Direct and Indirect Method Cash Flow
One of the first things that you will need to decide when creating your cash flow report is which method of calculation you will use to work out your net cash flow. Net cash flow is simply your business’ cash income over a given period, minus your cash expenses over the same period, which can produce a positive or negative result, providing some insight into your business’s financial wellbeing.
The two most common methods of calculating cash flow from operating activities are the indirect method and the direct method. While both of these methods will produce the same figure at the bottom of your cash flow statement, each is calculated slightly differently. The ideal method to use will hinge on a variety of factors and will vary from business to business.
Indirect Method Cash Flow
The indirect cash flow method uses net income, which can be found on the profit and loss statement, as the foundations for calculating cash flow.
By its nature, a profit and loss statement includes cash and non-cash transactions. As this statement’s primary function is to outline profit and loss, it also often excludes certain cash transactions that are needed to calculate cash flow, such as tax.
The indirect method takes the net income from the profit and loss statement, removes all non-cash transactions and makes estimated adjustments to the net income figure based on cash transactions that are excluded from the statement. Making it a relatively quick way to work out your company’s cash flow, particularly if your business has a high number of transactions for the cash flow period.
While the indirect method is a relatively quick way to get an overview of your business’s cash flow, and can be particularly useful for predicting cash flow from investments and loans, it does not provide a truly accurate picture as adjustments are made on estimations. For a more indepth picture of your business’s cash flow, it is better to use an alternative method that considers each of your cash transactions incoming and outgoing, such as in the direct method.
Direct Method Cash Flow
The direct method of calculating cash flow is considered the more ‘traditional’ of the two methods. Taking the definition of cash flow at face value, the direct method calculates cash flow by adding up all of your individual cash transactions, minusing cash income from cash expenses over the same period. This information can be taken directly from your business’s bank statements for the cash flow period.
Some of the cash transactions that are used in direct method cash flow can include;
Cash paid to suppliers
Cash received from sales
Cash paid in interest in loans
Cash paid for bills
As non-cash transactions are excluded from the offset, there is no need to make any adjustments when using the direct method. Over time, your direct cash flow statements will resemble a more structured version of your bank statements, and provide a more accurate overview of your business’s cash health.
The direct method is particularly useful for smaller eCommerce businesses, with fewer monthly transactions, but it can also be ideal for larger eCommerce businesses who are looking to evaluate the financial feasibility of growth.
The Direct Method vs the Indirect Method
The direct and indirect methods both have their advantages and disadvantages, and the most useful method to use will vary depending on the number of transactions your business makes over a month, what information you are looking for in detail, and if you are looking to explain discrepancies between your net profit and closing bank statements.
Here are some of the key differences between the direct and indirect method to help you determine which calculation would provide the most useful information for your business.
Method of calculation
The indirect method takes net income as the basis for calculation, and requires you to make adjustments to this according to items that are excluded from the profit and loss statement. Whereas the direct method involves collecting information from bank transactions, minusing cash income from cash expenditure to reveal your cash flow.
As the indirect method uses data that has already been collected in your business’s profit and loss statement, it can be much quicker to calculate cash flow using this method. In contrast the direct method requires you to sift through previous transactions and compile a new set of data to then calculate your cash flow. This method can take much more time, particularly if your business has a high volume of transactions.
Accuracy of cash flow statement
The direct method is considered to be the more accurate of the two calculations, as it takes into account each cash transaction from the period, whereas the indirect method is largely based on estimated adjustments. Nevertheless, the outcome of the two methods should not be too dissimilar.
The indirect method is most useful for gaining a quicker snapshot of your cash flow, and is often used by analysts to calculate investment potential. It can also be used to explain why your net profit differs from your closing bank statement for that period, for greater clarity when discussing your finances with your accountant.
The direct method is best for in-depth cash flow analysis and more accurate predictions of potential investments or expansion on cash flow. It can also be used to identify opportunities where cash expenses can be decreased, and analyse the potential effects of increases in your cash expenses, making it easier to plan for any periods of predicted negative cash flow.
Both the direct and indirect methods of calculating cash flow have their benefits for different businesses and situations. While a larger business may most often require a fast cash flow calculation and opt for the indirect method, another business may choose to use the direct method to analyse the feasibility of their new investment plans.
Ultimately, it comes down to the volume of transactions your business makes, your time constraints and how you use your cash flow statement.