Updated July 29, 2023
Definition of Direct Method of Cash Flow Statement
Direct Method of Cash Flow Statement is how actual cash flow information is retrieved from the segments of a company’s operations and used instead of the accrual accounting values. The Cash Flow for Operations statement will vary in direct and indirect methods.
In contrast, the other two forms of cash flow, Cash Flow from Investing and Cash Flow from Financing, will remain the same for direct and indirect methods.
Explanation Of Direct Method
As we know, any company’s financial statement has three important components: the balance sheet, income statement, and cash flow statement. The cash flow statement has three parts which are cash flow from operations (CFO), cash flow from investing activities (CFI), and cash flow from financing (CFF). Two direct or indirect methods can prepare this cash flow statement.
Under the direct method of cash flow statement, the cash flows from receipts and payments made during the financial period are listed. Then the cash outflows are subtracted from the cash inflows to calculate the net cash flow from a company’s operations. In the indirect method, net income is the starting point which is then adjusted for changes in different assets and liabilities either by adding or subtracting from the net income to arrive at the net cash flow from operations.
Example of Direct Method of Cash Flow Statement
Under the direct method, cash outflows and inflows include activities such as the firm paying cash salaries to employees, making cash payments to vendors and suppliers, receiving interest income and dividends, collecting cash from customers, paying income tax in cash, and making cash payments for interest, among others.
Cash flow from operations in the direct method is presented in the following format:
Cash Flow from Operations
- Cash collected from customers – $10000
- Salaries and Wages paid – ($2500)
- Cash paid to vendors – ($1500)
- Interest Income – $700
- Total cash flow before taxes – $6700
- Interest paid – ($1000)
- Taxes paid – ($700)
- Net Cash Flow from Operations – $5000
Differences Between Direct and Indirect Methods of Cash Flow Statement
- In the direct method, the cash flow statement from operations is calculated using only cash transactions such as cash spent and received. On the other hand, in the indirect method, cash flow from operations calculation is done using net income as the base. Then non-cash expenses like depreciation are added back, and non-cash income like profits from scrap sales are deducted. Also, a net adjustment is made between current assets and liabilities to reach the final cash flow from operations.
- Another difference between the direct method and the indirect method is reconciliation. In the direct method, the separation of various cash flows from others is accomplished through reconciliation. In contrast, in the indirect method, the conversion of net income into cash flow is performed.
- Non-cash expenses like depreciation and amortization are ignored in the direct method, while they are considered in the indirect method.
- The direct method of preparing the cash flow statement does not require any preparations, whereas the indirect method involves a significant amount of preparation for converting income.
- The indirect accuracy method is high due to a lack of required adjustments. An indirect method has low accuracy since many adjustments to the cash flows are required.
- The direct method of cash flow statement takes more time to prepare than the indirect method.
- Companies prefer using the indirect method since they are preparing a balance sheet and income statement based on accrual accounting, and the indirect method uses accrual accounting. If companies were to prepare a direct method of cash flow, they have to look at every transaction as a cash outflow or inflow.
Advantages and Disadvantages
Companies use both methods of preparing cash flow statements depending on specific situations and various requirements as per standards, as they find both methods useful. Generally, firms prefer the indirect method of preparing the cash flow statement; using the direct method is time-consuming due to the need for pre-recording and adjustments to cash inflows and outflows.
Also, an indirect method is less accurate. In the direct method of cash flow statement, preparation time is less than in the indirect method. But since cash transactions must be separated from non-cash transactions, it will take a relatively long time for bigger companies with thousands of daily transactions.
The major disadvantage of the direct method is the consumption of time and difficulty it takes to list all the disbursements and receipts of cash, and it is more cumbersome for large companies that have a large number of transactions almost daily. Moreover, most companies follow the accrual method of accounting and prepare the balance sheet and income statement based on the same. Hence it makes sense to prepare a cash flow statement using the indirect method, which uses the accrual method of accounting. The direct method of preparing the cash flow statement presents an additional issue as per US GAAP. It requires companies to publicly disclose the reconciliation of net income to net cash provided and used in cash flow from operations when utilizing the direct method. Due to the additional task involved, companies find using the indirect rather than the direct method sensible.
Conclusion
The direct method of preparing the cash flow statement retrieves actual cash flow information from the segments of the company’s operations. It utilizes it instead of relying on accrual accounting values. Although the direct method of Cash Flow Statement has its advantages, such as it is more reliable and taking less preparation time, companies predominantly use the indirect method due to compliance requirements of accounting standards and the consumption of time and difficulty it takes to list all the disbursements and receipts of cash in the direct method.
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This has been a guide to the Direct Method of Cash Flow Statement. Here we have discussed the whole concept with examples and how it differs from the Indirect Method of Cash Flow. You may also look at the following articles to learn more:
