Direct and indirect cash flow reporting and how to choose the right one

Evaluating an organization's financial health is crucial for making informed decisions for strategic planning and future growth. Understanding your cash flow is a critical part of that.  Unlike profits or revenue, cash flow tells the story of how money moves in and out of your business, and you tell that story with a cash flow statement.

The cash flow statement is one of the key statements that make up a company’s overall financial model, otherwise known as the three-statement model. The other two statements in the model are the profit and loss (P&L) statement and the balance sheet. 

This article focuses specifically on cash flow statements and the direct and indirect methods used to create them.

The graphic below provides a simple way to understand how cash flow statements work with the other statements in the three-statement model. 

In a nutshell, the cash flow statement incorporates the information in the P&L statement, which provides the basis for the balance sheet. 

But let’s break this down a little more…

The P&L statement tracks a company's revenues, expenses, and profit over a given period of time, which provides insight into the company’s ability to generate revenue and manage expenses to achieve a profit.

The net income from the P&L (its summation) is then used to prepare the cash flow statement. 

In contrast to the P&L statement, the cash flow statement tracks all the cash coming in and going out of the organization for both operating and non-operating activities (investing and financing). It does not, however, include non-cash items such as depreciation and amortization). The goal here is to provide a clear picture of the company's liquidity and ability to meet its financial obligations, and non-cash items don’t impact that.

Once you have your cash flow statement, the ending cash balance for the period becomes the starting point for creating your balance sheet. 

The balance sheet provides a record of the company's assets (which includes cash from the cash flow statement), liabilities, and equity, which is a reflection of its overall financial stability.

Now that you have a good sense of how cash flow statements fit into the three-statement model that provides the foundation for financial reporting, let’s zero in on the different components of cash flow and they are determined. 

The Three Components of Cash Flow

Cash flow statements include three key categories:

• Operating Cash Flow is cash generated or spent during regular business operations such as sales, payment of expenses, increases and decreases in accounts receivable and/or accounts payable. A positive OCF indicates the company is “operating in the black” meaning it can generate sufficient revenue without relying on external financing.

• Investing Cash Flow is cash coming in and going out from investments in long-term assets, such as investments in securities or the purchase of an office building. A negative ICF indicates the company is investing in its future growth, while a positive flow might suggest that a divestment or sale of assets has occurred.

• Financing Cash Flow records of the net flow of cash used to fund the company's operations and its financial structure are maintained in financing cash flow. It includes transactions involving debt, equity, and dividends. Positive FCF means more cash coming into the company through borrowing or issuing stock. In contrast, a negative FCF indicates debt repayments, company shares repurchases, or dividend payments.

Of the three, operational plays a far more significant role in determining a company's financial stability than investing and financing cash flows because it is highly variable.

There’s only one method for calculating investing cash flow and only one for financing cash flow. However, for the flow of cash resulting from operational activities, there are two methods–indirect cash flow vs direct cash flow. 

What is the difference between direct and indirect cash flow methods?

The key difference between direct vs. indirect is that they start from two different places. So let’s unpack that here.

Understanding the direct cash flow method

The direct cash flow method starts at the account level and involves listing all the operating transactions (cash receipts and payments) during the period. 

It includes cash received from customers or paid to suppliers against invoices, employees against salaries, and all other transactions related to operating activities. 

By providing a detailed list of cash inflows and outflows, the direct method offers a clear picture of how and where the company's cash is generated and spent. However, because it requires gathering all transactional data each time you prepare your cash flow statement, it can be a complex, time-consuming approach to financial analysis.

Exploring the indirect cash flow method

The indirect cash flow method starts with the net income from the P&L statement and adjusts for all non-cash transactions plus any changes in balance sheet items. 

Non-cash transactions might include depreciation, changes in working capital, deferred taxes, and any stock-based compensation to shareholders).

Changes in the balance sheet items can include increases or decreases in assets and liabilities, which affect cash but are not immediately apparent from just looking at income. 

For example, an increase in accounts receivable indicates that the company sold products or services without receiving cash, necessitating an adjustment to the net income to reflect this non-cash income.

The indirect method makes your cash flow statement easier to prepare because it uses information from existing financial statements. It provides a more straightforward approach to understanding overall cash flow without the granular detail provided by tracking individual transactions.

Using the indirect cash flow method allows you to show the difference between a company's net profit and its actual cash position at the end of a period. You can reconcile non-cash activities and changes in working capital with the net income reported. However, it does not provide transparency into specific cash transactions and their origins. 

What types of expenses does each method consider?

The direct and indirect cash flow methods consider different types of expenses in their calculations. 

The direct cash flow method lists all major operating cash receipts and payments, including:

• Cash received from customers
• Payments to suppliers
• Employees' salaries
• All other transactions related directly to operating activities

On the other hand, the indirect cash flow method considers:

• Net income from the P&L statement
• Non-cash transactions such as depreciation and deferred taxes
• Changes in balance sheet items, such as assets and liabilities

Choosing between direct vs indirect cash flow reporting

It is, therefore, critical to choose a cash flow reporting approach that aligns with the capabilities and resources of your finance team. 

There aren’t any convenient rules of thumb for choosing which method will be best for your business. There are several factors you should consider. 

Start by asking yourself, how much transparency and granularity do you need? Do you need the level of detail that the direct method would provide, or will a less detailed cash-flow statement suffice? 

If you think you do need the granularity that the direct method offers, you should further consider the following questions before making your decision:

• How many customers and vendors do you have? With the direct method, if you have a large number of  customers and vendors, you’ll be tracking an even larger number of income and expense transactions to track over potentially many different accounts.
• How many bank transactions do you have to look at? If your banking is complex, including multiple payment processors and banks, possibly spread across different geographies with multiple currencies, tracking your cash flow at the transactional level could be onerous.  
• How much transparency and granularity do you need? Do you need the level of detail that the direct method would provide, or will a less detailed cash-flow statement suffice? 
• How much time can your team devote to cash flow reporting? The direct method obviously will require more time and potential opportunity costs in terms of the time that could be spent on other important activities. 

If you want more control over your operational cash flows, the indirect method will still give you what you need because it's based on your P&L and your balance sheet. These two statements “talk” to each other, so you will still know what is happening with your cash flow even if you don’t have the transaction-level detail.   

If on the other hand, you need more granular detail, you may also want to generate a separate cash flow statement using the direct method. This of course will require more work, but it also provides more detailed insights. 

Why most businesses opt for the indirect method

All but the smallest businesses typically opt for the indirect method for developing the operational cash flow portion of their cash flow statement. There are a number of reasons for this. 

The main reason is that the indirect method offers a straightforward and more streamlined approach than the direct method because it starts with net income, linking directly to the P&L statement, and then incorporating adjustments from the balance sheet. 

Additional validations are not needed as the statements inherently complement each other. Adjustments from the balance sheet are simply layered onto the net income, simplifying the process. 

With the indirect method, the net income encapsulates the results from the P&L statement, allowing for a broad overview without the need to scrutinize each account separately. 

It does require having both a P&L and a balance sheet available; however, these are standard financial documents that most companies already maintain.

The ready availability of P&L statements and balance sheets is, in large part, what drives the widespread use of the indirect method among businesses.

The indirect method also helps companies satisfy their key stakeholders. Boards and investors typically do not scrutinize the line items of a company's cash flow statement. Their primary interest lies in understanding the company's financial health, and the indirect method provides this information.

Using both methods for enhanced financial analysis and forecasting

While most businesses use the indirect method, both methods can work well together if you want more comprehensive insights into the company's operations and financial performance.

Of course, doing both requires significant work. However, the deeper insight the direct method can provide might well be worth it. 

Consider this. By emphasizing the interconnection between statements, the indirect method provides a broad understanding of cash flow movements and financial stability at a monthly glance. 

On the other hand, the direct method can help you more effectively manage your operational cash flow because it offers deeper insight and control at a granular level. The insights gained can also help you in your strategic planning and analysis every quarter. 

For example, by generating a weekly cash flow using the direct method, you can get a quarterly view of your cash flow at the weekly level because every quarter has 13 weeks. 

We all know that cash flow modeling is already a very time-consuming process. So, while using both methods together would clearly give you deeper insight into your business, the real question is, can you do both? 

‍You can in Drivetrain. 

Creating cash flow statements using both approaches simultaneously can be complex and time-intensive. However, a modern cash flow software like Drivetrain can handle a lot of the heavy lifting with automated three-statement modeling in real time that allows you to take the pulse of financial health in minutes. 

Drivetrain is also a robust financial reporting tool, with its custom report builder and best-in-class interactive visualizations. Contact us for a demo to see how Drivetrain can level up your cash flow reporting today.