Indirect vs Direct Cash Flow: Definition, Advantages, and Disadvantages - Growth Freaks

Indirect vs Direct Cash Flow: Definition, Advantages, and Disadvantages

Indirect vs direct cash flow help companies report operational cash flow. The statement of cash flows features three different sets of activities, namely financing, investing and operating. When it comes to indirect vs direct cash flows, the operations section is in charge. If you compare the income statement with the operations section, you will be able to spot the differences between cash and income collections when it comes to timing.

This comparison will also point out the differences between cash payments and expenses time-wise. If the differences are big, this might indicate that the company is aggressive in recognizing income. Furthermore, this may also indicate that company probably spend money to maintain or purchase assets.

Direct cash flow

When a company uses the direct cash flow method, it will list the cash flows from the cash flow statement in the operations section. Usually, cash flows in the operations section come from cash paid to suppliers employee and from customer collections. Furthermore, the operations section can also report cash paid for interest and income tax. However, when using the direct cash flow method, there might be a problem.

A company will probably not keep the data in the required form. For instance, those businesses that use accrual accounting will pair together credit and cash sales. In this way, they will need to make special provision to separately track cash sales.

​Indirect cash flow

​​When using the indirect cash flow method, companies alter net income, converting it from an accrual to a cash basis one. Therefore, this demands from entrepreneurs to add back some non-cash expenses like loss provision for accounts receivable, losses on the sale of a fixed asset, amortization, and depreciation.

Furthermore, when using the indirect method, you can also adjust net income for changes occurring between the ending and the starting account balances in current assets. You will also alter net income for current liabilities for the period.

​Which one is best?

You should also know that these accounts also include unearned revenues, payable liabilities, prepaid assets, supplies, inventory, and accounts receivable. Apparently, most companies find it easier to use the indirect cash flow method. Shareholders and managers might complain if a company continuously reports that its net income surpasses the cash flows. Furthermore, they will try to spot the non-cash income sources to establish

​Many companies believe that the indirect cash flow method is more helpful than the direct one.

whether they are hiding other problems.

​If you want to establish which is your company liquidity, then you will need to look at the cash flow statement. A company’s liquidity relies on its ability to avoid defaulting on debt and to pay bills. However, cash shortages may lead to bankruptcy. On the other hand, excess cash might show that the company should increase investments, executive salaries, distribute dividends and pay down debts.

​Summing up

​The difference between indirect vs direct cash flow methods relies on cash flows from operating activities, which is the first section of the statement of cash flows. The direct method implies that the cash flows from operating activities will include cash paid to suppliers and cash from customers. The indirect method will reveal the net income and the adjustments required to convert the total net income.

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Author: Amanda Knowles