Direct and Indirect Cash Flow Statements: Definitions and Benefits
Building your own cash flow statement is a powerful method to identify your top business priorities. It reminds you of how much money you have available in each expense category; it’s easy to spot red flags and to see trends in your spending habits that you might want to change.
Two methods to build a cash flow statement
The cash flow statement provides a snapshot of your current position in the money market. There are two methods to build a cash flow statement.
The direct method requires less time upfront and is generally used in a way that categorizes payments such as rent, bills, and groceries. The indirect method involves using an accounting software program to create the cash flow statement from the P&L and balance sheet for you.
The main advantage of the direct method is simplicity and speed. You don’t need to remember any complicated formulas or work out any complicated snares as you would with an indirect method.
The direct method is what you usually use for your own business. You create a detailed cash flow statement showing your income, expenses, cash balance and cash flow for each month. You then analyze the results to see if anything had changed or improved and try to forecast these values up to 12 months in the future.
Many accountants use the indirect method when they are analyzing a company because they have no direct knowledge of how every part of the business works. As such, the indirect method is somewhat easier to generate if you know how to transfer it from your accounting but gives little decision support and insight into which cash transactions hold the possible potential to keep more bucks at the end of the day.
How to calculate cash flows using the direct method
Calculating cash flows using the direct method involves adding up all of the cash inflows and cash outflows of your business as they happened — independent from accounting recognition.
This can be done for any period of time — past or present — not just a single month. It includes any income and any expenses, including non-P&L items that hit the bank account in this period. Using this method, you can determine how much money you made in any given period and also how much is left over each month after paying off any debt.
To get started, collect all your bank statements for a period and start allocating the transactions to an expense or income category from your cash flow statement. On average, finance managers split the income and expenses across 20–30 categories. They monitor these categories to determine ways to reduce cash outflows and forecast those categories’ cash flows, usually, by 12 months.
The direct cash flow method is used by finance managers to track the flow of cash from one place to another without incorporating any accounting or other hocus-pocus. It is also known as a straight cash method because it does not require accounting records to complete the transaction.
We have created a template for you here, so you don’t have to care about finding the right logic, structure, or categories: The one template you need for your cash flow is — Cash Flow Template.
How to calculate cash flows using the indirect method
The indirect method of calculating cash flows is helpful when doing any kind of balance sheet activity because the information gives you an idea of what your cash generation and cash outflows look like without having to calculate them from the bottom up. Instead, you calculate your cash flows based on your P&L and balance sheet data of the previous month.
The indirect method is more efficient when your accountant maintains records and generates the indirect cash flow statement for you. However, the indirect method is also quite error-prone if not calculated correctly. In the end, it needs some accounting expertise after all. To calculate your cash flows with the indirect method, we have set up a template for you: The one template you need for your cash flow is — Cash Flow Template.
Which method should you use: Direct cash flow method or indirect cash flow method
As with any finance concept, there are good and bad ways to approach it. Always treat your cash flow statements as educated guesses rather than gospel. Don’t be satisfied with your guess until it matches up with your expectations. The most common mistake people make with regard to building a cash flow statement is waiting until they have everything in place before beginning the process.
A decent tool to get started tracking cash flow is a spreadsheet. You can use free software such as MS Excel or Google Sheets to calculate your direct cash flow statements. However, that will come at the cost of little guidance and high error probability. If you decide on that option, we have prepared templates for you to make this effort easier for you: The one template you need for your cash flow is — Cash Flow Template.
Using a cash flow management tool
The better alternative, however, is using a free cash flow management tool such as Airbank. Airbank is a unified business banking solution that marries your bank statements to generate your cash flow statements automatically. That way you don’t have to go through the messy process of transferring and categorizing all your transactions yourself.
Airbank allows you to connect your bank accounts, which auto-categorises all your historic transactions. In addition, you can also initiate new payments and have them categorised for your cash flow statements from the get-go as well. Airbank then produces your direct cash flow statement for you in real-time and even lets you input your cash flow forecast numbers in the spreadsheet based on your planned billings. To make your cash flow calculations error-proof, try Airbank for free today.