Direct vs. Indirect Cash Flow – Which Is the Best?

Imagine driving across the country without knowing how much gas you have left in the tank… That's what managing a business without understanding cash flow feels like. Cash flow is the lifeblood of your business, the fuel that keeps your company running smoothly.

Cash flow gives you a real-time picture of your financial health. It isn’t just about looking profitable on paper – it's about having the actual funds in the bank to pay your employees, invest in material, and be resistant to unexpected setbacks. A company can look great on the income statement but still struggle if cash isn't flowing in at the right time.

Understanding your cash flow helps you make informed decisions. Should you expand your product line? Can you afford to hire more staff? Is it time to find more funding? These questions all depend on your cash flow situation.

Before you get into this article, it would be beneficial to learn about cash and accrual accounting. We wrote a two-part series on it: Part 1 and Part 2. 

Different Types of Cash Flow

When it comes to analyzing cash flow, there are two methods: direct and indirect. Think of them as two different lenses through which you can view your business's cash movements. Each has its benefits, and knowing when to use which can give you a step ahead.

Direct Cash Flow

Direct cash flow refers to the method of accounting for cash flows that records actual cash inflows and outflows from a company's operations during a specific period. The direct method directly lists cash transactions such as payments received from customers and cash paid to suppliers and employees. 

Direct gives a clear and detailed view of how cash moves in and out of the business, making it super easy for stakeholders to understand the company's liquidity and financial health. It's a straightforward, no-nonsense approach that tracks actual cash movements during a specific period.

This method categorizes cash flows into three main buckets:

1. Operating activities – The day-to-day business operations

2. Investing activities – Buying or selling long-term assets

3. Financing activities – Transactions with lenders and owners

How to Read It

Reading a direct cash flow statement is pretty intuitive, even if you don’t have a finance background. You’ll see the following things:

1. Cash from operations: This section shows cash received from customers and cash paid out for operating expenses. 

• Cash received from sales

• Cash paid to suppliers

• Salaries and wages paid

• Interest and taxes paid

2. Cash from investing: This section focuses on long-term cash use and generation. 

• Purchase of equipment or property

• Sale of investments or assets

• Acquisitions of other businesses

3. Cash from financing: Here, you’ll find details on the capital structure of a business. 

• Proceeds from issuing stock or taking on debt

• Repayment of loans

• Dividend payments

As you can see, it’s simple and transparent. You can easily trace where each dollar came from and where it went.

Indirect Cash Flow

The indirect method of cash flow analysis is more complicated. It starts with net income from your income statement and then makes adjustments to arrive at cash flow from operations. It's called "indirect" because it doesn't directly report cash movements but instead turns accrual-based net income to cash flow.

How to Read It

Because of its complexity, indirect cash flow statements are a bit harder to read. 

1. Start with net income: This is your starting point, taken directly from the income statement.

2. Add back non-cash expenses: Items like depreciation and amortization are added back because they reduced net income but didn't actually require cash.

3. Adjust for changes in working capital: Here, you'll see adjustments for changes in:

• Accounts receivable

• Inventory

• Accounts payable 

These changes show the difference between accrual accounting and actual cash movements.

1. The Result: After these adjustments, you arrive at cash flow from operations.

Investing and financing activities are reported the same way as in the direct method, which in the end gives you a total overview of cash flow.

Comparing Direct vs. Indirect – Which Is Better?

Both methods get you to the same end result, but they get you there in different ways. Here are the pros of both:

Direct Method Pros

• Easier to understand for non-financial stakeholders

• Clear, detailed picture of cash sources and uses

• Useful for cash-based businesses or those with simple operations

Indirect Method Pros

• Preferred by most companies and accountants, because it connects to the income statement and the balance sheet

• Easier to prepare if you're already using accrual accounting

• Insights into how non-cash transactions affect your cash position

At Ursa, we lean towards accrual accounting and the indirect method. Why? Because it provides a more nuanced view of our financial health. 

1. Better visibility into unit economics: By turning net income into cash flow, we can see how our revenue translates to actual cash, giving us a better picture of our true profitability.

2. The matching principle: This matching principle suggests that expenses should be recorded in the same period as the related revenues. The indirect method helps us see this relationship clearly.

3. Better for growth: As the business grows, the indirect method helps us understand how our cash flow changes in relation to our growth, which is crucial for strategic planning.

While cash-based accounting (and with that, the direct method) is simpler, accrual accounting and the indirect method give a more accurate picture of financial health over time.