June 15, 2021

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Indirect Method – Cash Flow

Indirect Method – Cash Flow

Overview

Cash is the most liquid category of assets, which provides the greatest degree of liquidity and, consequently, freedom of choice. It represents the beginning and end of the life cycle of any enterprise whose purpose is to make a profit. As a result of activities, cash takes different forms, that is, different types of inventories and other types of assets. The cycle is considered complete if these assets turn back into cash and a new profitable cycle can begin.

The cash flow statement discloses information to users about the receipt of funds and payments made by the company during the reporting period. Users are interested in knowing how the company generates and uses cash and cash equivalents (hereinafter cash).

Indirect Method – Cash Flow

Actually, this document explores the details of just one line in the Balance sheet. The business owners will not only see how much cash they got during the year but also how their entity generated it: such as an increase in revenue, sale of long-term assets, and getting new loans.

When compiling a report, cash flows are shown in the context of three categories of activities: operating, investment, and financial. These activities can be interpreted as follows: the company received X amount of dollars from sales or provision of services, spent Y amount on its development, and since there was not enough cash flow from sales for development and other needs, the company borrowed Z amount of dollars.

Preparing a cash flow statement can be a challenge for an accountant. Why? Because the basic accounting principle of accrual bookkeeping is ignored only when compiling this particular report. It is cash-based, while other financial statements are accrual-based.

Companies usually have a choice of a direct or indirect way of reflecting cash transactions arising from operations. When using the indirect method, this type of cash flow is calculated by adjusting the net profit or loss for non-cash transactions. The reflection of cash activities of an entity with this method demonstrates to those who work with reporting how certain business transactions affect the flow of finances.

Although it is advised that businesses use a direct method, one is usually not limited to one or the other. The choice applies only to operating activities, that is, the main type of activity of the enterprise, while cash flows from other categories are always reflected using the direct method.

Indirect Method – Cash Flow

Advantages and Disadvantages

One of the main advantages is the simplicity of calculations and establishment of a link between net profit or profit before tax and changes in Balance sheet items involved in the main activity. Thus, the Statement of cash flows can be drawn on the basis of the Income statement and the Balance sheet. When using this method, the data on real cash flows taken from accounting systems or any significant automation of the bookkeeping process are not required.

A significant advantage of the indirect method over the direct method is that the information presented in the report does not reflect the direction of cash flows in one direction or another (transfer of money for purchases and their receipt as payment), but the reasons for the change in the balance and their transformation into various forms of assets.

This method also has some downsides, one of them is the need to wait for the closing of the reporting period. Accordingly, you will not be able to see a summarized data on the cash movements in your organization after the end of the reporting period, since it is drawn up on the basis of other financial reports. It is also less visual, and it is difficult to interpret any item to the level of cash flow transactions, which is often required for internal control and budgeting. Finally, it does not provide information useful in estimating future cash flows.

Direct vs Indirect Method – Cash Flow Statement

Let’s compare how the two different reporting methods line up against each other.

Indirect Method – Cash Flow

As you can see, the direct method gives a better conceptual understanding of what happened to the money from operations.

The use of various forms and methods of constructing a Statement of cash flows makes it possible to analyze their volumes and structure in several aspects. As a result, the user gets a detailed view of the operational, investment, and financial transactions carried out by the company during the period under review. This, in turn, allows one to evaluate the strengths and weaknesses of the company, its current and potential problems.

In general, the company’s ability to generate significant cash flows from its core activities is a positive aspect. However, one should always pay attention to the extent to which operating flows cover the need for investments, repayments of loans, or dividends. The stability of the operational flow in dynamics shows a stable financial position of the company and the effective work of its management. At the same time, too much dependence on external funding to cover current needs should be seen as a negative signal.

Finally, a stable negative net cash flow indicates serious financial issues that lead to bankruptcy. The construction and analysis of a report on cash flows in combination with other types of reports provide a deeper understanding of the real position of the company, the actual results of its activities, and future prospects.

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Author: Charles Lutwidge

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