Cash Flow Statement, Importance, Direct and Indirect Methods
The Cash Flow Statement shows the financial position of a company established to run its operations. The accounts department provides details of the cash inflows and outflows over a specific time. The motive is to provide a financial picture of the organisation to potential people.
It includes the creditors, investors, and board members. They can plan to focus on improving the cash position and future decisions related to the organisation. Two methods are applied to prepare the cash flow statement, including direct and indirect methods.
What is a Cash Flow Statement?
A Cash Flow Statement is a summary of the cash inflows (money coming in) and cash outflows (money going out) in a period. It provides a clearer picture of a company's financial health than the Income Statement alone. It is divided into three sections.
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Operating Activities: This is the cash flow from the main, everyday work of the business.
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Investing Activities: This is the cash flow from buying or selling long-term assets, like land or factory machines.
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Financing Activities: This is the cash flow from getting money from owners (investors) or banks (loans) and paying it back.
Importance of Cash Flow Statements
The Cash Flow Statement is important for many different people. It helps owners, managers, banks, and other investors understand the company better.
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For Managers and Owners: Managers need to check the cash flow statements regularly. They want to have an idea of the cash available with the company for operational purposes.
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For Banks and Lenders: Lenders and Banks follow an approach to refer to the cash flow statement. They can know the financial health of the organisation. It can help to make a decision whether they should give the loan to the organisation or not.
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For Investors: People are interested in making investments in the organisations. They try to evaluate the financial position by knowing the cash position of the organisation. It can help them to think about the decision to invest in any particular company or not.
Direct Method Explained
The Direct Method is one of the two ways to present the operating activities section of the Cash Flow Statement. This method is the most straightforward because it shows the actual large amounts of cash received and paid out. It is like keeping a simple cash register for the main business activities.
The company lists the main types of cash that came in and the main types of cash that went out.
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Cash received from customers: The actual money collected from people who bought goods or services.
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Cash paid to suppliers: The actual money used to pay for materials or inventory.
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Cash paid to employees: The actual money used for salaries and wages.
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Cash paid for operating expenses: The actual money spent on things like rent, electricity, and simple office supplies.
After listing all these main cash movements, the report calculates the net cash from operating activities. This number is the final cash balance after all the daily cash ins and outs are accounted for. The advantage of the Direct Method is that it is easy for anyone to read and understand.
It gives a clear, itemised view of where the company's money is flowing every day. However, it can sometimes be hard for a company to collect all this specific cash information if its accounting system is not set up that way.
Indirect Method Explained
The Indirect Method is the second way to present the operating activities section of the Cash Flow Statement. This method is the most common way companies do it because it is easier to prepare from the existing accounting records. Instead of listing every cash transaction, the Indirect Method starts with the company’s Net Income (the profit) from the Income Statement.
Since the Net Income includes non-cash items, the Indirect Method makes adjustments to that profit number to turn it back into cash flow. It adjusts for two main types of things.
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Non-Cash Expenses: It adds back expenses that did not involve actual cash leaving the business. The most common example is Depreciation. Depreciation is an accounting trick to show that an asset (like a machine) is wearing out, but no money is physically paid out for this expense. So, the depreciation amount is added back to the Net Income.
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Changes in Working Capital: It adjusts for changes in things like Accounts Receivable (money owed to the company) and Accounts Payable (money the company owes). For example, if the money owed to the company (Accounts Receivable) went up, it means the company made sales but hasn't received the cash yet. So, that increase is subtracted from the Net Income to reflect the true cash received.
Advantages of Direct Method & Indirect Method
Companies apply both the direct and indirect methods in preparing the cash flow statement. They can check the financial health of the organisation.
Advantages of the Direct Method:
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Clarity and Simplicity: It is easy to read. Anyone can quickly see the main sources of cash (like customers) and the main uses of cash (like employees or suppliers). This clear detail is very helpful for making daily management decisions.
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Detailed Information: It provides clear insights into the efficiency of cash collection and payment habits. It helps managers focus on things like how fast customers are paying their bills.
Advantages of the Indirect Method:
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Ease of Preparation: This is the biggest advantage. Companies can prepare this report directly from their Income Statement and Balance Sheet, which are already prepared. This saves time and money.
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Focus on Reconciliation: It clearly shows how the company's profit (Net Income) relates to its cash flow. It helps investors understand the difference between the two numbers. This is a very valuable feature for financial analysts.
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Widespread Use: Because it is so commonly used, it is what most accountants and financial people are used to reading and preparing.
Both methods give the same result for the final net cash flow from operating activities. The difference is only in how they show the details of the calculation.
When to Use Direct or Indirect Method in the Cash Flow Statement?
The choice between the Direct Method and the Indirect Method is only for the first section of the Cash Flow Statement: Operating Activities. The other two sections, Investing and Financing, are always presented in the same direct format regardless of the method chosen for operations.
When to Use the Indirect Method?
The Indirect Method is commonly used in organisations. Accounting rules allow for either method, but the Indirect Method is generally simpler to create because it ties directly into the other main financial reports. Companies usually prefer to use the Indirect Method because it is less work to prepare. The financial community, including investors and analysts, is completely comfortable with this method. Because it is easier to prepare, the vast majority of companies choose the Indirect Method for their Cash Flow Statement.
When to Use the Direct Method?
The Direct Method can be used when the company wants clear information about the daily cash flow. It can be useful for internal management or when presenting to a bank for a loan. It gives a very transparent view of how cash is flowing in and out of the core business.
However, it requires a company's accounting system to be set up to track those cash inflows and outflows. Even if a company uses the Direct Method. The authority must include a separate paper showing the reconciliation to the Indirect Method, making it more work overall.
The choice does not change the total health of the company. It is a matter of presentation. The final result of the Cash Flow Statement—the change in cash for the period—is the same no matter which method is used.