Ok, I’ll level with you. I didn’t even know there was an ‘indirect’ method of cash flow generation until recently.
Coming from a non-accounting background, the ‘direct’ method seemed the only way of describing cash flows that made sense to me. In this short article, I’ll draw out the differences between the direct and indirect method, and explain why Brixx is well suited to producing direct method cash flow forecasts.
How do direct and indirect statements of cash flow differ?
Depending on which articles you read, the direct method is either a laborious waste of time or the best possible way of forecasting cash flow. And the indirect method is either the easiest (and therefore best) method or seriously lacking in detail.
The truth is that both methods have their uses. So what’s the actual difference?
1. Cash flows from Operating Activities
This covers cash from the company’s day to day activities, what it sells, buys, the bills it pays, salaries, etc. It can also include the interest the business pays on loans.
It is this part of the cash flow statement that can be calculated in the direct or indirect method. The rest of the cash flow is always calculated in the direct method.
2. Cash flows from Investing Activities
This covers cash flows from the company’s long-term activities, the investments the business has made or fixed assets it buys and sells. It also includes cash generated by interest on savings.
3. Cash flows from Financing Activities
This covers cash flows from the company’s sources of funding, including any costs associated with these. This includes funding received from loans, but also the monthly cost of paying them back. It includes new inflows of cash from money being invested in the business, or gained through selling shares, but also the company’s dividends to its shareholders.
Splitting out these three areas is a way of categorising the different types of cash that flow into and out of the business. Total these up, add on taxation and you have a cash flow statement. Nice.
The part we are interested in, in terms of direct and indirect cash flow is the first – operating activities. So what do the direct and indirect methods of calculating operating activities do differently?
The direct method draws its data from actual cash transaction – accounts receivable and accounts payable – bills paid, income from certain products or services, salaries etc. Because this data is directly related to the paying of cash it takes into account when the cash payment happens, rather than just when it is recorded in the Profit & Loss statement.
The indirect method starts with the business’ net income from the Profit & Loss statement. This is then adjusted to remove items that appear on the Profit & Loss but do not affect cash, to give a net cash amount. A simple example is depreciation, which is a loss to the business but does not have a knock-on effect on cash.
Deciding which method to use
Over a long period, the direct and indirect methods produce the same results. But short-term volatility caused by late-paying clients is hidden by the indirect method and revealed under the direct method’s clear demonstration of actual cash payments. Under the indirect method the cash flow is prepared on an accrual basis straight from the P&L and so payments are recognised when they are earned rather than when they are actually paid. But as we know, cash payments can happen on a different day (or month!) to when they are accounted for in the Profit & Loss statement. In the short term, the direct method’s realistic ‘cash in the bank’ approach to cash payments gives a truer picture of the businesses’ fluctuating cash position.
This, in turn, is incredibly useful in forecasting. One of the biggest challenges to startups and small businesses is managing their cash flow. Even if a business is profitable on paper (or on its indirect method cash flow…) it can run out of money. As soon as the business can’t pay its suppliers or its staff, it’s in real trouble. This is why cash flow forecasting is such a vitally important part of financial planning.
But it not just the cash timing side of the direct method which makes it useful for planning. It also breaks down business activities in a way that the indirect method avoids by just looking at net income, adjusted for non-cash items.
Just look at these examples – it’s clear which method produces a clearer picture of the business.
Cashflow Statement – Direct Method Cash Flow Example:
Cash Received £3000
Cash Paid to Suppliers (£800)
Employee Costs Paid (£1200)
Interest Paid (£100)
Net Cash from Operating Activities £900
Cashflow Statement – Indirect Method Cash Flow Example:
Net Income £1000
Adjustment: Depreciation (£100)
Net Cash from Operating Activities £900
The downside to the direct method is that it takes more work to calculate than the indirect method. But the advantages are, I hope, clear. The good news is that Brixx automatically calculates a direct method cash flow from your financial forecast, along with a Profit & Loss statement and Balance Sheet statement. Alternatively, we have an Excel or Google Sheets template for cash flow which you can have for free!