Recently, we took a look at one of the key financial statements for your small business, the cash flow statement. The cash flow statement is a way for you to get an idea of your company’s financial position by way of the cash flowing in and out of the business (otherwise known as cash flow). When it comes to recording cash flows on this statement, there are two methods you can choose from: the direct method and the indirect method. Question is: which one is right for your business?
The Operating Activities Section
First of all, you should know that the direct and indirect methods apply to only one of the three sections on the cash flow statement: the operating activities section. This is the first section that appears on your cash flow statement, followed by investing activities and financing activities.
The information you’ll find in the operating activities section comes from the accounts reported on your income statement, like Accounts Payable and Accounts Receivable. Whereas the income statement reports net income on the accrual basis of accounting, the cash flow statement is true to its name and reports earnings using the cash basis. As we’ll soon see, this will require some adjustments to be done in the operating activities section, depending on whether you choose to use the direct or indirect method.
The Direct Method
If you’re using the direct method of reporting cash flows you will be including cash flows in the operating activities section such as cash paid to employees, cash from customer collections and cash paid to suppliers. These cash flows are found by adding together your cash receipts from all sales and then adding interest and dividends and subtracting any cash payments (for items like operating expenses and company purchases).
The direct method is generally preferred by standard-setting bodies in the accounting world, like the Financial Accounting Standards Board (FASB), because it gives a more transparent view of how cash is flowing through a business. However, most businesses, regardless of size, find it challenging to follow the direct method, since it requires very meticulous tracking and organizing of accounts. (It may even require the restructuring of your chart of accounts, which is no small task when you’re handling the bookkeeping in addition to the actual business!)
The Indirect Method
If the direct method sounds a bit daunting, don’t worry: most companies choose to go with the indirect method, which is generally easier to integrate into your accounting system. However, you will need to do some adjusting in the operating activities section when utilizing this method.
When using the indirect method, the net income from your income statement will be reported in the operating activities section, followed by some adjustments. These adjustments bring net income from the accrual basis (used on the income statement) to the cash basis. To do this, you will need to add back non-cash expenses like depreciation and amortization, as well as losses on Accounts Receivable and on the sale of fixed assets.
The information needed to make these adjustments is all easily accessible in your chart of accounts, so this option of recording cash flows can be a little kinder than the direct method. Most companies—from small businesses to larger corporations—prefer the indirect method because of this.
Whichever method you end up choosing, it will be important to familiarize yourself with the cash flow statement. Not only will it help you understand and project your cash flows better, but it will also be an important piece of the financial picture presented to outside parties like creditors and potential investors, which can be crucial to growing your business.