Cash flow is one of the most crucial tools for a company’s financial management. It allows for the assessment of liquidity, the ability to cover debts, and the planning of future investments.
However, there is no single cash flow method. In fact, there are two main methods for calculating cash flow: the direct method and the indirect method.
Each has its own advantages and disadvantages, and it is vital to understand when and how to use each method for effective financial management.
Let’s break down each method, along with its key advantages and disadvantages.
What is the direct cash flow method?
The direct cash flow method is used to calculate the net cash generated or used by a business over a specific period, by specifically recording all cash inflows and outflows.
Unlike the indirect method, which relies on accounting adjustments, the direct method focuses on actual cash transactions, offering a clear and detailed view of operating cash flows.
This method is commonly used to prepare a cash flow statement and helps businesses better understand their liquidity and ability to meet short-term obligations.
The direct cash flow method is especially useful for organisations where precise tracking of cash movements is essential, such as small businesses, startups, or companies with high volumes of cash transactions in their daily operations, like supermarkets and large retail chains.
By focusing on actual transactions, this method eliminates potential accounting distortions, providing a transparent picture of the company’s financial position.
How the direct cash flow method works
The direct cash flow method operates by identifying and recording all income sources and cash payments made during a specific period.
This approach requires constant tracking of cash transactions, involving the detailed and chronological recording of each cash inflow and outflow.
It is calculated by adding up all cash inflows and subtracting all cash outflows. The result shows the net cash generated or used by the company’s operations during the given period.
For example, if a business receives £50,000 in cash sales and £10,000 from accounts receivable, while paying £20,000 to suppliers and £15,000 in wages, its net cash flow would be:
Net Direct Cash Flow = £50,000 + £10,000 - £20,000 - £15,000 = £25,000.
Advantages and disadvantages of the direct cash flow method
The main advantages of direct cash flow are as follows:
- Greater accuracy in cash flow projections: this method allows each cash transaction to be recorded and analysed as it happens, offering a clear and accurate view of cash flow.
- Identification of cash sources and uses: it provides a detailed view of where cash is coming from and how it is being spent, helping management make more informed decisions regarding resource allocation.
- Facilitates short-term liquidity management: as the direct method provides real-time information, companies can continuously monitor their cash position, ensuring they always have sufficient liquidity to meet immediate obligations.
- Accounting compliance: in some jurisdictions, the use of the direct method is required for financial reporting, particularly for public sector entities or large corporations. Using this method ensures compliance with relevant accounting and legal regulations.
The disadvantages include the following:
- Greater complexity and time commitment: preparing a direct cash flow statement can be more complicated and time-consuming as it requires constant and detailed tracking of every cash transaction.
- Need for a robust accounting system: effectively implementing the direct method often requires an advanced accounting system that can accurately record and report cash transactions. This can be a challenge, especially for smaller businesses with limited technological resources.
- Requires detailed monitoring of daily transactions: to maintain the accuracy of the direct method, each cash transaction must be closely tracked, which can be logistically challenging, especially for larger or more complex organisations. This increases the risk of human error.
- Limited adaptability: the direct method may not be suitable for all businesses, particularly those with complex financial operations or multinational structures that prefer a more general approach to managing their finances. Moreover, in industries where cash movements are less frequent or predictable, the indirect method might be more convenient.
What is the indirect cash flow method?
In contrast to the direct cash flow, there is the indirect cash flow.
Unlike the previous method, the indirect cash flow starts from the net accounting result (normally, the company’s net profit), and is adjusted to reflect transactions that do not involve cash, as well as changes in the balance sheet accounts that affect cash.
The indirect method is based on the idea that a company’s net profit does not necessarily reflect the actual amount of cash it has earned or spent. This is because accounting standards include various adjustments that do not involve cash movements, such as depreciation, amortisation, provisions, and changes in accounts receivable and payable. The indirect cash flow method takes these adjustments into account to provide a closer view of available cash.
This method is particularly useful for providing a long-term view of a company’s ability to generate cash from its operations and finance future activities, as it shows how net income is adjusted to reflect actual cash movements.
How the indirect cash flow method works
The indirect cash flow method follows a systematic approach to adjust net income based on both cash and non-cash movements.
The formula for calculating indirect cash flow is as follows:
Net Cash Flow (Indirect Method) = Net Income + Depreciation + Provisions + Accounts Payable - Accounts Receivable + Inventory + Other Adjustments
For example, if a company has net income of £150,000, £20,000 in depreciation and amortisation, an increase in accounts payable of £5,000, an increase in accounts receivable of £8,000, a decrease in inventory of £3,000, an increase in other operating liabilities of £2,000, and a decrease in other operating assets of £4,000, the net cash flow generated by the company’s operations during the period would be £176,000, using the indirect method formula.
Advantages and disadvantages of the indirect cash flow method
The main advantages of the indirect cash flow method are as follows:
- Simplicity and ease of preparation: one of the main advantages of the indirect method is that it is based on information already available in the income statement and balance sheet. This means there is no need to record each cash transaction separately, simplifying the preparation of the cash flow statement.
- Time-saving: since the indirect method uses data already collected for other accounting purposes, it is less labour-intensive compared to the direct method. This is especially advantageous for companies with a high volume of transactions or limited accounting resources.
- Better long-term perspective: the indirect method allows businesses to take a broader, more strategic view of their ability to generate cash, as it adjusts net income to reflect changes in working capital and other factors. This provides a better understanding of how operations, changes in working capital, and other factors impact liquidity over time.
- Easier to audit: due to its alignment with the income statement and balance sheet, the indirect method is easier to audit, as it allows for a more direct verification of the accounting figures.
- Regulatory compliance: the indirect method is widely accepted under international accounting standards (such as IFRS) and is preferred for financial reporting, which simplifies compliance with legal and regulatory requirements.
Among the drawbacks, the following can be highlighted:
- Dependence on accounting adjustments: while this can be seen as an advantage, the fact that the indirect method relies on accounting adjustments means that it does not always accurately reflect the cash available at a given moment. This could present a distorted image of the company's immediate liquidity, especially in situations where the accuracy of actual cash is critical.
- Less detailed view: since the indirect method does not provide a detailed breakdown of cash transactions, it may be less useful for daily liquidity management. Companies that need precise, real-time cash tracking may find the indirect method less suited to their operational needs.
- Non-cash adjustments: adjustments such as depreciation, amortisation, and other adjustments can make a company appear healthier from a cash flow perspective than it actually is. For example, high net income adjusted for significant depreciation might suggest a positive cash flow, even if the company is facing liquidity challenges.
- Difficult comparisons between companies: the indirect method can complicate comparisons between companies in different industries or with different operational structures. This is because accounting policies, such as depreciation methods or working capital management, can vary significantly, affecting the consistency and comparability of net cash flow.
Direct cash flow or indirect cash flow: which is better?
For a company, the choice between using the direct or indirect cash flow method largely depends on its needs and the type of financial analysis it wishes to perform.
The direct cash flow method is ideal for businesses that require detailed, real-time control over their cash flows, such as small businesses or startups where every cash movement is critical to operational survival.
On the other hand, the indirect cash flow method is better suited for companies seeking a broader, more strategic view of their ability to generate cash over time. Additionally, as it is easier to prepare, it is the preferred option for large corporations or companies with complex financial operations.
In conclusion, there is no universally better method, as the choice depends on the operational context of the company. Some businesses even opt to use both methods in different scenarios to get a more complete view of their financial position.
Whichever method is chosen, adopting an integrated treasury management solution will streamline the company’s financial processes, enhancing control and visibility over cash flows.
