What it means
A cash flow statement has three sections: operating, investing and financing. The investing and financing sections are always presented as gross cash flows, since buying a machine or repaying a loan is naturally a cash transaction.
The operating section is where the choice arises, because operating activity is recorded in the accounts on an accrual basis, as revenue and expenses, and converting it to cash can be done in two ways. The direct method converts each line: revenue becomes cash received from customers by adjusting for the change in receivables; cost of sales becomes cash paid to suppliers by adjusting for the changes in inventory and payables; and so on.
The indirect method converts the total: it takes net profit and adds back depreciation and other non-cash charges, then adjusts for the changes in working capital in aggregate. The two methods give the same net operating cash flow.
The difference is in what the reader sees. Under the direct method, the statement shows that the business collected $9,700,000 from customers, paid $6,100,000 to suppliers, paid $2,050,000 to employees and others, paid $150,000 of interest and $300,000 of tax, and generated $1,100,000 net.
Under the indirect method, it shows that the business made a profit of $1,050,000, that depreciation of $400,000 was added back, that receivables and inventory grew and absorbed cash, and that payables and accruals grew and released it, to the same $1,100,000. The direct method reads like a bank statement; the indirect method reads like a reconciliation.
The direct method's advantage is clarity. A reader can see the scale of cash receipts and payments, compare receipts with revenue to judge collection, compare payments with costs to judge how the business is managing its suppliers, and forecast future cash flows from the pattern.
Lenders, credit analysts and owner-managers of small businesses generally find it more intuitive, and it is the natural format for a cash flow forecast, which is built from expected receipts and payments. Its disadvantage is preparation: accounting systems record transactions by account, not by cash flow type, so producing the gross figures requires either a cash-basis analysis of bank transactions or a systematic conversion of each income statement line, and the reconciliation from profit to operating cash flow, which readers also want, has to be given as well.
The indirect method's advantage is that it falls out of the accounts with little extra work and that it makes explicit the relationship between profit and cash, which is often the question an analyst is asking: why did a profitable company generate no cash, or a loss-making one generate plenty? Its disadvantage is that the gross flows are invisible, and the working capital adjustments can hide a great deal, such as a business whose receipts are falling behind its sales because customers are paying late, which shows only as an increase in receivables.
Standards under both international and United States frameworks allow either method for the operating section, and both encourage the direct method while requiring, if it is used, a reconciliation of profit to operating cash flow as well. In practice the indirect method dominates listed company reporting, while the direct method is common in cash flow forecasts, in management accounts for smaller businesses, and in the public sector and not-for-profit organisations in some jurisdictions where it is required.
A finance professional needs to be able to prepare and read both, and to convert one to the other.
In practice
Real-world examples.
Example
A retailer's direct-method cash flow statement shows cash received from customers of $48,000,000 against revenue of $48,200,000, confirming that almost all sales are for cash or card.
Example
A construction company's direct-method statement shows cash paid to subcontractors of $22,000,000 against subcontractor costs of $19,000,000, revealing that it has been paying down its subcontractor balances.
Example
A charity presents its operating cash flows by the direct method as its regulator requires, showing donations received, grants received and payments to suppliers and staff.
Think of it
“The direct method shows actual cash in and out-listing real receipts and payments rather than adjustments.
Formula
Calculation
Cash received from customers = Revenue + Opening receivables minus Closing receivables
Purchases = Cost of sales + Closing inventory minus Opening inventory
Cash paid to suppliers = Purchases + Opening payables minus Closing payables
Cash paid for operating expenses = Operating expenses minus Depreciation and other non-cash items + Opening accruals minus Closing accruals (and adjusted for prepayments)
Net cash from operating activities = Receipts minus Payments minus Interest paid minus Tax paid
Indirect check: Net profit + Non-cash charges minus Increase in working capital = the same total
Worked example. A company's income statement shows revenue $10,000,000; cost of sales $6,000,000; operating expenses $2,500,000 (including depreciation of $400,000); interest $150,000; tax $300,000; net profit $1,050,000. Balance sheet movements: receivables rose from $1,200,000 to $1,500,000; inventory rose by $200,000; trade payables rose from $800,000 to $900,000; accrued expenses rose by $50,000. Interest and tax were paid as charged.
Direct method:
- Cash received from customers = $10,000,000 + $1,200,000 minus $1,500,000 = $9,700,000
- Purchases = $6,000,000 + $200,000 = $6,200,000; cash paid to suppliers = $6,200,000 + $800,000 minus $900,000 = $6,100,000
- Cash paid to employees and for other expenses = $2,500,000 minus $400,000 minus $50,000 = $2,050,000
- Interest paid $150,000; tax paid $300,000
- Net cash from operating activities = $9,700,000 minus $6,100,000 minus $2,050,000 minus $150,000 minus $300,000 = $1,100,000
Indirect method (the reconciliation):
- Net profit $1,050,000 + depreciation $400,000 minus increase in receivables $300,000 minus increase in inventory $200,000 + increase in payables $100,000 + increase in accruals $50,000 = $1,100,000
The totals agree. The direct method shows that the company collected 97% of its revenue in cash during the year; the indirect method shows that $300,000 of the shortfall was customers paying more slowly and that inventory absorbed a further $200,000.Case study
Seen in the real world.
A wholesale distributor with revenue of $30,000,000 reported its cash flow statement by the indirect method, as its accounting software produced it. Its bank, reviewing the annual accounts for a facility renewal, saw operating cash flow of $600,000 against a profit of $1,400,000 and a working capital adjustment for receivables of $900,000, and asked the finance director for a direct-method statement for the last two years so that it could see the pattern of receipts.
The direct-method figures made the problem visible in a way the indirect figures had not. Cash received from customers had been $29,100,000 against revenue of $30,000,000 in the latest year, and $28,400,000 against $28,000,000 the year before: collections had gone from slightly ahead of sales to $900,000 behind. Cash paid to suppliers, by contrast, had tracked purchases closely in both years.
The business was extending credit to its customers faster than it was growing, and it was funding the gap from the bank. The bank's credit officer noted that the indirect method had shown the same fact as a single line, "increase in receivables", which the finance director had described as growth; the direct method showed it as $900,000 of sales not yet collected, which invited the question of when and whether they would be.
The finance director, prompted, analysed the receivables and found that two large customers had unilaterally extended their payment terms from 30 to 60 days and that nobody had objected. The company renegotiated, recovered most of the gap over the following six months, and adopted the direct method for its monthly management accounts and cash forecast, so that receipts against sales became a routine measure. The bank renewed the facility at the previous limit rather than the increase requested, and the finance director conceded that the direct method had told her something she should have known from her own figures.
Watch out
Common mistakes.
- Assuming the direct and indirect methods give different totals; they present the same net operating cash flow in different ways, and the choice is about what the reader sees, not about the answer.
- Forgetting to adjust for inventory when converting cost of sales to cash paid to suppliers; purchases, not cost of sales, are what suppliers are paid for.
- Presenting the direct method without the reconciliation from profit, which readers also need and which standards require if the direct method is used.
Questions
People also ask.
What is the difference between the direct and indirect methods?
Both present the operating section of the cash flow statement. The direct method lists gross cash receipts and payments by type; the indirect method starts from net profit and adjusts for non-cash items and working capital movements. The investing and financing sections are the same under both.
Why do most companies use the indirect method?
Because it can be prepared from the income statement and balance sheet with little additional analysis, whereas the direct method requires cash flows to be classified by type, which most accounting systems do not do automatically. The indirect method also shows the profit-to-cash reconciliation that analysts commonly want.
Which method is better for forecasting?
The direct method. A cash flow forecast is built from expected receipts and payments, week by week or month by month, which is the direct-method format. Businesses that manage cash closely usually forecast by the direct method whatever they report.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%Related