As a business owner or founder, few metrics are as important to you as cash flows. You want to make sure you’re generating enough cash to pay your bills and take care of other obligations.
The cash flow statement provides a summary of your inflows and outflows, providing important insights into the stability of your operations and a better understanding of where your cash comes from and goes.
In this article, we’ll cover how to make a cash flow statement using the direct and indirect methods, explore the differences between these two approaches, and provide additional insights to help you understand the importance of this financial statement.
What is a Cash Flow Statement?
The cash flow statement is one of the key financial statements that businesses prepare to report their financial position and performance over a certain period of time, alongside the income statement and the balance sheet.
Specifically, the statement of cash flows is meant to show the business’s different sources and uses of funds. In other words, it provides a breakdown of where the company’s cash is coming from and what they’re spending it on.
For instance, the cash flow statement will help show whether the money the company uses comes from its operations or whether it’s funded by debt or external investors.
Compared to the income statement, which reports income and expenses on an accrual basis, the cash flow statement provides visibility into the company’s actual cash positioning at the time the statement is prepared.
Importance of Cash Flow Statements
All prepared financial statements provide business leaders and external stakeholders with key insights about the business’s financial positioning.
The cash flow statement, in particular, helps reflect the company’s ability to generate funds from its operations and how efficiently it manages these funds thereafter.
In-house teams might use the cash flow statement to inform short-term purchasing decisions or plan long-term strategic initiatives. Similarly, investors may analyze the this statement to determine the financial health of the business and gauge whether it’s stable enough and produces enough cash flow to provide a potential return.
Additionally, publicly traded companies must file a cash flow statement with the Securities and Exchange Commission (SEC) to meet reporting requirements.
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Key Components of a Cash Flow Statement
There are three main sections to a cash flow statement. This includes operating activities, investing activities, and financing activities. Here’s a quick look at each:
- Operating activities: Provides a summary of what the company generates from its core business activities, like selling its products or services, and the cash that’s used to support them, like purchasing inventory or producing goods.
- Investing activities: Shows how much the company generates from long-term investments and any cash it earns from selling fixed assets.
- Financing activities: Summarizes the cash a business receives from investors and creditors and also what it uses to repay debts, pay out dividends, etc.
Direct vs. Indirect Methods of Cash Flow Calculation
As mentioned above, there are two cash flow statement formats that businesses can use — the direct method and the indirect method. Importantly, these two methods only apply to the operating activities section of the statement. The investing and financing activities sections are prepared the same way with either method.
Regardless of the format you choose, it will result in the same net cash flow value. However, the individual components and steps used to prepare the statement will vary between the two, and there are plenty of reasons why business leaders might choose one over the other.
We’ll now make a more in-depth comparison of the two methods so you can better understand which might be best for your business.
Direct Method Cash Flow Statement
The direct method for preparing the operating section of a cash flow statement may also be referred to as the income statement method.
As the name might suggest, this method uses the individual transactions that directly impacted the business’s cash account during the period.
In other words, when the business receives payment from a customer for an order of goods or services, this is considered an inflow. This differs from the accrual-based standards used on the income statement, which requires businesses to record a sale as soon as it’s earned, even if they haven’t received the payment for it yet.
Additionally, cash outflows are only recorded when the business sends the payment to its suppliers or vendors.
The direct method lists out each inflow and outflow during the period. The difference between the two shows the net operating cash flow the company produced or used.
Pros of the Direct Method
- It may provide a more accurate summary of the company’s operating cash inflows and outflows for the reporting period since it’s directly built from the actual transactions the business completed.
- Teams may like the added transparency and visibility the direct method provides, as they can clearly see a summary of each transaction that impacted the cash balance during the period.
- It may be easier for teams to optimize cash flows when the direct method is used to prepare the statement, as teams can more easily pinpoint which use of cash is weighing on the net cash flow value.
Cons of the Direct Method
- It may be a bit more tedious and time-consuming to prepare, as teams will need to record each inflow and outflow that occurred during the reporting period.
- The tedious and complex nature of the direct method may open up more room for potential errors, as one missed transaction will impact the accuracy of the final net cash flow calculation.
- It will be harder for teams to scale the direct method as they grow and incur more inflows and outflows, and taking the time to review each cash-based transaction may not be practical or a good use of the team’s time.
Who is the Direct Method Best for?
When might a company choose to use the direct method? It might be a good option for companies that use cash-based accounting for their reporting.
Many companies, especially those that are publicly traded, follow accrual-based accounting standards. Thus, the direct method is not as commonly used as the indirect method, as we’ll cover below.
The direct method may provide more granular information about where the company’s operating cash flow stems from. However, it’s also more tedious and time-consuming to prepare, as you’ll need to go through each transaction individually. For this reason, it may be best for small businesses that complete few transactions
Indirect Method Cash Flow Statement
The other option for building this statement is the indirect method. In comparison to the direct method, the indirect approach is not concerned with each individual transaction that impacts the cash balance.
Instead, it backs into the net cash flow value indirectly by reconciling the net income with non-cash transactions during the period. This typically includes changes to balance sheet items that did not require the actual outflow or inflow, like:
- An increase or decrease in asset or liability accounts
- An increase or decrease in accounts payable or accounts receivable
- Depreciation expense
So, rather than tracking down each cash-based transaction, all teams need to produce the cash flow statement with the indirect method are the other two financial statements.
Pros of the Indirect Method
- It’s a widely used method, since it’s best suited for the large number of companies that use accrual-based accounting.
- It supports compliance with reporting requirements for publicly-traded companies, which the direct method does not.
- It’s not as tedious or resource-intensive as the direct method, as teams don’t need to track each individual inflow or outflow.
- This method is much more scalable and streamlined, as it requires the same amount of work no matter how many transactions the company makes in a period.
Cons of the Indirect Method
- It may not provide as granular details about the company’s operating activities, as it finds the net cash flow value indirectly instead of using the actual transactions that affected the company’s cash balance.
- It can be difficult for teams to point to the specific sources or uses of cash that they’d like to optimize for better cash flows, as these details are not provided with the indirect method.
- This method may not be totally accurate in representing the exact timing of inflows or outflows and the current cash positioning, as it’s not based on the actual transactions.
Who is the Indirect Method Best for?
The indirect method is most commonly used among businesses that follow accrual-based accounting, which public companies are required to use. Even if these companies use the direct method to prepare the statement internally, they’ll also have to prepare it using the indirect method to meet reporting requirements.
It is also the preferred method by the International Financial Reporting Standards (IFRS). Thus, both small businesses and large firms alike can use the indirect method for preparing a statement of cash flow.
Plus, the indirect method is also considered the easier and more straightforward of the two. So, companies that don’t have a ton of resources or accounting expertise in-house might be drawn to this method.
How Do Cash Flow Statements Work with Other Financial Statements?
The cash flow statement is one of the three core financial statements that businesses prepare, including the balance sheet and the income statement.
Of the three, the cash flow statement is typically produced last. This is especially the case for teams that use the indirect method, as they’ll need the net income from the income statement and the changes to balance sheet accounts to prepare the statement.
However, if you’re using the direct method, you don’t necessarily need to have the others prepared beforehand. It may help with identifying cash-based transactions, though it’s not necessary like with the indirect method.
How to Prepare a Cash Flow Statement
The steps you take to prepare this statement will look differently depending on the method you select. Below, we’ll provide an overview of the formulas for both methods.
Direct Method
As a reminder, the direct method finds the net cash flow by considering each cash-based transaction from operating activities during the reporting period.
This is a basic format for the direct method:
+ Cash Inflows from Operating Activities
– Cash Outflows from Operating Activities
____________________________________________
= Net Cash from Operating Activities
When preparing the statement with this method, you’ll need to parse through each transaction that affects the cash balance.
From there, you’ll add up the total outflows, the total inflows, and find the difference between them to come up with the net cash flow from operating activities. Then, you’ll combine this with the sections for investing and financing activities to prepare the full statement.
Indirect Method
Here is the formula for the indirect method of a cash flow statement:
Net Income
+ Non-Cash Expenses
+/– Changes to Short-Term Assets & Liabilities
+/– Changes to Long-Term Assets & Liabilities
_______________________________________________
= Net Cash from Operating Activities
The starting point for the indirect method is the net income, which you’ll find on the prepared income statement.
Then, you’ll need to add back non-cash expenses, like depreciation and amortization, since these didn’t require an actual exchange of cash.
You’ll also need to take some time to consider changes to current assets and liabilities that didn’t impact cash, which is typically accounts payable and receivable. The rules here can be a little tricky at first, but thinking through their impact on the cash balance can be helpful:
- Add back any decreases to current assets
- Subtract any increases to current assets
- Add back any increases to current liabilities
- Subtract any decreases to current liabilities
Finally, you’ll also need to make adjustments for changes in long-term assets and liabilities, using the same rules as above for either type of account.
To find the net cash flow from operating activities, make the appropriate additions or subtractions from the net income value to reconcile for all non-cash transactions.
Example of a Cash Flow Statement – Indirect Method
The following is a sample statement using the popular indirect method:
Example of a Cash Flow Statement – Direct Method
Using the same values as above, here’s what the cash flow statement would look like prepared with the direct method. Keep in mind, the only difference between the two methods is how the cash flow from operating activities are prepared.
Positive vs. Negative Cash Flow
When reviewing a company’s cash flow statement, a positive value indicates that the inflows outweighed the outflows for the period. In other words, more cash was generated than was used, and the company has a surplus.
In contrast, a negative cash flow would indicate that the company used more money than it received, and may have had to dig into its reserves to cover its obligations.
There may be reasons why a company’s cash flows are negative temporarily, like after making a large investment or capital purchase. However, all things considered equal, companies generally strive for a positive cash flow.
Common Misconceptions about Cash Flow Statements
Cash flow statements can provide important information to business leaders and external stakeholders about the health of the operations and the actual cash positioning. However, there are some common misconceptions to be aware of:
- A company that generates a positive cash flow isn’t necessarily profitable. The statement doesn’t consider all income and expenses, only the actual exchange of cash.
- It’s not always ideal to have high cash flows. It may mean the company is engaged in unsustainable practices, like prolonging paying suppliers.
- Cash flow statements aren’t just valuable to large businesses. Small companies and startups can get just as much from a cash flow statement to inform strategic planning and purchasing decisions.
Conclusion
Preparing a cash flow statement is an essential part of financial reporting. It keeps you compliant with relevant reporting requirements, and provides important insights into your cash positioning.
If you still have questions about this statement and how to prepare it for your business, an expert team like Bob’s Bookkeepers has you covered. We have decades of experience working for companies in your industry, so we understand the unique considerations and nuances to ensure accurate reporting.
Contact us at Bob’s Bookkeepers to offload your accounting and bookkeeping tasks today.
