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Direct vs Indirect Cash Flow Methods

Updated on April 30, 2024
Article byWallstreetmojo Team
Edited bySusmita Pathak
Reviewed byDheeraj Vaidya, CFA, FRM

Direct and indirect are the two different methods used for the preparation of the cash flow statement of the companies, with the main difference relating to the cash flows from the operating activities. In contrast, in the case of the direct cash flow method, changes in the cash receipts and the cash payments are reported in cash flows from the operating activities section. In contrast, in the case of the indirect cash flow method, changes in assets and liabilities accounts are adjusted in the net income to arrive at cash flows from the operating activities.

Direct vs. Indirect Cash Flow Differences

The cash flow statement contains three activities, namely operating, investing, and financing. Usually, the investing and financing sections are calculated similarly.

But when it comes to calculating cash flow from operational activityCash Flow From Operational ActivityCash flow from Operations is the first of the three parts of the cash flow statement that shows the cash inflows and outflows from core operating business in an accounting year. Operating Activities includes cash received from Sales, cash expenses paid for direct costs as well as payment is done for funding working capital.read more, two methods of calculation are majorly used – indirect method and direct method.

Direct vs Indirect Cash Flow Methods

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Direct and Indirect Cash Flow Methods Infographics

Here are the top 7 difference between Direct and Indirect Cash Flow Methods

Cash-flow-indirect-method-vs-Cash-flow-direct-method

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Direct vs. Indirect Cash Flow Methods Explained in Video

Direct Cash Flow vs. Indirect Cash Flow Method  Key Differences

Here are the key differences between direct vs. indirect cash flow methods–

  • One of the key differences between direct cash flow vs. indirect cash flow method is the type of transactions used to produce a cash flow statement. The indirect method uses net income as the base and converts the income into the cash flow through adjustments. The direct method only takes the cash transactions into account and produces the cash flow from operations.
  • The cash flow indirect method makes sure to automatically convert the net income in terms of cash flow. The cash flow direct method, on the other hand, records the cash transactions separately and then produces the cash flow statement.
  • The cash flow indirect method needs preparation as the adjustments that are made require time. The preparation time for the cash flow direct method isn’t much since it only uses cash transactions.
  • The accuracy of the cash flow indirect method is a little less as it uses adjustments. The cash flow direct method is more accurate as adjustments are not used here.

So, what are the differences between direct and indirect cash flow methods? First, let’s look at the head-to-head differences between the direct and indirect cash flow methods.

Direct vs. Indirect Cash Flow Method Head to Head Differences

Here are the basic differences between direct vs. indirect cash flow methods

The basis for comparison between Direct vs. Indirect Cash FlowsCash flow indirect methodCash flow direct method
DefinitionThe indirect method uses net income as a base and adds non-cash expensesNon-cash ExpensesNon-cash expenses are those expenses recorded in the firm's income statement for the period under consideration; such costs are not paid or dealt with in cash by the firm. It involves expenses such as depreciation.read more like depreciation, deducts non-cash incomes like profit on the sale of scraps, and net adjustments between current assetsCurrent AssetsCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc.read more & liabilities to produce the overall cash flow statement.The direct method uses only the cash transactions, i.e., cash spent and cash received to produce the cash flow statement.
WorkingNet income is automatically converted in the form of cash flow.ReconciliationReconciliationReconciliation is the process of comparing account balances to identify any financial inconsistencies, discrepancies, omissions, or even fraud. At the end of any accounting period, reconciliation involves matching balances and ensuring that debits (credits) from one account for one transaction is same as the credit (debits) to another account for the same transaction.read more is done to separate the cash flow from others.
Factors are takenAll the factors are taken into account.All non-cash transactions like depreciationDepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. read more are ignored.
PreparationsPreparations are mainly needed during the conversion of net income into cash flow statement.There’s no such preparation required.
AccuracyThe cash flow statement under the indirect method is not very accurate as adjustments are being made.The Cash flow statementCash Flow StatementA Statement of Cash Flow is an accounting document that tracks the incoming and outgoing cash and cash equivalents from a business.read more under the direct method is very accurate as there is no need for any adjustments here.
Time takenIt takes less amount of time compared to the direct method.It takes more amount of time compared to the indirect method.
PopularityMany companies predominantly use this method.Compared to the indirect method, they are only a very few companies that use this method.

Direct vs. Indirect Cash Flow Method – Conclusion

The direct vs. indirect cash flow method is useful at different points, and it can be used depending on the situation and the requirement. The indirect method is the most popular among companies. But it takes a lot of time to prepare (before recording), and it’s not very accurate as many adjustments are used.

On the other hand, the direct method doesn’t need any preparation time other than segregating the cash transactions from the non-cash transactions. And it’s more accurate than the indirect method.

This article has guided the top differences between direct and indirect cash flow methods. Here, we discuss key differences between direct vs. indirect cash flow methods with infographics and a comparison table. You may also have a look at the following articles –

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Comments

  1. Jackson Mwambola says

    Thank you very much. For the article is very helpful and i have got may answers to my many quetions. Thank you and i wish you all the best in preparation of many best useful works.

    • Dheeraj Vaidya says

      Thanks for your kind words!