There are two popular methods to calculate cash flow, the direct method and the indirect method. Before we help you think of the method that best suits your business type or size, let’s breakdown some of the differences between the two ways of doing things.
What’s the difference between the indirect method and indirect methods of calculating cash flow?
The main difference between the direct method and the indirect method of calculating your cash flow is about the cash flow from operating activities. Investing and finance activities are the same in both methods.
Using the direct method of calculating cash flow
The direct method of preparing the statement of cash flows shows the net cash from operating activities (we won’t look at investment or financing activities). When it comes to operating expenses we’ll be looking at cash receipts and payments. An obvious example of a cash receipt would be the cash that you get from a customer. An example of a cash payment would be money you pay a supplier.
Three things to remember when using the direct method
- Think cash, not overall income. You’re not looking at profit or loss in this view–Just cash in and out.
- Record your financing and investing expenses, in the same way, no matter which method you use.
- The direct way is easy for small, but it’s a good idea to learn how to use the indirect method so that if your business grows you know how to take all of your assets into consideration.
Using the indirect method of calculating cash flow
The indirect method takes more into consideration. In fact we made a video to make it easier for you to follow.
First you look at the operating activities (the direct method part), then you look at the income statement for any special items that might have occurred and impacted the business. The depreciation of a company asset would be an example of a non cash item.
If you bought or sold assets such as equipment or property, you would need to adjust this in your records. The indirect method allows you to reflect the depreciation of an asset and the sale of the asset.
Here’s a break down using the indirect method of a company’s cash flow ledger. We’ve marked where operating, financing and investing activities occur. You can also watch our video here.
Take our fictional company, the Craft Brew Brewery Inc. Here’s how a monthly cash flow statement might look for their business.
Unless this is the first month you are in business, you will have a record of the amount of cash you ended last month with and started with this month. We’ll need this number again at the end.
-It all starts with the cash from operating activities, the day to day comings and goings of cash.
-Let’s consider three revenues and three expenses that would be most typical.
-Revenue 1 is the beer they sell to bars and restaurants. This comes in at $200,000 for the month.
-Revenue 2 is the brewery merchandise that they sell on their eCommerce website such as apparel and homeware. They made $30,000 in sales this month.
-The third revenue stream are homebrew ingredient kits. These have generated $5000 for the month.
-Expense number 1 is workers’ salaries. This amounts to $15,000 for the month.
-Expense number 2 is ingredients. Hops, barley, sugar and flavourings. This is costing $30,000 monthly.
-Expense 3 is bottles, labelling and packaging. This is costing $10,000 monthly.
-If you have any income taxes or have accumulated any interest in the month, you should record this too.
-Once we do all our additions and subtractions, we are left with our net profit from operating activities of $180,000.
-If there are any exceptional items from operating activities, you can put them after the net profit line and before the next section.
-Remember this statement is all about the current cash, even if it’s going to depart your account the following month.
-Let’s say for example, the brewery is running a contest for a local bar that will give them the chance to win $10,000 worth of sports memorabilia for their bar. The brewery received the funds for this contest as part of a local enterprise grant. It’s currently sitting in their account, so it should go on the statement.
-We add it all up and we have our total cash from operating activities of $190,000.
-Now it’s time to look at the investing activities.
-The brewery had to buy some equipment this month but sold off some outdated machinery.
-The purchase of a new fermentation tank cost $33,500 this month.
-While a batch of old cask wooden barrels were sold for $3,000 this month.
-If any assets your business owned was affected by amortization or deprecation you would make a note of these sums here.
-With everything added up our total cash amount from investing activities was 30,000 this month.
-The last section of the statement relates to cash from financing activities.
-This month the brewery decided to pay down $6,000 dollars of existing debt on a loan they had taken out for initial startup costs.
-Next we add up the summaries of all three sections to get our cash amount for the end of the month.
-All that’s left to do now is to add the beginning cash amount and the change in cash amount to get the ending cash amount.
Download our free Cash Flow Statement and follow along with our video on to help get you started.