Accounting

Creating a Cash Flow Statement: Direct vs. Indirect Method of Cash Flow

By Paige Smith

When it comes to understanding your business’s financials, a cash flow statement is one of the most important resources to have. A cash flow statement is a summary of your company’s incoming and outgoing cash from three main areas: 1) operations, 2) investments, and 3) financing. 

Along with your income statement and balance sheet, a cash flow statement can give you a better picture of your business’s financial health, including your profitability and spending habits. 

Figuring out how to calculate cash flow may seem tricky, but it’s fairly straightforward in practice. There are two ways to prepare your cash flow statement: the direct method of cash flow and the indirect method of cash flow

Direct vs. indirect method of cash flow

Both methods of cash flow analysis yield the same total cash flow amount, but the way the information is presented is different. The difference, however, only applies to the operating cash flow. The investing and financing sections present the same way whether you use the statement of cash flows direct method or indirect method. 

With the direct method of cash flow, you count only the money that actually leaves or enters your business during the designated reporting period. To do that, you start with a blank slate, then add and subtract all your company’s operational cash transactions. These transactions could include receipts from product or service sales, payroll, rent, supplier payments, or materials expenses. 

The indirect method of cash flow uses accrual accounting, which is when you record revenue and expenses at the time a transaction occurs, rather than when you actually lose or receive the money. Using your income statement, you start with your company’s net income as a base. From there, you refer to the changes on your balance sheet to add and subtract from your net income. Keep in mind that the indirect method accounts for non-cash factors like depreciation, while the direct method doesn’t.

The direct method can be tedious and time-consuming, which is why business owners tend to prefer the indirect method. Plus, since most businesses already use accrual accounting to record their financial information, using the indirect method to calculate cash flow from operations keeps things consistent. 

How to create a cash flow statement using the indirect method

You can use an Excel spreadsheet to prepare your cash flow statement, or check out the resources and templates your accounting software offers. Whichever route you choose, make sure you have your most recent income statement and balance sheet on hand to draw from. 

Step 1: Record your net income and adjust for non-cash expenses

Start by recording your net income for the reporting period in question. Calculating net income requires subtracting your business’s expenses, operating costs, and taxes from your total revenue. 

Next, adjust your net income to account for non-cash expenses, like depreciation of your assets.

Step 2: Adjust for assets 

Looking at your balance sheet, adjust your net income for increases and decreases to your assets. Your assets include things like accounts receivable, inventory, property, stock, and cash. In general, increases to your assets (except for cash) decrease your cash flow, while decreases to your assets increase your cash flow. 

As an example, if you buy a commercial property, you accumulate another asset, but the amount of cash you have decreases. 

Step 3: Adjust for liabilities 

After you account for assets, adjust your net income for changes in your liabilities, like accounts payable, expenses, and debt. Keep in mind that decreases to your liabilities—say, for example, making a loan payment—can decrease your cash flow. 

On the other hand, increases to your liabilities in the form of credit—like adding a vendor payment to accounts payable—may either increase your cash flow or keep it steady. 

Step 4: Include cash flow from investing and financing

To finish off your cash flow statement, you’ll need to include cash flow from your investing and financing activities. Investing activities could include buying or selling property or equipment, or issuing or buying back common stock. The financing section accounts for activities like making debt repayments and selling company stock. 

The net change in your cash flow is the sum of all three sections of your cash flow statement. 

Cash flow example statement 

Item

Increase or (Decrease)

Cash Flow From Operations
Net Income $500,000
Depreciation ($20,000)
Accounts Payable ($40,000)
Accounts Receivable  $35,000
Net Cash From Operations $475,000
Cash Flow From Investing
Equipment Sale $5,000
Common Stock Purchase ($15,000)
Net Cash From Investing ($10,000)
Cash Flow From Financing
Loan Payment ($5,000)
Net Cash From Financing ($5,000)
Total Net Cash  $460,000

 

Use your cash flow statement to get ahead 

A cash flow statement is a crucial component of your company’s collective financial statements. And regularly reviewing your financials can give you a better idea of what your business is doing right, and what you may need to improve upon. 

If, for example, you discover you need more cash flow to cover operational expenses, consider applying for a Fundbox line of credit. If you’re approved, you can get funds as soon as the next business day. 

Disclaimer: Fundbox and its affiliates do not provide financial, legal or accounting advice. This content has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for financial, legal or accounting advice. You should consult your own financial, legal or accounting advisors before engaging in any transaction.

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