Question

Format of the Statement of Cash Flows (Operating Activities Section)

Which format do you prefer,  direct or indirect method?
What advantages & disadvantages are there for the method you prefer?

Answer 1

I Prefer Indirect format over direct format. The advantages are as mentioned below:

1. The indirect method of cash flow uses net income as the base and does the adjustments needed, i.e adding and subtracting the variables to convert the total net income to cash amount from operations.  

2. The direct method of cash flow in operating activities includes the cash being received from the customers and the cash paid to the suppliers, employees, and others. The cash can also be paid for income tax, interest, and other variables.

3. The direct method of cash flow starts with cash transactions such as cash received, and cash paid while ignoring the non-cash transactions.

4. Indirect cash flow method, on the other hand, the calculation starts from the net income and then we go along adjusting the rest.

5. The direct method is more useful for the users of financial statements as it gives them the true financial picture of the organization.

6. It is suitable for predicting future cash flows. It also provides more confidence to investors as a direct method is accepted by GAAP.

7. Indirect methods also have advantages such as firms can reconcile their net profit from operating activities with net actual cash flow. It gives a better understanding of the non-cash transaction. Assets and liabilities of firms are disclosed in a very simpler form.

Disadvantages of Indirect method:

1. It is very difficult to evaluate the performance of the firm by the users of financial statement if the indirect method is used. It is very difficult to estimate future cash flows by evaluation cash flow statement from the indirect method.

2. The direct method also requires a reconciliation of net income to the cash provided by operating activities. (This is done automatically under the indirect method.)

Cash flows from operating activities	Amount	Amount
Profit before tax
Adjustments for:
Depreciation
Amortization
Impairment losses
Bad debts written off
Interest expense
Gain on revaluation of investments
Interest income
Dividend income
Gain on disposal of fixed assets
Working Capital Changes:
Movement in current assets:
(Increase) / Decrease in inventory
Decrease in trade receivables
Movement in current liabilities:
Increase / (Decrease) in trade payables
Cash Generated from Operations
Dividend Paid
Income Tax paid
Net cash from operating activities (A)