Question

Statement of Cash Flows

The Statement of Cash Flows (also referred to as the cash flow statement) is one of the three key financial statements that report the cash generated and spent during a specific period of time (e.g., a month, quarter, or year). The statement of cash flows acts as a bridge between the income statement and balance sheet by showing how money moved in and out of the business.

Three Sections of the Statement of Cash Flows:

1. Operating Activities: The principal revenue-generating activities of an organization and other activities that are not investing or financing; any cash flows from current assets and current liabilities
2. Investing Activities: Any cash flows from the acquisition and disposal of long-term assets and other investments not included in cash equivalents
3. Financing Activities: Any cash flows that result in changes in the size and composition of the contributed equity capital or borrowings of the entity (i.e., bonds, stock, dividends)

Cash Flow Definitions

Cash Flow: Inflows and outflows of cash and cash equivalents (learn more in CFI’s Ultimate Cash Flow Guide)

Cash Balance: Cash on hand and demand deposits (cash balance on the balance sheet)

Cash Equivalents: Cash equivalents include cash held as bank deposits, short-term investments, and any very easily cash-convertible assets – includes overdrafts and cash equivalents with short-term maturities (less than three months).

Cash Flow Classifications

1. Operating Cash Flow

Operating activities are the principal revenue-producing activities of the entity. Cash Flow from Operations typically includes the cash flows associated with sales, purchases, and other expenses.

The company’s chief financial officer (CFO) chooses between the direct and indirect presentation of operating cash flow:

• Direct Presentation: Operating cash flows are presented as a list of cash flows; cash in from sales, cash out for capital expenditures, etc. This is a simple but rarely used method, as the indirect presentation is more common.
• Indirect Presentation: Operating cash flows are presented as a reconciliation from profit to cash flow

The items in the cash flow statement are not all actual cash flows, but “reasons why cash flow is different from profit.”

Depreciation expense reduces profit but does not impact cash flow (it is a non-cash expense). Hence, it is added back. Similarly, if the starting point profit is above interest and tax in the income statement, then interest and tax cash flows will need to be deducted if they are to be treated as operating cash flows.

There is no specific guidance on which profit amount should be used in the reconciliation. Different companies use operating profit, profit before tax, profit after tax, or net income. Clearly, the exact starting point for the reconciliation will determine the exact adjustments made to get down to an operating cash flow number.

2. Investing Cash Flow

Cash Flow from Investing Activities includes the acquisition and disposal of non-current assets and other investments not included in cash equivalents. Investing cash flows typically include the cash flows associated with buying or selling property, plant, and equipment (PP&E), other non-current assets, and other financial assets.

Cash spent on purchasing PP&E is called capital expenditures (or CapEx for short).

3. Financing Cash Flow

Cash Flow from Financing Activities are activities that result in changes in the size and composition of the equity capital or borrowings of the entity. Financing cash flows typically include cash flows associated with borrowing and repaying bank loans, and issuing and buying back shares. The payment of a dividend is also treated as a financing cash flow.

Based on the upper information,

Question: What is the difference between the direct and indirect method of cash flow preparation? Which method provides better information and why?

Answer 1

Direct and indirect are the two different methods used for the preparation of the cash flow statement of the companies with the main difference relates to the cash flows from the operating activities where in case of direct cash flow method changes in the cash receipts and the cash payments are reported in cash flows from the operating activities section whereas in case of indirect cash flow method changes in assets and liabilities accounts is adjusted in the net income to arrive cash flows from the operating activities.

Companies prepare the income statement using both expenses and revenues. direct vs indirect cash flow method want to look at their overall performance over a period of time.  Likewise, cash flow statement is another financial statement that every investor should look at. The cash flow statement contains three sets of activities namely operating, investing and financing. Usually, the investing and financing sections are calculated in a similar manner.

But when it comes to calculating cash flow from operational activity, two methods of calculation are majorly used – indirect method and direct method.

• 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.
• 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.
• The direct method of cash flow starts with cash transactions such as cash received and cash paid while ignoring the non-cash transactions.
• Indirect cash flow method, on the other hand, the calculation starts from the net income and then we go along adjusting the rest.

The main difference between the direct method and the indirect method of presenting the statement of cash flows (SCF) involves the cash flows from operating activities. Under the U.S. reporting rules, a corporation has the option of using either the direct or the indirect method. However, surveys indicate that nearly all large U.S. corporations use the indirect method.

Example of the Indirect Method of SCF

When the indirect method of presenting a corporation's cash flows from operating activities is used, this section of SCF will begin with a corporation's net income. The net income is then followed by the adjustments needed to convert the accrual accounting net income to the cash flows from operating activities. A few of the typical adjustments are:

· Adding back depreciation expense

· Adding the decrease in accounts receivable

· Deducting the increase in inventory

· Deducting the decrease in accounts payable

· Adding the increase in accrued expenses payable

Example of the Direct Method of SCF

When the direct method of presenting a corporation's cash flows from operating activities is used, the amount of net income is not the starting point. Instead, the direct method lists the cash amounts received and paid by the corporation. Here are a few of the more common descriptions that will be seen under the direct method:

· Cash from customers

· Cash paid to employees

· Cash paid to suppliers

· Cash paid for interest

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.)

Here are the key differences between direct vs indirect cash flow methods–

• One of the key differences between direct cash flow vs indirect cash flow method is the type of transactions used to produce a cash flow statement. The indirect method uses net income as the base and converts the income into cash flow through the use of adjustments. The direct method only takes the cash transactions into account and produces the cash flow from operations.
• The cash flow indirect method makes sure to convert the net income in terms of cash flow automatically. Cash flow direct method, on the other hand, records the cash transactions separately and then produces the cash flow statement.
• The cash flow indirect method needs preparation as the adjustments that are made to require time. The preparation time for the cash flow direct method isn’t much since it only uses cash transactions.
• The accuracy of the cash flow indirect method is a little less as it uses adjustments. Comparatively the cash flow direct method is more accurate as adjustments are not used here.

Here are the basic differences between direct vs indirect cash flow methods

Basis for comparison between Direct vs Indirect Cash Flows	Cash flow indirect method	Cash flow direct method
Definition	Indirect method uses net income as a base and adds non-cash expenses like depreciation, deducts non-cash incomes like profit on sale of scraps and net adjustments between current assets & liabilities to produce the overall cash flow statement.	Direct method uses only the cash transactions, i.e cash spent and cash received to produce the cash flow statement.
Working	Net income is automatically converted in the form of cash flow.	Reconciliation is done to separate the cash flow from others.
Factors taken	All the factors are taken into account.	All non-cash transactions like depreciation are ignored.
Preparations	Preparations are mainly needed during conversion of net income into cash flow statement.	There’s no such preparation required.
Accuracy	Cash flow statement under indirect method is not very accurate as adjustments are being made.	Cash flow statement under direct method is very accurate as there is no need for any adjustments here.
Time taken	It takes less amount of time compared to the direct method.	It takes more amount of time compared to the indirect method.
Popularity	This method is predominantly used by many companies.	Compared to indirect method, they are only a very few companies that use this method.

Direct vs Indirect Cash Flow Method – Conclusion

Both the direct vs indirect cash flow method is useful at different points and they can be used depending on the situation and the requirement. The indirect method is the most popular among companies. But it takes a lot of time to prepare (before recording) and it’s not very accurate as many adjustments are used.

The direct method, on the other hand, doesn’t need any preparation time other than segregating the cash transactions from the non-cash transactions. And it’s more accurate than the indirect method.