How do you compare the indirect method with the direct method of cash flow statement?

1 The indirect method

The indirect method starts with the net income from the income statement and adjusts it for non-cash items and changes in working capital. Non-cash items are expenses or revenues that do not affect cash flow, such as depreciation, amortization, deferred taxes, and gains or losses on asset sales. Changes in working capital are the differences between the current assets and current liabilities from the balance sheet, such as accounts receivable, inventory, accounts payable, and accrued expenses. The indirect method reconciles the net income with the net cash flow from operating activities.

2 The direct method

The direct method shows the actual cash inflows and outflows from operating activities, such as cash received from customers, cash paid to suppliers, cash paid for wages, and cash paid for taxes and interest. The direct method requires more detailed information and analysis of the transactions that affect cash flow, such as invoices, receipts, and payments. The direct method presents the net cash flow from operating activities as the sum of the cash flows from each category.

3 The comparison

The indirect method and the direct method result in the same net cash flow from operating activities, but they differ in the presentation and the calculation. The indirect method is more common and easier to prepare, as it uses the data from the income statement and the balance sheet, which are readily available. The indirect method also highlights the relationship between the net income and the cash flow, and the impact of non-cash items and working capital on cash flow. The direct method is more transparent and informative, as it shows the actual sources and uses of cash from operating activities, which are useful for cash flow forecasting and management. The direct method also complies with the International Financial Reporting Standards (IFRS), which recommend using it.

4 The advantages

The indirect method has several advantages over the direct method. First, it is simpler and less time-consuming to prepare, as it does not require additional data or analysis of the cash transactions. Second, it is consistent and comparable with other financial statements, as it uses the same accounting principles and methods. Third, it is useful for investors and creditors, as it shows how the net income is converted into cash flow, and how the non-cash items and working capital affect the cash flow.

5 The disadvantages

The indirect method also has some disadvantages compared to the direct method. First, it is less intuitive and clear, as it does not show the actual cash inflows and outflows from operating activities, which are essential for cash flow forecasting and management. Second, it is less detailed and informative, as it does not provide the breakdown of the cash flows from each category, such as cash received from customers or cash paid to suppliers. Third, it is less compliant with the IFRS, which prefer the direct method for better disclosure and transparency.