Cash flow - What's the difference between the direct vs. indirect method?

What is the Cash Flow Statement?

A cash flow statement is a financial statement that takes into account a company's cash inflows and outflows. The cash flow statement is one of the three main financial statements widely used in Accounting.

It is used to assess a company’s cash generation and liquidity, and is an important input in valuation models like DCF.

The cash flow statement’s operating activities section can be prepared using two methods: the direct method and the indirect method. Each method has its own unique application, and this article will explore the differences between the methods and the reasons why companies choose one over the other.

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Companies present their cash flow statements in two different ways: the direct method and the indirect method. The Direct Method shows major categories of cash receipts and payments from operating activities, while the indirect method starts with net income and adds back non-cash items.
Companies can choose either method to report cash flows. Some might choose the Direct Method because it is intuitive, as it clearly shows all cash inflows and outflows, while others might use the Indirect Method for its simplicity.
While companies can choose either method, the vast majority use the Indirect Method for its simplicity.
With the cash flow statement, investors can see how cash is generated and used, and how it affects liquidity, which is important because “Cash is King”, and the more liquid a company, the better.

Types of Cash Flow

The cash flows are categorized into three main areas:

Operations
Investing
Financing

Operating refers to the day-to-day activities of a business. It is what keeps a business running for the time being.

Investing involves a company using cash to invest in assets such as property, which can improve or generate revenue for the company. These activities represent the core, day-to-day business functions that generate cash inflows and outflows.

Finally, the last section of the cash flow statement is the Financing section, which includes raising capital through debt or equity and returning capital via debt repayment or dividends.

Note

You can find the Cash flow statement in a company's 10-K filings or its 10-Q filings. You can click the link to view Apple's Cash Flow Statement, which is located on page 36 of its 10-K.

Cash Flow: Direct Method

Companies can present the operating section of the cash flow statement using either the Direct Method or the Indirect Method.

The Direct Method of the Cash Flow Statement does NOT begin with the Net Income. For the Direct Method, consider the changes in cash flows and adjust the cash flow statement accordingly.

You analyze actual cash inflows (e.g., from customers) and outflows (e.g., payments to suppliers) to build the statement..

Additionally, it is essential to recognize that the Direct Method only considers the changes in cash flows associated with Operating Activities. While you will include the Investing and Financing sections in the cash flow, there will only be changes in the operating section.

You can use two different year balance sheet items and income statements to help you prepare your Direct Method Cash Flow Statement. To prepare the Direct Method cash flow, you analyze cash-based transactions from the income statement and balance sheet changes over two periods.

Example

We will look at the example for ABC Corporation Below.

ABC Corporation
Income Statement
For the Period Ending Dec 31, 2024

Income Statement
Revenue Sales Revenue:	$180,000
Other Revenue	$6,000
Total Revenue	$186,000
Cost of Goods Sold	-$75,000
Depreciation Expense	-$19,000
Other Operating Expense:	-$36,000
Total Expenses	-$130,000
Income Before Income Tax	$56,000
Income Tax Expense	-$10,000
Net Income	$46,000

ABC Corporation
Balance Sheet
As of December 31, 2024, and 2023

Balance Sheet
	2024	2023	Increase/Decrease
Cash:	$19,000	$3,000	$16,000
Accounts Receivable:	$22,000	$23,000	-$1,000
Inventory:	$24,000	$21,000	$3,000
Prepaid Expenses:	$1,000	$3,000	-$2,000
Intangible Assets:	$7,000	$7,000	$0
Total Assets:	$73,000	$57,000	$16,000
Accounts Payable:	$14,000	$9,000	$5,000
Accrued Liabilities:	$14,000	$17,000	-$3,000
Income Tax Payable:	$18,000	$16,000	$2,000
Long-term Note Payable:	$40,000	$45,000	-$5,000
Common Stock:	$35,000	$24,000	$11,000
Retained Earnings:	$75,000	$51,000	$24,000
Liabilities and Stockholders' Equity:	$161,000	$134,000	$27,000

Compute the following cash flow amounts for 2024:

Collections from customers
Payments for inventory
Payments for other operating expenses
Payment of income tax
Acquisition of equipment that had a book value of 25,000
Issuance of long-term notes payable: ABC Corporation paid off $20,000 of long-term notes payable.

Now, if you want to form a cash Flow in the direct Method, you will only look at the Operating Activities.

To do this using the Direct Method, you will first start with each of the operating activities.

To calculate Collections from customers, you take the Sales plus the increase in what you collected from Accounts Receivable. Since you received cash, a decrease in accounts receivable (A/R) is an increase in collections. That will be

Collections from customers = $180,000 + $1,000 = $181,000

For payments of inventory, you will look at the COGS and add back the increase in inventory since you bought inventory, which will, in turn, increase COGS.

Additionally, you have a 5000 increase in Accounts payable, which will decrease COGS since you don't pay them back. In total, that would be

payments of inventory = $75,000 + $3,000 - $5,000 = $73,000

For payments related to other operating expenses, refer to Operating Expenses and subtract the decrease in prepaid expenses that you have recognized. You will add back the reduction in accrued liabilities, since you recognized them as expenses. This will be

Payments for other operating expenses = 36,000 - 2,000 + 5,000 = $39,000

The total Operating cash inflow would be the sum of the above three components:

Collections from customers: $181,000

Payments for inventory: $73,000

Payments for other expenses: $39,000

Net operating cash flow = $181,000 - $73,000 - $39,000 = $69,000

This is where the rule hits for the direct Method to take action. You will have a -20,000 on the financing action. You wouldn't look at the balance sheet to see changes in cash; record what's there. That is done for both Investing and Financing Activities.

Cash Flow: Indirect Method

As mentioned before, another method used to form the cash flow statement is the Indirect Method. For this, you are allowed to start with Net Income and add back or deduct any non-cash expenses.

The Indirect Method is much more commonly used when filing, and as shown in the link, Apple’s 10-K is prepared using the indirect method.

An indirect Method of Cash Flow follows this formula,

Net Income
+ Depreciation
+ Depletion
+ Amortization
+ Loss on disposal of assets
- Gain on disposal of assets
+ Decrease in current operating assets (excluding cash)
- Increase in current operating assets (excluding cash)
+ Increase in current operating liability
- Decrease in current operating liability

Because you're converting accrual-based net income into actual cash from operations, these adjustments remove the effect of non-cash items.

Example

Considering the previous example, you would start with the net income.

Example
Net Income	$46,000
Depreciation	$19,000
Decrease in A/R	$1,000
Increase in Inventories	-$3,000
Decrease in Prepaid	$2,000
Increase in A/P	$5,000
Decrease in Accrued Liabilities	-$3,000
Increase In taxes payable	$2,000
Inflow in Operating Expenses	$69,000

As shown here, you obtain the same number for the operating section; ultimately, it is the same method used to arrive at the answer.

The Indirect, however, is more popularly used and easier to use, as you add back the sections instead of adding or subtracting based on your section.

Direct Vs. Indirect Method

Let’s understand the main differences between the two methods in the table below:

Direct Vs. Indirect Method
	Direct Method	Indirect method
Definition	Uses real-time figures to consider only cash flows in a certain situation or transaction	Adjusts Net Income by adding back non-cash transactions
Use Preferences	Not very popular, and used by smaller businesses	The most common method of presenting cash flows is on the 10-Q and 10-K
Simplicity/Accuracy	It is accurate, but it is harder to calculate, since you have to take into account the real cash flows in a situation	This is by far the most popular method of calculating cash flow, since you just add back the non-cash transactions

Conclusion

The Cash Flow statement remains a powerhouse in finance. Through cash, you see the overall health of a company. Experienced investors consider cash flow when deciding whether to acquire a company.

The Direct and Indirect methods, although different, both serve the same purpose. They give an overview of a company's cash statements.

While the direct method is seen as easier by most and is more commonly used, ultimately, the method for preparing the cash flow statement is up to you. Through these methods, you can achieve this short yet powerful statement.

Then you can become a seasoned investor and maximize your profits and investment through this powerful statement. In the end, “Cash is King!”