Reviewed by Oct 05, 2020| Updated on
There are two methods that can be used to prepare a cash-flow statement, the direct method and the indirect method. Under the direct method, all changes with regard to the inflow and outflow of cash for a particular financial period are taken into account to find the total cash flows for the period.
In simple words, all cash receipts and payments made are accounted for under the direct method. On the other hand, under the indirect method, the cash flows are obtained by making adjustments to the net income for the financial period, i.e. adjusting any increases and decreases in the balance sheet items.
The direct method of preparing a cash flow statement involves the grouping of cash transactions under three heads:
The first head is operating activities which include cash paid to suppliers, cash received from customers, cash paid as employees’ salaries, taxes paid, interest paid, etc.
The second head is investing activities which include dividends received, proceeds from the purchase and sale of fixed assets, etc.
The third head is financing activities which include dividends paid, proceeds from the issue of shares and debentures, etc.
The advantages of the direct method are that the format used is simple and straightforward. The major categories of cash receipts are payments disclosed, especially the cash flows from operating activities, which the management could use for decision-making. The direct method provides clear information to stakeholders and investors on the cash position of the business, and whether cash flows are increasing or decreasing through each financial period.
The biggest disadvantage is that preparing a cash flow statement under the direct method is more time-consuming than the indirect method. As companies follow the accrual system of accounting, the cash inflows and outflows need to be separately calculated.