A ‘cash flow statement’, also known as ‘statement of cash flow’, is a part of financial statements that shows how changes in Balance Sheet accounts and Income statement (P&L a/c) affect cash and cash equivalents.
A Cash flow statement is prepared to measure the company’s liquidity; the ability to pay bills and avoid defaulting on debt.
There are two methods of preparing a Cash Flow Statement viz, the direct method and the indirect method. Both the direct and the indirect method of Cash Flow Statement contains 3 sections/areas viz,
- Operating Activities
- Investing Activities
- Financing Activities
- Only difference between ‘Direct’ and ‘Indirect’ method is under ‘Operating Activities’
- There are NO differences while reporting activities under ‘Investing Activities’ and ‘Financing Activities’ sections of both the methods.
- Nearly all the companies/entities prepare Statement of Cash Flow using ‘indirect method’.
- ‘Direct method’ of cash flow statement is the easier of the two. However, when there is a huge amount of data to be processed it becomes extremely tedious and therefore complicated.
- Indirect method uses readily available information from P&L a/c and Balance Sheet. Most companies find it easier to employ.
- Direct method shows actual amount of cash received and cash paid while indirect method starts with the Net Income amount (more correctly the profit-before-tax amount). From this amount all non-cash items (such as depreciation, amortization, provision for bad debt, accruals and loss/gain on sale of fixed assets) are removed to arrive at a final number for ‘Operating Activities’.
- Line headings or the format of Cash Flow Statement is different for both the methods under Operating activities.
- The final balance that you get after completing all three sections in both direct and indirect method will be/must be the same.
Video: Cash Flow Statement – Direct vs Indirect method