DIRECT VS INDIRECT METHOD
In my previous post, I spoke about how important cash flows are for a business and provided tips on how to improve your businesses cash flow.
Major factors that affect cash flow are large purchases such as inventory which would be purchased all at once but sold over time, large capital or asset purchases such as equipment which would be an up-front cost but would have a benefit to net income over time. Your gross profit could be positive but your cash flow could be negative.
For example: you are a contractor and just purchased new equipment for $10,000 in March. So in March your cash balance will go down by $10,000 but your net income will not be affected.
The next month you sell an old truck for $8,000. So, in April your cash balance will go up by $8,000, but again your net income will not be affected. Below a visual representation of this example assuming that net income for both months is $4,000.
There are two methods of preparing a cash flow. The direct method and the indirect method. I will discuss both methods.
INDIRECT METHOD
The indirect method is the most commonly used method for preparing cash flow statements. This method involves starting with your net income (in other words, your accounting income) which is based on accruals. Then adjusting it for items that did not affect cash that month because cash flows are based solely on cash. Such as cash received or cash outlays that would not be part of your net income.
Adjustments:
Revenue & Accounts Receivable
When using the accrual method the full revenue for services should be recorded in the month the service is provided even if you did not get paid. So, net income includes the full revenue, with a receivable on the Balance Sheet for the unpaid portion.
- Accounting effect = Net Income for the full amount Receivable
- Cash flow adjustment effect = adjust Net income by subtracting Receivable
When payment is collected net income is not increased again, therefore would not be included in the current month income. Instead, your receivable would be reduced, while your cash would increase.
- Accounting effect = Cash Receivable
- Cash flow adjustment effect = adjust Net income by adding Receivable
In theory you would take the beginning balance of accounts receivable and subtract the ending balance of accounts receivable. If it went down, it means you collected receivables. Therefore you would adjust cash flow by adding the amount of receivable collected in the month.
If it went up you, it means you collected less and therefore would adjust cash flow by subtracting amount of the receivable that was not collected in the month.
Non cash related items
These are usually depreciation and/or amortization which are purely accounting entries and do require a cash payment. To adjust cash flow you simple add these back to net income.
Cash transactions that are capital in natural
Some transactions require a cash outlay but are not included in net income. Such as inventory purchases, capital or asset purchases such as equipment and building. These items would normal be recorded on the Balance Sheet and are not part of net income. To adjust cash flow, you would subtract these items from net income.
Loan principal payments
While the interest payment on a loan would already be included in net income, the principal payment on loans would not be. Principal payments reduce your loan balance on the Balance Sheet and therefore you would need to adjust cash flow by subtracting this from the net income.
Other purchases, expenses or accounts payable
Like with all businesses there are costs or expenses incurred to run the business. As mentioned in the previous post, a tip for managing cash flow is to take advantage of payment terms offered by suppliers. This will result in a timing difference between when the expense is recorded and the cash outlay happens. Similar to revenue, when you incur an expense, the expense is recorded in the month it is incurred even if it has not been paid for yet.
So, net income includes the full expense, with a payable on the Balance Sheet for the unpaid portion.
- Accounting effect = Net Income for the full amount Payable
- Cash flow adjustment effect = adjust Net income by adding Payable
When payment is made net income is not decreased again, therefore would not be included in the current month income. Instead, you payable would be reduced, while your cash increases.
- Accounting effect = Cash Payable
- Cash flow adjustment effect = adjust Net income by subtracting Payable
In theory you would take the beginning balance of accounts payable and subtract the ending balance of accounts payable. If it went down, you made a cash payment therefore you will adjust cash flow with a decrease to net income for the amount you paid. If it went up, you did not made a payment and therefore would adjust cash flow with an increase to net income for the amount you did not paid.
Cash injections such as Equity or Financing
When a business receives cash in the form of financing, partner or owners' equity, this would be recorded on the Balance Sheet and not affect the net income. To adjust net income for cash flow you would need to add the amount cash injection received. The opposite would be true if there was a payment to pay back any financing or equity. You would adjust net income for cash flow by subtracting the amount paid.
DIRECT METHOD
With the direct method you simply are tracking the money coming in and money going out. Cash received would include all cash received such as cash collected from customers, cash received from equity or loans.
Then you would subtract all the cash payments you made in the month such as operating expenses, purchases, loan payments, dividends payable, etc.
The results whether using the indirect or direct method are the same.
Below is an example of both methods:
Direct Method
| Cash Receipts | |
|---|---|
| Cash collected from customers | $59,000 |
| Interest earned on bank funds | 500 |
| Total Cash In | $59,500 |
| Cash Payments | |
| Purchases and operating expenses | ($25,000) |
| Interest on loan | (1,500) |
| Total Cash Out | ($26,500) |
| Net Cash Flows | $33,000 |
Indirect Method
| Net Income | $50,000 |
|---|---|
| Differences between net income and net cash flows from operating activities: | |
| Revenues earned this period which were not received in cash (change in Accounts receivable) | ($7,000) |
| Cash payments for expenses of previous months (change in Accounts payable) | ($10,000) |
| Net Cash Flows from Operating Activities | $33,000 |
WHICH METHOD SHOULD YOU CHOOSE?
It depends on your business.
With the direct method, a company may not track the information needed to use this method such as detailed cash records. This would not be a problem under the indirect method.
If a company is already keeping accrual accounting records, the indirect method would be easy to prepare and not require additional tracking.
For a company with many transactions, the indirect method would be easier. The direct method would be more time consuming and difficult with many transactions.
For a company dealing mostly with cash transactions, the direct method would be easier.
For a company's whose records are recorded based on cash and not accrual the direct method would be a good choice.
If the number of monthly transactions are small, it would make the direct method easy to use.
Most people find the direct method easier to follow since it shows the ins and outs of actual cash helping management understand the liquidity of the company. Which in turn helps management make better decisions.
At the end of the day you should use the method that best helps you be able to make business decisions, helps you monitor your cash and be able to manage your cash position.
For a free excel template for both the indirect and direct cash flow method, provide your name and email address below.