How to Prepare a Statement of Cash Flows Using the Direct or Indirect Method

In today’s post, we are going to explore how to prepare a statement of cash flows using the direct or indirect method. The statement of cash flows, or cash flow statement for short, is a vital financial tool that provides a summary of the money and other assets that are coming in and out of a company. This measures the efficiency of a company in terms of cash management -- especially how it can generate resources to pay its obligations or even remain viable. Since 1987, the cash flow statement has been a mandatory part of financial reports.

Why is this tool for both business owners, investors and other stakeholders?

It’s really quite simple; the cash flow statement shows cash flow and defines the capability of the business to generate cash, which provides important insight for business owners and prospective investors, both of whom want to see the business succeed. For investors in particular, if the business doesn’t show a solid cash flow statement that demonstrates a viable, profitable business, they will often walk away. 

When you look at how to prepare a cash flow statement using the direct method, the difference is primarily in how the operating activities section is structured. But in any case, now that we know why it is important, let’s look at how to prepare a statement of cash flows using the direct or indirect method. We’ll start with the direct cash flow method. 

Direct Method

The generally accepted accounting principles (GAAP) of the US and the International Accounting Standards (IAS) both recommend that businesses adopt the direct cash flow to develop their cash flow statement. One of the primary reasons for this is that it is easier to comprehend and is straightforward. And even though I have an MBA (and even a doctorate in business), developing a cash flow statement is just not my toolbox of skill sets. 

Your basic statement of cash flows--or cash flow statement--has three basic components:

1. Operating activities;
2. Investing activities; and 
3. Financing activities.

The direct method cash flow statement provides a summary of transactions and sorts them according to category. This can be broken down according to customer receipts: payments to suppliers, payments to employees, interest earned and dividends received, for example. 

When added up, these figures are calculated using the beginning and ending balances. This helps identify the net increase or decrease in the accounts of the company. The basic steps for preparing a cash flow statement using the direct method include (thank you to the Balance of Small Business):

1. Cash Flow from Revenue.
2. - Cash Payments for Expenses.
3. = Income Before Income Taxes.
4. - Cash Payment for Income Taxes.
5. = Net Cash Flow From Operating Activities.

Now you know how to prepare a cash flow statement using the direct method. Now let’s move on on the indirect method

Indirect Method

Preparing a cash flow statement using the indirect method is a little bit more complex, but may provide a clearer picture when it comes to its usefulness as a tool for business analysis. In essence, using the indirect method reconciles the accrual accounting net income to cash from operating activities. 

Accrual accounting is an accounting method that counts revenues and expenses, even if the cash is not yet on hand. This includes depreciation, accounts payable, accounts receivable, inventory expenses, and working capital changes. 

Using this technique, the company begins with the net income as reflected on the income statement. Afterwards, adjustments are made on the net income on an accrual basis instead of cash basis. 

Its major advantage is that it provides a clearer picture of the net income and the cash flows. It helps chart the various linkages of the financial statements. The basic steps for preparing a statement of cash flows using the indirect method are below (again thank you to the Balance of Small Business):

1. Net income before preferred dividends
2. Non-cash adjustments to net income
3. Changes in working capital
4. Investments
5. Securities transactions and dividends

These five items summarize the business’ position in terms of its cash. Next you you include the following: 

1. Cash flow from operations (the formula for this is (Net Income + Depreciation + or - Increases/(Decreases) in Assets and (Liabilities) = Net Change in Cash Account ;
2. Cash flow from investing activities; and 
3. Cash flow from financing activities. 

You can see that this method is more complicated but that it also can provide a clearer picture of the firm’s financial position. 

Choosing the Best Method for Developing Your Cash Flow Statement

What is the best method to use to prepare your cash flow statement?

Our expert opinion is that it depends on the type of business that you have.

In a nutshell, the cash flow statement will be a reflection of your business capital and how money flows into and out of your company. The goal is to show to your investors or other stakeholders that the company is doing well and has a clean bill of health when it comes to its financial resources and ability to generate cash flow.

The direct method is most useful for smaller entities that do not have a lot of fixed assets. If the actual cash income is strong and the expenses are managed well, this method is sufficient and should work well.

The indirect method is better for companies that have a lot of depreciation expenses or many transactions involving receivables that have yet to arrive. Although the resources are not yet with the company, the indirect method will provide a much better picture of their cash flow and cash position.

You now have an admittedly very basic understanding of how to prepare a statement of cash flows using the direct or indirect method.

Want to learn more? Contact me today and let’s talk!