The direct method is one of two accounting treatments used to generate a
. The statement of cash flows direct method uses actual cash inflows and outflows from the company’s operations, instead of modifying the operating section from accrual accounting to a cash basis.
Cash flow is an important element of any business, and the direct method of calculating cash flow is a popular way to track a business’s financial health. This method of tracking cash flow provides an accurate snapshot of a business’s financial situation by only taking into consideration the actual cash that has been received and spent during a given period of time. It offers more clarity than the more traditional indirect method of calculating cash flow. In this blog post, we’ll be looking at the direct method of calculating cash flow in greater detail: what it is, how it works, its advantages and disadvantages, and how to use it. With this knowledge, you will be able to better assess your business’s financial health and make better decisions that will benefit your bottom line.
Intro to Cash Flow Statements | Direct Method
How does direct method cash flow work?
Under the direct method, you will deduct cash payments made during the accounting period being considered from cash receipts. As a result, the net cash flow from operating activities is calculated. The net change in the company’s cash flow for that time period is calculated by adding net cash from investing and financing activities after net cash flow from operations.
On the other hand, the indirect method of determining net cash from operating activities is a fairly straightforward procedure. Simply add back depreciation to the net revenue from the income statement. After that, note any adjustments to current assets, current liabilities, and other sources (e g. , non-operating gains/losses from non-current assets) on the balance sheet.
The cash flow from operating activities section of the statement of cash flows determines the differences between the direct and indirect cash flow methods. The direct method implies that both cash from customers and cash paid to suppliers will be included in the cash flows from operating activities. The indirect approach will show the net income and the modifications needed to convert the total net income.
What is direct method cash flow?
The direct method is a technique in accounting that is used to produce a thorough cash flow statement that displays changes in cash over time. In contrast to accrual accounting, which recognizes revenue when it is earned rather than when the payment is actually received from a customer, the direct method cash flow measures changes in cash receipts and payments as a result of the company’s operations. The income statement method is another name for the direct method.
Only the cash flow from operations section of the cash flow statement, which includes the balance sheet, income statement, and cash flow statement, is affected by this method of accounting; the cash flow from financing and investing sections, which include the financing and investing sections, are unaffected by either method (direct or indirect).
Disadvantages of direct method cash flow
Some businesses opt to use the direct method cash flow, but others discover that it may not be the best option for their bookkeeping needs. Some of the disadvantages commonly cited are as follows:
Time and effort
The direct method requires listing all cash receipts and disbursements, which can take a lot of time. Because of this, using the indirect method is usually preferred and more common.
FASB requirements
A company using the direct method must disclose to the Financial Accounting Standards Board how it reconciles net income to cash flow from operating activities in accordance with GAAP. The reconciliation report, which includes net income, adjustments for non-cash transactions, and changes to the balance sheet accounts, confirms the accuracy of the operating activities. Because of the additional work involved, business accountants are less likely to use this method for accounting and reporting.
Advantages of direct method cash flow
Although there are various calculation methods, none of them are necessarily superior to the others, and each business will choose the method that best suits its needs. The advantages of the direct method are listed below:
Transparency
Investors and creditors may find the direct method’s reporting of cash receipts and payments from direct sources useful.
Accuracy
A more reliable way to track cash flows is to use real-time data in financial reporting.
Ease of comprehension
The straightforward nature of the direct method makes it the most simple to read and comprehend. This method essentially divides a company’s transactions into two categories: positive, which includes cash inflows (cash received from customers, receivables), and negative, which includes cash outflows (rent, employee salaries, etc.). The direct method resembles a bank statement in this regard.
Direct method cash flow example
Even if a sale was made on credit and no money has yet been received from the customer, businesses that use the accrual method of accounting still include sales revenue in the income statement for the current period. Additionally, this sum would be shown on the balance sheet in the accounts receivable section. Businesses that use accrual accounting are exempt from keeping track of cash transactions with clients or suppliers.
The following are some instances of the direct method for the statement of cash flows in the operations section:
Using the direct method, the cash flow from operations section can be presented simply as follows:
This method of listing the data gives the user a thorough understanding of the sources and uses of a company’s cash. For this reason, the FASB recommends using the direct method.
Frequently asked questions about direct method cash flow accounting
What is the purpose of the cash flow statement?
The cash flow statement lists the significant cash flows that take place between the related balance sheets and during the time period covered by the company’s income statement.
Major cash flows are classified as one of the following:
The changes in the company’s cash and cash equivalents between two periods are explained by the net change resulting from these classifications. The cash flow statement also discloses other details, including the amount of taxes and interest paid as well as any significant investing and financing activities for which cash was not used.
What are financing activities?
Financing activities are the cash flows from:
When a business borrows money or receives money from the sale of capital stock, these funds are shown as positive dollar amounts in the section of the statement of cash flows devoted to financing activities. The company’s cash and cash equivalents will increase if the amount is positive, indicating that cash was received.
The amount of cash used will be shown as negative dollar amounts in the cash flows from financing activities section of the statement of cash flows when the company pays back the principal amount of its loans (short- or long-term), cashes in any of its bonds, buys back shares of capital stock (treasury stock), or distributes cash dividends on its capital stock. A decrease in cash and cash equivalents for the company is indicated by a negative amount.
What are investing activities?
Cash inflows and outflows from the purchase or sale of a company’s long-term assets that occurred during the period shown on the statement are referred to as investing activities.
The assumption is that a company will use (decrease) its cash and cash equivalents when it makes long-term investments like purchasing real estate, machinery, vehicles, securities, or expanding its facilities. The cash flows from investing activities section of the statement of cash flows shows negative dollar amounts for these investments and capital expenditures.
When the business sells any of the aforementioned long-term investments, it is regarded as increasing its cash and cash equivalents. As a result, the cash received from selling long-term assets is shown in the statement of cash flows’ cash flows from investing activities section as positive dollar amounts.
FAQ
What is direct and indirect cash flow?
The direct cash flow method ignores non-cash transactions and begins with cash transactions like cash received and cash paid. On the other hand, when using the indirect cash flow method, the calculation begins with the net income and is adjusted as we go.
What is indirect method in cash flow?
The indirect method for presenting data for a cash flow statement demonstrates how much money a business spent or made over a specific time period and from what sources. To calculate cash flow, add or subtract balance sheet items from the company’s net income.
Why is the direct method of cash flow preferred?
The International Accounting Standards Board prefers the direct method because it provides a clear view of cash flow receipts and payments, whereas most businesses prefer the indirect method because it is simple to use.
