A cash flow statement provides a snapshot of your business’s financial wellbeing.
Its primary job is to show how much cash you have available after subtracting cash outflows from cash inflows. This information helps you assess your ability to generate enough income to cover the costs of operating activities. But, equally important, your net cash flow tells you whether you can cover your debts, or liabilities.
That part is straightforward. It can be difficult to work out which cash flow statement calculation method your accountant used – either direct or indirect cash flow.
Each type of cash flow statement reveals different information about your business. Of course, the easiest way to find out which cash flow calculation your accountant used is to ask them. They’ll be able to tell you what type you’re looking at and also give you a lot of insight into what all the figures mean.
But if you’re keeping your own books, here we’ll explain the differences between direct and indirect calculation methods. You can then decide which one works best for your business.
What are the elements of a cash flow statement?
Before we dive in, let’s review the three main parts of any cash flow statement.
- Operating cash flow: This is revenue and expenses from day-to-day operations, including cash from sales revenue, interest, vendor payments, taxes, and wages.
- Investing cash flow: This is cash earned from and spent on investments. Revenue includes things like business asset sales or stock wins. Expenses could be loan payments and the purchase of assets.
- Financing cash flow: This is revenue and expenses relating to stocks, bonds, servicing debt, and dividend payments to investors.
Net cash flow equals total cash inflows minus total cash outflows. For example, imagine your company’s operating activities bring in a net cash flow of €150,000, a net cash flow from investment earnings of €20,000, and a negative net cash flow of €60,000 from servicing debt.
Here’s how you calculate your company’s net cash flow:
€150,000 + €20,000 – €60,000 = €110,000
In this example, your company has a net cash flow of €110,000, which points to a reasonably strong business that will likely allow you to continue paying overhead and reduce your debt.
If you consistently have positive net cash flow, your business is in a good place. Conversely, it may be challenging to continue paying operational costs if you consistently have negative cash flow.
What is the difference between direct and indirect cash flow?
Direct and indirect cash flow methods use different starting points, calculations, and levels of detail to create a closing bank statement.
Direct cash flow
Accounting standards organisations typically recommend using the direct cash flow method because it provides more accurate information. However, many businesses still choose the indirect method because it’s simpler, less complex for reporting purposes, and less time-consuming to prepare. To create the cash flow statement, you individually itemise cash transactions, add them up, and then subtract expenses from cash revenue over a given period. Non-cash transactions are not included.
Direct cash flow transactions are mainly cash payments from customers, employee wages, cash paid for bills, money paid to vendors, and income tax. After you subtract the expenses from the payments received, there will be a clear positive or negative cash flow.
Indirect cash flow
Indirect cash flow uses estimations to calculate your organisation’s net income. Larger businesses with many delayed payments, significant assets, and investments use the indirect method because it’s simpler and quicker – though less precise.
The indirect cash flow method involves starting with your net income and adjusting the figure as the balance sheet changes. Some adjustments might include:
- Removing non-cash expenses and payments
- Accrual entries
- Changes in inventory, receivables, and payables
What is the relationship between cash flow and an income statement?
An income statement shows revenue and expenses over a specific period, while the cash flow statement provides the cash flow from your operating, financing, and investing activities. You use income statements to calculate cash flow statements. You can compare the two financial statements to help make conclusions about your cash management. For example, if your income statement shows a healthy cash balance, but your cash flow statement shows a smaller figure, you’re likely paying a lot of debt or have made some capital improvements.
A poor income statement and a healthy cash flow statement can mean that your business is asset-heavy. This means you’re not making much profit from selling your product or services, but you do have assets like real estate, equipment, or office furniture that you could sell to generate capital if needed.
How to decide which cash flow methods to use
Your accountant will typically choose the cash flow method that best fits your business size and reporting goals. However, if you’re trying to decide which to use or just want to understand each one better, here are some factors to consider:
Direct cash flow
Since you’re pulling every cash transaction to compile a new data set, the direct method is a transparent record of your cash flow. Direct is a more in-depth cash flow analysis than indirect, but reporting this way can be time-consuming. This is especially true if your business sells a high volume of low-value goods.
It might be worth using the direct cash flow method because it makes it easier to predict potential cash flow investments and the potential impact of increasing cash expenses. It can also show where you can reduce costs and prepare for predicted negative cash flow periods.
Indirect cash flow
The indirect method allows you to compare cash flow to net profit, clarify how you receive cash, and record income. For example, if you have a period where your net profit and closing bank statement don’t match up, you’ll be able to see why this is happening.
Since you’re starting with the net profit data you already have from your company’s profit and loss statement, you can get a quicker picture of your cash flow. It may be less accurate than using the direct method because you use estimated adjustments, but it should still be fairly accurate. If your business has a lot of investments, loans, or assets, you’ll probably use the indirect method. You’ll also likely use accrual accounting, which means you count income and expenses when they are agreed to, rather than when the payments are sent or received. Having net-60 or net-90 terms means there can be a lot of money in the air even though it’s accounted for on paper.
Ultimately, both methods will deliver similar results.
Simplify cash flow for your ecommerce businesses
Whether you choose the direct or indirect method to assess your cash flow, you’ll be able to monitor the money you make and spend to ensure your company is profitable long-term. To do this, it’s vital to keep your accounts up to date and plan for future expenses as your business grows.
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