Direct Method versus Indirect Method

What you'll learn to do: Distinguish between the Direct and Indirect methods of preparing a statement of cash flow

There are two ways we can build a cash flow statement. Both ways end up at the same answer, but in a different way.

The direct method, the income statement is reformulated on a cash basis, rather than an accrual basis from the top of the statement (the income part) to the bottom (the expense part).

The indirect method works from net income, so the bottom of the income statement, and adjusts it to the cash basis. We will look at both methods with the same data, so you can see the differences in analysis, but the same ending number.

Learning OUtcomes

  • Calculate cash flows from operating activities by the indirect method
  • Calculate cash flows from operating activities by the direct method

The Indirect Method

Let’s look at the indirect method first. Remember from our previous conversations, companies only use one method and typically they use the direct method! We just want to talk about the indirect method so you understand the concept!

The indirect method starts with your net income and adds or subtracts the items based on changes in their balances. Remember the operating activities that affect cash flow:

Description Inflow Outflow
Collect cash from your customers X
Pay for inventory X
Pay your bills! (utilities, rent, insurance) X
Pay your employees X
Pay interest on loans X
Pay your taxes X
There are related accounts on the balance sheet, that when changes happen, we need to know how they affect the statement of cash flows:

If the account balance increases If the account balance decreases
Current Assets
Accounts Receivable (money from customers) Subtract Add
Inventory (buy or pay for inventory) Subtract Add
Prepaid expenses (insurance) Subtract Add
Current Liabilities
Accounts Payable (pay your bills) Add Subtract
Accrued Liabilities (payroll) Add Subtract
Income taxes payable (tax payments) Add Subtract
This can be a really confusing concept, so let’s look at some examples.

  • 1/1/20XX Accounts Receivable Balance    $5000
  • 1/31/20XX Accounts Receivable Balance  $4000

The account balance decreased, so we need to add $1000 to our cash for the month because we received that much more in cash from our customers.

Let’s look at another one!

  • 1/1/20XX Accounts Payable Balance    $8000
  • 1/31/20XX Accounts Payable Balance  $5000

The account balance decreased so we need to subtract $3000 from our cash for the month because we paid down our accounts payable balance?

Hopefully this is making more sense! If you are working on a cash flow statement, you can keep the little chart with you!

Practice Questions

The Direct Method

Sales are great at your company, but cash flow is a mess! You are working on your cash flow statement trying to figure out what is going on. When you look at your income statement, you see sales of $20,000, which is an increase of 50 percent over last month! This is amazing. Why then, are you needing to take money out of your working capital line of credit to cover payroll? These are the questions a good cash flow statement can answer.

When working from the income statement and taking it back to cash basis from the accrual basis, some of the answers to these questions become very clear. Once you take a look you notice that payroll expense was higher to meet the higher sales demand. But since you offer net30 day terms to your customers, you are waiting on payment from them. The hope is this is a short term blip while your cash received from customers comes in to cover your line of credit payment. So what looks good on an income statement, could create temporary or long term cash flow issues!

Learn More

Let’s dig in a little further and discuss the direct method of preparing your cash flow statement. Stop back over and review this video for a quick reminder:

So the direct method, starts with the income statement and rebuilds it on the cash basis. Most companies operate on the accrual basis, where income is recognized when it is earned and expenses are recognized when they occur, so in order to see how much cash we spent or earned, we need to adjust those amounts to the actual cash we spent or received.

This is the method that will typically be used. Feel free to go back and watch the videos again for a review here!

In this method, we wouldn’t be concerned with changes in the accounts receivable balance. We would simply look at how much cash was paid by customers for the month. So, in our conversation about the indirect method, you noticed that the accounts receivable balance went down. If we look at this from a direct method:

  • Cash received by customers: $10,000
  • Cash spent on bills/expenditures: $5,000
  • Cash paid for payroll: $3,000
  • Net increase in cash for period: $10,000 − $5,000 − $3,000 = $2,000

So it wouldn’t matter if sales for the month was $20,000, purchases were $2,000 and payroll was $3,000 for the month right? What might that show? Well, if sales was $20,000 but we only received $10,000 in cash we either have difficulties collecting our accounts receivable, or we have net 30 and the sales last month was much lower than this month, right?

Cash flow can be a huge challenge, especially for small businesses. So, if we struggle with collection on our receivables, or if we have a low sales month, or an unexpected expense. This is where the cash flow statement can be very important to the health of a company.

Practice Questions

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