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Cash flow statement: Direct versus indirect cash flow accounting methods

Posted by Neha De

July 1, 2022    |     10-minute read (1860 words)

A cash flow statement summarizes the movement of cash and cash equivalents coming into (cash inflows a firm gets from its ongoing operations as well as external investment sources) and leaving (cash outflows that finance business activities and investments) a business. It calculates how well a business is able to manage its cash position — how well it can generate money to honor its debt obligations and fund its operating expenses. 

Apart from the balance sheet and the income statement, the cash flow statement is one of the three top financial statements that disclose the cash generated and spent during a specific period of time (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 look into all the transactions that go through the business, where every transaction contributes to its growth. The cash flow statement follows the money made by the company in three top ways: through operations, investing and financing. The sum total of these three sections is known as net cash flow. 

The three different segments of the cash flow statement — operations, investments and financing — allows investors to settle on 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 and it comprises cash flows from operating activities as well as transactions from all operational business activities. The cash flows from operations segment starts with net income, after which it reconciles all non-cash elements to cash items that involve business operational activities. 

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

Usually, organizations can generate ample positive cash flow for operational growth. However, for some reason, if enough cash flow cannot be generated, they may have to raise money in order 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 time period, it implies that sales are up, but 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 non-cash 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 basically 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 there is a decrease in cash flow. However, it may also suggest that a business is making investments into its future operations. Organizations with high capex are often considered to be those that are expanding or growing.

That said, even though positive cash flows in this segment can be viewed as a positive, investors tend to 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 flows from financing provides an overview of money used in business financing. It calculates cash flow between an organization as well as its owners and its creditors, and its source is usually equity or debt. These amounts are usually required to be reported to shareholders on the firm’s 10-K report.

Analysts make use of 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 be used to help establish how a firm raises money for operational growth.

Cash obtained or paid back using capital fundraising efforts, such as debt or equity, is included in this section, and so are loans taken out or paid back. 

A positive cash flow from financing activities indicates that there is more cash coming into the organization than going out. But when the same number is a 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 the first segment of its cash flow statement. Operating cash flow indicates how much net cash a company generates from its everyday business operations, and this is, in most cases, an apt indicator of how profitable the business is. 

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 be an indication of the fact 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 this 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 expensesThe 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 as well as taxes from total revenue. 

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

Step 2: Fine-tune for assetsKeeping the balance sheet in mind, the next step is to adjust the net income for additions and reductions to company assets. The assets cover items such as inventory, accounts receivables, property, cash and stock. Basically, any increase in assets (except for cash) lowers the overall cash flow, whereas 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 it leads to a decrease in the amount of total cash it has. 

Step 3: Fine-tune for liabilitiesAfter accounting for assets, it is important to regulate the net income for any changes in liabilities, 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. Whereas, the financing segment takes into account activities like selling 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

For using the direct method to calculate cash flow from operations, the first step 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. 

To arrive at total net cash flow from operating activities, add total cash receipts and delete total cash payments.

Drawbacks of the cash flow statement

As essential as a cash flow statement is, because it allows a business to ascertain how well it is able to manage 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 changes in cash flow from one accounting time period to the next allows an investor to determine how an organization is performing, 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, namely, the income statement and the balance sheet. 

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

Differences between indirect and direct cash flow methods of accounting

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

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

The indirect method, on the other hand, backs into cash flow by adjusting net income or net profit with changes that happen due to non-cash transactions. For this, it starts with documenting the net income, adding non-cash expenses, before adjusting for any profits and losses from the sale of assets. Then, it accounts for any changes in non-cash current assets as well as changes in 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, which makes the method easier to use.

Conclusion

Cash flow statements are valuable documents for companies, as they show a company's ability to pay its bills and invest in assets. 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 as well as the income statement in order to get a relatively clear picture of how the business is performing.

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