When preparing a cash flow report, one of the first choices you need to make is whether you’re going to derive your figures using the direct method or the indirect method.
Now if you’re new to this, you might be thinking “what on earth is that, how do they differ, and which one should I use?”
Put simply, the direct and indirect methods are both ways of calculating your net cash flows.
The figure at the bottom of your report, your closing bank position, will be the same in both methods. It’s the calculation that differs and it draws upon different data sources to arrive at the same result.
Which method you use will be dependent on a variety of factors and will differ from business to business such as:
- Which report is easier to generate with the data I have?
- What information do I want to track in detail?
- Do I need to find out why my profit is different from my cash?
- Do I need to focus on cash flow management?
Throughout this article, we’ll explain each method, how they are calculated and why you might choose to use either one. We’ll wrap up with the differences and which one to use and when.
Let’s start with the indirect method.
What is the indirect cash flow method?
The indirect cash flow method starts with a line from a completely different report, the profit & loss statement. You take net profit and adjust this figure for non-cash transactions.
Once you’ve made these adjustments the net result will be your closing bank position at the bottom.
Cash Flow Statement – Indirect Method Cash Flow Example:
Net Profit £1100
Adjustment: Depreciation +£100
Adjustment: Accounts Payable +£150
Adjustment: Accounts Receivable -£200
Adjustment: Inventory -£250
Net Cash from Operating Activities £900
Ok, now let’s step back a bit and work out what on earth just happened.
Net profit is the result of all the transactions recorded on your profit & loss report.
We need to take a moment to understand the P&L report before we can get to grips with our indirect cash flow calculation.
Transactions on the P&L aren’t all recorded on a cash basis.
It will include some non-cash transactions that have an impact on profit.
It will also exclude other cash-based transactions because they don’t have an impact on profit.
- Depreciation is a non-cash item that is included on the P&L
- Unpaid invoices are a non-cash item that are included in revenue on the P&L
- Sales Tax/VAT/GST is a cash item that is excluded on the P&L
- Loan drawdowns are a cash item that are excluded on the P&L
On the indirect cash flow you’ve got to work through these cash inclusions and exclusions adjusting the top net profit figure to get to the cash figure at the bottom.
Let’s go through the above adjustments in more detail to see why:
- Adjustment: Depreciation – depreciation is a loss on the profit & loss, deducted from your revenue to get to net profit. It’s a non-cash item though so it needs to be added back in to get to your cash figure.
- Adjustment: Accounts Payable – AP represents the total of all bills you owe. The loss will be included on your P&L. Since you haven’t yet paid the cash for them, you have to add it back in to get to the correct cash amount.
- Adjustment: Accounts Receivable – AR represents the total of all invoices owed to you. The revenue will be included on your P&L. You haven’t received the cash for them so net profit has to be negatively adjusted by AR to get to the cash amount.
- Adjustment: Inventory – The purchase of inventory isn’t a loss on the P&L since you’ve gained items you can sell later. You have paid cash for it though so the value of inventory is a negative adjustment to your net profit.
These adjustments come from your balance sheet report where you can see the totals for changes in total inventory value, accounts payable etc.
Why use the indirect cash flow method?
We’ve looked at what the indirect method is, now, why should you use it?
The indirect method is widely used by many businesses. It is a simple way of calculating your cash flow and can be done quickly from data readily available in your accounting software.
As you are simply making a few adjustments to one figure, you can arrive at your final figure much quicker than the direct method.
Financial reports should do more for you than just calculate a single figure though. What does the indirect cash flow tell you about your business?
The primary benefit of the indirect method over the direct method is that it helps you explain why your net profit is different from your closing bank position.
People who aren’t used to looking at these reports may not realise or understand why their closing bank position would be different from their net profit for the same period.
When business owners are having conversations with their accountant they need to ensure they are talking about the same figure. The business owner might be looking at their bank statement. Their accountant might be looking at the Profit & Loss report generated in their accounting software.
The indirect report shows why they are different as the differences are clearly highlighted though the adjustment rows.
The indirect method is also commonly used by outside analysts who are looking in at the company, assessing it for its investment potential. They can read a lot in this report by looking at how the adjustments change between different time periods.
However, the indirect method doesn’t offer a clear picture of cash origins, why? The indirect report is focused on breaking down ‘adjustments’. It misses out on breaking down cash transactions into their individual sources.
You get your end result, the closing bank position. However, this leaves you with a lumped figure, not broken down or analysed in any fine detail. It can hide a lot of the useful insights you could learn from by investigating in more depth.
Due to this lack of clarity, the indirect method makes forecasting or decision making around cash flow difficult as you can’t plan or analyse in any detail.
This is something the direct method solves, so let’s go over that now.
What is the direct method?
As the name suggests, the direct method calculates your closing bank position by directly totalling up all your individual cash transactions.
Unlike the indirect method it completely excludes non-cash transactions from the outset. A good way to think about it is just to consider your monthly bank statement. This is as pure as it gets since it only consists of real cash moving in or out of your bank account.
Your direct cash flow report is a structured version of your bank statements over time, collating all these transactions together in an ordered manner.
These cash transactions could be:
- Cash received from customers
- Cash paid to suppliers
- Cash paid to staff
- Cash paid in interest (loans etc.)
No balance sheet adjustments are necessary here, meaning you’ve got plenty of space to break out the above categories even further to allow for even more analysis around your cash in and out.
Why should you use the direct method?
The direct method is your go to way of calculating a cash flow report that aids analysis, cash management and ‘what-if’ scenarios.
It helps you identify cash related problems or opportunities that might be hidden with the indirect method.
As non-cash items are ignored there is no chance of getting your figures muddied by transactions that aren’t relevant to the cash flow (depreciation, unpaid invoices etc.).
If you just look at one figure at the bottom of an indirect cash flow, you can see what has happened, but this needs to be broken down to understand why.
A categorised direct cash flow gives you that vital ‘why’. It also goes hand in hand with cash flow forecasting too.
Forecasting is all about looking at the past and present and using that information to make better decisions about the future.
Many of the short term ‘what-if’ questions you need to ask can be clearly mapped in the direct cash flow:
- What if my rent goes up?
- What if my customers pay late?
- Can I pay my tax bill?
The mid and long term ‘what-if’ questions are key too:
- When can I hire new staff?
- Can I afford to upgrade older equipment?
- When is the right time to open a new store?
- Do I have enough cash to survive the low season?
If you want to get started with a direct cash flow, grab our Free Cash Flow Template.
Should I use the direct or the indirect method?
Both methods have their place and a lot will depend on how easy it is for you to collate the data.
Some businesses find the direct method more intensive due to having to build it from the ground up from every single cash transaction. This is getting easier with the adoption of online accounting tools with digitised invoices, bills and receipts. Much of the labour can be automated now.
If building a direct cash flow is feasible for you, you’ll reap a number of benefits from its rich insights.
The indirect method is still very useful for reconciling your net profit with your closing cash position. It can be quick to generate too.
Ultimately, choose the method that best fits your time constraints, data sources and analysis goals.
If you are new to cash flow forecasting and we’ve got an easy entry point for you. Take a look out our beginner’s guide article: