Mastering Cash Flow Methods: Strategies for CEOs and CFOs to Professionalize Financial Management

Indirect vs direct cash flow

A company management team typically focuses on the Income Statement. That's where they see sales, costs, and the profit or loss the business makes each period. Especially if the company is doing well, cash flow might be a minor concern, so regularly checking the bank account is sufficient.

However, when something changes and managing cash closely becomes a priority, even CEOs or Presidents can be caught off guard if they haven't done their homework beforehand.

This article explains the two different methods of preparing a cash flow statement—direct and indirect. It aims at CEOs, Founders, Business owners, finance professionals, and anyone else who needs to manage a business's cash balance and cash flow.

Why are these concepts important?

Nobody will disagree that cash is significant to the health and prosperity of any enterprise. Therefore, understanding this aspect of finance is crucial for anyone trying to build a successful business in the long term.

The usual first step when a company needs to manage cash is to list and estimate expected collections from clients versus expected payments to suppliers, employees, vendors, and banks in the following days or weeks. This information, combined with ‘today’s’ cash balance, goes into a spreadsheet that might get refined over time and shows how much cash the company will have in the short term.

Even though this is helpful and may be sufficient for a quick analysis, I often see firms stuck with this short-term cash view. Understanding when the team should consider 'upgrading' to a more robust cash flow model that provides better insights into the longer term is essential.

What is the DIRECT cash flow method?

The direct cash flow method calculates changes in cash balance from Inflows minus Outflows of cash for the period (days, weeks, months, years). It is straightforward to understand, as the idea of money inflows minus outflows is easy to grasp—hence the name.

For most companies, inflows are mainly cash collected from customers but include other inflows like interest and dividends received and funding like new debt or equity. Outflows are all payments to suppliers, vendors, employees, and banks, as well as interest, taxes, debt amortization, and dividends.

What is the INDIRECT cash flow method?

While the direct method looks at inflows minus outflows of cash, the Indirect method starts from an Income Statement metric - usually Net Income, but it can also use other metrics like EBITDA - and calculates the change in cash by adding non-cash adjustments and other changes in the balance sheet accounts. The intention is to reconcile how much net income (or EBITDA) becomes cash flow in the period.

There is an implied assumption here that the Income Statement is being prepared on an accrual basis, which means that there will be differences between the net cash movements and the net income statement. Therefore, a reconciliation is required.

Side note: If your company prepares its "income statement" only on a "cash basis," this article might be less relevant to you as, essentially, your cash flow will pretty much match its "net income." I added quotes here because, technically, the income statement and, therefore, the net income are accrual-based by definition, but this is often not how small businesses function. I recommend discussing moving to an accrual basis with your bookkeeper/accountant.

Even though I tried to keep the above explanation as simple as possible, you can tell that the indirect method is more complex than the direct method. It requires some accounting understanding. Throughout my career, I've noticed that non-accounting teams and often even people in finance teams need help understanding these concepts, so I hope this article provides a starting point.

Here is a step-by-step example to clarify the concepts:

Let’s imagine a straightforward business that only has 'revenue’ and ‘costs.' In its first year of operations, the business had $100 of revenue and $80 of costs, netting a nice $20 net income. Below is the income statement for the business:

Let’s also say that by the end of the year, the business collected only $60 of that $100 revenue as it gives time for its clients to pay, but on the other hand, only paid $10 of those $80 costs, as its suppliers also gave it (quite a bit of) time to pay. By the end of the year, the business went from zero cash balance to +$60 - $10 = $50 cash balance. Only from this information can we calculate the direct cash flow as below:

Now, the leftover amounts to be received from clients and to be paid to suppliers go to the Balance Sheet as ‘accounts receivables' and 'accounts payables,' respectively. The same goes for the $50 Cash balance (Asset) and the cumulative profit or net income of $20 (Equity):

From the above, we can calculate the indirect cash flow starting from net income (see below). Notice that the change in cash of $50 matches the direct method (as it should), but the path to get to it is different (‘indirect’). In other words, instead of looking at what was received, we look at what was not received from clients and adjust that from the net income amount. Similarly, we do the same with payables/suppliers, but with the opposite sign:

The above statement should be read as follows: Out of the $20 net income, $40 of revenue was not yet received, and $70 of the cost was not yet paid to suppliers, leaving us with the $50 change in cash for the period.

Moving on - let's say the company had the same level of operations in Year 2 ($100 revenue and $80 cost), netting the same $20 net income.

However, let’s say that besides collecting and paying the Year 1 ending receivables and payables balances, respectively, during Year 2:

• The company did a better job collecting from clients and collected $70 out of the Year 2 $100 revenue and;
• it could not delay payments to suppliers so much and had to pay $30 out of the Year 2 $80 cost.

With the information above, we can, again, calculate the direct cash flow for Year 2 and conclude that the change in cash for the year was a positive $10 balance increase:

Similarly, we can calculate the Balance Sheet for Year 2. You can see below how the year-end balances of receivables and payables change compared to Year 1. The new receivables balance is $30 from what was not collected from clients yet, and the balance of payables is $50 from what was not paid to suppliers yet, both by the end of Year 2:

This is the moment you've been waiting for: we can calculate the indirect cash flow by reconciling those balance sheet changes against the net income, just as we did for Year 1. From the Balance sheet above, we can see that the change in accounts receivables is a decrease of $10, and the change in payables is a decrease of $20. Therefore, this is how the Indirect cash flow for Year 2 looks like:

You might be asking yourself: why is the sign different between change in receivables and payables if both accounts showed a decrease year-over-year in the balance sheet?

The easiest way I found to explain this is the following:

• Receivables: The earlier the company receives from its clients (time to transform revenue into actual cash inflow), the lower the receivables balance will be by the end of the year. Hence, it is better for the cash balance.
• Payables: On the other hand, the longer the company can take to pay its suppliers (time to transform cost into actual cash outflow, the higher the payables balance will be by the end of the year and, therefore, the better it will be for the cash in the bank account.

That’s why a decrease in both those accounts must receive different ‘signs’ in the indirect cash flow statement.

Why do we need the indirect method if we already used the direct method to calculate the balance sheet and know the cash balance for the end of Year 2?

Even though the example above 'mechanically' precisely demonstrates what happens behind the scenes in every firm's accounting department, the reality is more complex. It will involve many more 'entries,' sometimes impacting several different accounts in the balance sheet at once. Accounting teams use various applications to help them produce the income statement and balance sheet at the period's close.

The example above for cash flow calculations can be used for realized periods (in the past) or forecasting (in the future), as one can project expected revenue and costs. As we will see below, we start to understand the different use cases for each method, mainly in forecasting.

Both indirect and direct cash flow methods are helpful in different circumstances:

If you consider forecasting the business's cash needs, it might be easier to understand the role of each cash flow method within the activities of a finance team. As we will see below, the direct method is more beneficial for the short term, while the indirect method is more appropriate for longer-term analysis.

Here are a few examples of situations when the Direct Cash Flow is better:

• The company is in a tight cash situation, and managing cash daily or weekly is a priority. For example, management must prioritize paying salaries in the short term against other expenses.
• The company is experiencing a heavier investment phase and needs to manage the timing of cash inflows and outflows accordingly.
• The company can't delay an up-and-coming cash outflow (in the following weeks). It wants to make sure it has enough cash in the bank.
• The company has a ‘timing gap’ (usually a few days or weeks) between paying suppliers and receiving money from clients, so management often needs to double-check the cash position before making batches of payments.
• The company must meet covenants in a few days or weeks, so daily tracking of that progress is essential.

These are just some examples, but it is crucial to clarify that none necessarily mean the company is in a bad financial situation (even though that could be true). The only underlying common aspect is that management deals with a short-term problem that ideally will only last a while. The goal should be to build a cash cushion large enough to absorb such fluctuations.

Remember that the actions resulting from such analysis are needed regardless of the situation. For example, if possible, you should ensure you receive invoices on time or faster than initially planned, work to reduce or delay expenses, postpone investments, pull money from a line of credit, or raise money.

In other words, the direct cash flow method helps navigate short-term fluctuations.

Very often, management in smaller firms starts forecasting cash flow by preparing a short-term direct cash flow, trying to anticipate the inflows and outflows of cash in/out of their business account for the next days or weeks. They eventually realize that this method has limitations once they need a longer-term forecast.

Here are a few examples of situations when the Indirect Cash Flow is better:

• Management is starting to professionalize the business's finances and has moved from ‘cash basis’ to ‘accrual basis’ accounting.
• Management is not worried about the cash position in the short term. Still, it considers capital investment, personnel expansion, geographic growth, or product launch, for example, in the following months, quarters, or years.
• The company has debt, loans, debentures, etc., that require more sophisticated monitoring of its finances over time (covenants, for example), and it wants to anticipate potential problems to meet those obligations well in advance.
• The company needs to raise money (debt or equity) and plans to talk to potential investors.
• The company has relatively heavier capital needs (for example, it requires significant working capital or PP&E – Property, Plant & Equipment to operate).
• Management wants to understand the mid-to-long-term future state of the businesses better.

Again, these are just some examples of situations when the indirect cash flow is more valuable than the direct cash flow. As you probably noticed, the Indirect method is more helpful anytime the problem requires more long-term planning (usually longer than a few weeks).

Also, keep in mind that the Indirect Method ‘talks’ to your income statement (by starting from your net income) and your balance sheet (by adding adjustments from the balance changes), so it is a better tool for doing proper financial planning in the mid to long term. However, regular preparation of those statements is required.

There is nothing wrong with doing longer-term financial planning using the direct cash flow method. If that works for the business, that's fine. However, I think it would be better to use the indirect method, as it can provide a more comprehensive view of the business finances and expected performance, and it works with the other statements.

Summary of Pros and Cons of each method and situations to use each one:

Direct cash flow method:

What is it: Changes in cash are calculated from Inflows minus Outflows of money.

Benefits:

• It is simple to understand, especially for smaller businesses with low transaction volume.
• Great for the short term and likely more accurate in estimating the cash position in the short term (forecasting days or weeks)
• Links directly to the bank account movements, so you don't need a balance sheet and an income statement prepared to be prepared.
• Suitable for day-to-day or week-to-week cash change estimates.
• Can be frequently updated for recurring reviews (daily or weekly, for example)

Cons:

• Not great for longer term (approximately longer than 13 weeks)
• It doesn't link to the income statement. Therefore, it ignores non-cash transactions.
• It provides limited insights into the performance of the business.

When to use: When you need to understand short-term cash movements.

Indirect cash flow method:

What is it: Changes in cash are calculated starting from an Income statement metric (like Net Income or EBITDA) and reconciled to the change in cash by including non-cash adjustments (like depreciation) and changes in the balance sheet accounts.

Benefits:

• It links to an income statement metric, a reconciliation from 'profit' to 'cash in the bank.'
• More insight into the business performance as it reconciles the accrual view (income statement) to cash.
• It is suitable for the mid-to-longer time frame, typically than three months.

Cons:

• Understanding it might take work, especially for folks with little accounting know-how.
• The Indirect Method is not good for estimating short-term cash movements (days or weeks), so it is not helpful for companies managing cash tightly.
• It requires preparing a P&L and a Balance Sheet (the three statements work together), so your company will likely have it monthly at best (as it is unlikely that you close your books every day or week).

When to use: When you need a mid-to-long-term view of your business cash flow for planning purposes.

Final thoughts:

Both direct and indirect cash flow methods are used in business management, regardless of size. I observed over the years that the above concepts are not 100% understood by finance teams in small to large companies, let alone by non-finance or non-accounting folks and business owners. I tried to provide a simple and practical explanation of when these methods are applicable and why – from a managerial perspective. Therefore, remember that the intention of this article was not to make an accounting guide, even less a public accounting guide, as I ignored some nuances for simplicity.

Please let me know if you agree or disagree with these points! Did I miss something relevant? What method has your company been using to manage and forecast cash flow?

About the Author

I'm Vini Meirelles, Founder of FluxoCFO. In early 2020, I pivoted from a career at KraftHeinz to independent consulting, driven by a desire to have more control over my professional journey.

With roles such as CFO of a $300M business unit and Head of Financial Planning for an $18B business, I gained deep insights into managing high-stakes financial operations.

Now, I leverage this experience to help mid-size US food manufacturing companies professionalize their finances.

I offer a range of resources, including a unique free email course on profitability analysis designed specifically for CEOs and CFOs of food manufacturing companies. Learn more and sign up today HERE .