Difference between: Direct AND Indirect methods of Cash Flow Statement

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,

  1. Operating Activities
  2. Investing Activities
  3. Financing Activities

Key points:

  • 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

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