.

Steps to prepare a cash flow statement using the direct method

The first step in using the direct method to calculate cash flow from operations is to analyze all cash transactions in a given accounting period. A company’s cash transactions fall under one of two sections: cash receipts (what a business receives in cash) and cash payments (what it pays in cash). 

Cash transactions can include cash paid to suppliers or vendors, cash received from customer sales or payments, cash payments for operating expenses (such as rent, utilities, salaries, and the like), cash received from interest, tax refunds, or other activities, and cash payments for taxes. 

Add total cash receipts and delete total cash payments to arrive at total net cash flow from operating activities.

Drawbacks of the cash flow statement

As essential as a cash flow statement is because it allows a business to ascertain how well it manages its cash position, it is important to remember that negative cash flow could be the result of a firm’s decision to expand its business at a certain point in time, which can be a positive thing for the future. 

Assessing cash flow changes from one accounting period to the next allows an investor to determine how an organization performs and whether it is on the brink of success or bankruptcy. Hence, the cash flow statement should ideally always be considered in collaboration with the other two financial statements: the income statement and the balance sheet. 

The indirect method for calculating cash flow allows for a reconciliation between all three financial statements.

Difference between direct and indirect cash flow methods of accounting

In essence, the cash flow statement has three main sections: cash flow from operating activities, cash flow from investing activities, and cash flow from financing activities. The investing and financing segments are calculated the same irrespective of the accounting method used. The only difference between the two cash flow accounting methods is when calculating cash flow from operations.

The direct method of preparing a cash flow statement is more straightforward than the indirect method, as it presents all essential gross cash receipts and gross cash payments. 

Conversely, the indirect method backs into cash flow by adjusting net income or net profit with changes that happen due to noncash transactions. For this, it starts with documenting the net income and adding noncash expenses before adjusting for any gains and losses from the sale of assets. Then, it accounts for any changes in noncash current assets and working capital accounts (except dividends payable and notes payable).

Both methods of preparing the cash flow statement help arrive at the same conclusion. The indirect method is more widely used by companies, as the statistics used in this method are also used in other financial documents, making it easier to use.

Conclusion

Cash flow statements are valuable documents for companies, showing their ability to pay their bills and invest in assets. However, investors or analysts cannot determine a firm’s performance just by looking at the cash flow statement. They may need to analyze long-term trends after referring to the balance sheet and income statement to get a relatively clear picture of how the business is performing.

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