Keeping in control of your cashflow is a fundamental part of running a successful business. With careful management of your finances, you can keep the company in a positive cash flow position and improve the overall liquidity of your capital.
But when it comes to measuring your cashflow, there are two distinct approaches for how your figures can be calculated – the direct cashflow and indirect cashflow models.
So which is best: direct or indirect? We run you through the key differences between the two methodologies and explain why a direct approach to cashflow will generally come out on top.
Direct cashflow – how it works
Let’s start by defining and explaining the direct method for cashflow.
The direct method works by basing your cashflow calculations on the company’s cash receipts (money coming in) and disbursements (money being paid out).
Cashflow is recorded in your operating activities section, based on actual cash you’ve received or paid during the period. So rather than being recorded on an accrual basis on your balance sheet – i.e. when the sales invoice is first raised, for example – it’s recorded when the payment is received (or when you actually pay a supplier’s invoice).
As such, the direct cashflow method is a very accurate line-by-line measure of transactions that shows when genuine cash comes into the business, and when cash goes out. The advantage is that your cashflow management becomes more accurate by ignoring non-cash transactions.
Indirect cashflow – the key differences
So if the direct method is so accurate, why would you use the indirect method?
Generally speaking, the indirect method is easier to use. In fact, it’s the only feasible way of producing a cashflow forecast manually – it’s too difficult to model any volume transactions by hand, so in the past most finance people have relied on the indirect method.
Because you’re using information that’s already recorded in the company’s income statement and balance sheet, you already have the basic financial data that’s needed. To convert these number into an indirect view of cashflow, you simply adjust your net income to convert it from an accrual to a cash basis:
- Non-cash transactions (e.g. depreciation, losses or bad debts) are added back in
- You adjust the balances of your current assets (excluding cash) and current liabilities between the start and end of the period in question.
Why direct cashflow is better for your business
Traditionally, many businesses have preferred using the indirect cashflow method because it uses numbers that are freely available in other existing financial reports – so it’s quicker and easier to manage than the direct approach.
But the indirect model is also inferior in some key ways, including the fact that:
- You must add back in your non-cash expenses
- Your view of cashflow receipts and payments is less accurate
- In comparison to the direct method, indirect cashflow lacks transparency.
With the level of data and drilled-down financial information that’s now available with modern cloud accounting and cashflow tools such as Fluidly, there’s real value to opting for the direct approach, and using the power of cloud computing.
Cloud accounting brings unparalleled data access and computational power to your financial processes – so the vast calculations needed to produce a cashflow forecast using the direct method can now can be done with ease.
Cloud solutions bring high-level, sophisticated forecasting, that was previously only available to corporate-level treasury departments, and makes accurate forecasts accessible and understandable for smaller businesses and entrepreneurs.
Direct cashflow – a more accurate view of your cash position
Use of the direct cashflow model is encouraged by the IAS (International Accounting Standard) because it provides a greater level of accuracy, and therefore more reliable cashflow forecasts.
Fewer assumption need to be made, and your cashflow statement can be based on hard empirical data – meaning your cashflow position is more accurate, more predictable and a sounder foundation for making important business decisions and financial planning.