Your company’s cash flow statement is a measure of its strength and stability. It's a crucial piece of financial documentation that allows you to track all of your cash inflows and outflows, providing you with an important snapshot of your company's financial position. What's more, in the UK, you're also required to file cash flow statements at regular intervals [1], which helps the government ensure businesses are operating as transparently as possible.
When creating a cash flow statement, it’s important to understand that there are two different ways to go about it – the direct cash flow statement method and the indirect cash flow statement method.
In this article, we explore the indirect cash flow statement method and consider its pros and cons when calculating cash flow.
What is the cash flow statement indirect method?
Put simply, the indirect method of cash flow focuses on adjusting net income based on increases and decreases in the balance sheet.
When you use the indirect cash flow method, you calculate operating cash flows by tracking the changes between the opening and closing balance of working capital and adjusting for non-cash items, explains Aaron Saw, a senior subject manager for the Association of Chartered Certified Accountants (ACCA).
The indirect method of cash flow statement works with the accrual basis of accounting, which documents income for the period when it is earned, but not necessarily paid. This means that a product or service has been invoiced, but cash may not yet have changed hands.
Direct vs. the indirect method of cash flow statement
It's important to keep in mind that regardless of whether you use the indirect or direct method of calculating cash flow, both should always arrive at the same amount from operating activities. The fundamental difference is how that figure has been calculated and ascertained.
While the indirect method of cash flow statement works with the accrual basis of accounting, the direct method of calculating cash flow works with the cash accounting method. This method documents income only once payment has been received.
A disadvantage of the indirect cash flow method is that it provides more of an overview of your cash position, whereas the direct method details individual pieces of cash information. For this reason, a direct cash flow statement may be more preferable to potential investors so they can more easily break down and dissect your inflows and outflows.
Why use the indirect method of cash flow statement?
The indirect method is easier to prepare
According to Saw, the indirect method is a “simpler method to prepare operating cashflows and it makes more efficient use of resources". The reason it's simpler, and faster, is that it relies on net income and movements in the balance sheet rather than looking at direct cash inflows and outflows to calculate payments and expenses. There is no process of sourcing receipts and chasing up loose cash expenses as with the direct method.
Furthermore, businesses may feel more at home with the indirect method of cash flow because it is calculated using accrual basis accounting. And in the UK, any business which earns £300,000 or more per year must use accrual accounting as part of their annual reporting [2], so many businesses already understand it more than cash basis accounting.
It’s more useful as you scale
When it comes to the direct method of cash flow, listing all cash transactions and receipts at regular intervals can become labour-intensive, especially if you’re without an accountant. This becomes more of a problem as you scale. Because the indirect method of preparing cash flow statements relies on two main sources of information, the income statement and the balance sheet, it’s generally faster and therefore preferable to larger businesses.
It helps you understand your financial position
The indirect method of calculating cash flow is a useful way to get an idea of your company's financial health. It will also help you to understand where you stand in terms of your company's cash flow position.
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How to prepare a cash flow statement with the indirect method
When preparing a cash flow statement using the indirect method, you need to take information from several financial documents. For the period in question, usually a quarter or a full year, you must ascertain the cash flow from operating, investing and financial activities.
When it comes to calculating cash flows from investing and financing activities, the process is the same whether you use the cash flow statement with the indirect method or the direct method.
However, calculating cash flows from operating activities, where the bulk of business revenue is generated, is where things differ. With the indirect cash flow method, calculating the cash flow from operating activities is a three-step process:
- Ascertain the business' net profit or loss figure using an accrual basis.
- Account for non-cash expenses, such as depreciation or the gain on asset disposal.
- Account for changes in working capital.
What you are left with is the operating cash flow figure.
You can then use this information to calculate the cash amount at the beginning of the accounting period, the cash amount at the end of the accounting period and the net cash increase or decrease over this period. This shows you how much cash was generated over this time frame.
Cash flow indirect method: example
Using the three-step process described above for calculating operating expenses, let’s look at an example of the cash flow indirect method in practice.
ABC Company
Step 1: Using information found in their income statement, ABC Company start with a net income of £100,000.
| Operating cash flow | |
| Net Income | £100,00 |
Step 2: Next, they need to make adjustments for non-cash expenses like depreciation, which can be found in the profit and loss statement.
| Adjustments for: | |
| Depreciation of assets | £4,000 |
| Amortisation of assets | £1,500 |
Step 3: In the final step, which concerns the indirect method of calculating cash flow, increases or decreases in working capital also have to be accounted for.
| Adjustments for working capital: | |
| Increases/(decreases) in inventory | (£2,500) |
| Increases/(decreases) in receivables | (£15,000) |
| Increases/(decreases) in payables | £45,000 |
Cash inflow from operating activities: £133,000.
If step 3 were calculated using the direct method, expenses, receipts and individual transactions would be detailed above, broken down into their cash equivalencies and would only be added once that cash had been paid or received.
Again, the above example only details operating activities because cash flows from financing and investing are calculated in the same way for both the direct and indirect methods. If you were putting together a full cash flow statement using the template above, you'd have to remember to also make adjustments for financing and investments.
Many companies find the cash flow indirect method useful for showing everything that they have earnt and spent over a period, even if all the invoices accounted for have not yet been paid. It provides a clear record of earnings, can be quicker and more efficient, and helps you better understand your company's cash position.
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Sources:
[1] GOV.UK. (n.d.). Company accounts guidance
[2] GOV.UK. (n.d.). Cash basis
