Tags: cash flow statement, direct method, indirect method, financial reporting, small business accounting
In the world of accounting, the cash flow statement is one of the most powerful tools for tracking a company’s financial health. While the income statement shows profitability and the balance sheet outlines a company’s position, the cash flow statement focuses on actual cash movement—the lifeblood of any business.
There are two main ways to prepare a cash flow statement: the direct method and the indirect method. Each method offers different perspectives on how cash enters and exits a business. But here’s the kicker—both must arrive at the same ending cash balance.
In this blog post, we’ll walk through both methods using a consistent, easy-to-follow example so you can understand how each one works and when to use them.
What Is a Cash Flow Statement?
A cash flow statement summarizes the cash generated and used during a specific period, usually split into three sections:
- Operating Activities – Cash from day-to-day business operations.
- Investing Activities – Cash from buying or selling assets like equipment.
- Financing Activities – Cash from borrowing or equity transactions.
The cash flow statement ends with the net increase or decrease in cash, which, when added to the beginning balance, gives the ending cash balance.
Direct vs. Indirect Method: What’s the Difference?
The difference lies in how operating cash flow is presented:
- Direct Method: Lists all major cash receipts and payments. It shows exactly where cash came from and where it went.
- Indirect Method: Starts with net income and adjusts for non-cash items and working capital changes.
Investing and financing activities remain the same in both methods.
How to Prepare a Cash Flow Statement Using the Direct Method
The direct method requires a detailed review of cash transactions. It’s more transparent but often requires more data.
Steps:
- List all cash receipts (e.g., collections from customers).
- List all cash payments (e.g., to suppliers, employees, taxes).
- Subtract outflows from inflows to get net cash from operations.
How to Prepare a Cash Flow Statement Using the Indirect Method
The indirect method is more commonly used. It starts with net income, then adjusts for non-cash items and changes in current assets and liabilities.
Steps:
- Begin with net income.
- Add back non-cash expenses (like depreciation).
- Adjust for changes in working capital accounts.
Example: ABC Services Company
Let’s use a consistent example that results in the same ending cash balance for both methods.
Assumptions:
Income Statement Summary:
- Net Income: P130,000
- Depreciation: P20,000
Balance Sheet Changes:
- Accounts Receivable increased by P30,000
- Accounts Payable increased by P10,000
- Inventory decreased by P5,000
Cash Transactions (from records):
- Cash received from customers: P520,000
- Cash paid to suppliers: P310,000
- Cash paid for salaries and other expenses: P80,000
- Cash paid for income taxes: P20,000
Other Activities:
- Equipment purchased: P50,000
- Loan received: P40,000
- Dividends paid: P10,000
Beginning Cash Balance: P50,000
A. Cash Flow Statement Using the Direct Method
ABC Services Company
Cash Flow Statement (Direct Method)
For the Year Ended December 31, 2024
Cash Flows from Operating Activities:
- Cash received from customers: P520,000
- Cash paid to suppliers: (310,000)
- Cash paid for salaries and expenses: (80,000)
- Cash paid for taxes: (20,000)
Net Cash Provided by Operating Activities: P110,000
Cash Flows from Investing Activities:
- Purchase of equipment: (50,000)
Net Cash Used in Investing Activities: (P50,000)
Cash Flows from Financing Activities:
- Loan proceeds: P40,000
- Dividends paid: (10,000)
Net Cash Provided by Financing Activities: P30,000
Net Increase in Cash: P90,000
Beginning Cash Balance: P50,000
Ending Cash Balance: P140,000
B. Cash Flow Statement Using the Indirect Method
ABC Services Company
Cash Flow Statement (Indirect Method)
For the Year Ended December 31, 2024
Cash Flows from Operating Activities:
Net Income: P130,000
Adjustments:
- Add back depreciation: P20,000
Changes in working capital: - Increase in accounts receivable: (30,000)
- Decrease in inventory: P5,000
- Increase in accounts payable: P10,000
Net Cash Provided by Operating Activities: P110,000
Cash Flows from Investing Activities:
- Equipment purchased: (50,000)
Net Cash Used in Investing Activities: (P50,000)
Cash Flows from Financing Activities:
- Loan proceeds: P40,000
- Dividends paid: (10,000)
Net Cash Provided by Financing Activities: P30,000
Net Increase in Cash: P90,000
Beginning Cash Balance: P50,000
Ending Cash Balance: P140,000
Analysis: Why Do Both Methods Match?
Even though the starting points differ, both methods arrive at the same net cash from operating activities (P110,000) and the same ending cash balance (P140,000). That’s because both methods analyze the same financial reality—just through different lenses.
Which Method Should You Use?
- Direct Method: Offers a clearer picture for decision-making. Recommended if your accounting system can track cash inflows and outflows in detail.
- Indirect Method: Easier to prepare if you already have accrual-based financials. Preferred by most accountants and companies.
While the indirect method is more popular in practice, especially for public companies, using the direct method can offer deeper insight into the cash-generating power of your operations.
Final Thoughts
Whether you’re an entrepreneur, a student of accounting, or a finance professional, knowing how to prepare a cash flow statement using both methods is essential. This skill not only improves your understanding of business performance but also equips you to make smarter, cash-based decisions.
Want to take it a step further? Try applying both methods to your own organization’s financials and see how they reconcile. It’s a great way to sharpen your analytical thinking and reinforce your grasp of real-world accounting.
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