Introduction
There are two ways to present the operating section of a cash flow statement, and they always produce the same answer. The direct method lists the cash that actually came in and went out: collected from customers, paid to suppliers, paid to employees, paid in interest and taxes. The indirect method starts from net income and adjusts it for everything that was not cash. One reads like a bank statement; the other reads like a reconciliation. Almost every US public company chooses the second.
The choice affects how easy the statement is to read, not what it says. Knowing both helps a banker translate between them, which is useful when building a cash forecast for a business whose management thinks in receipts and payments, or when a target's internal reporting uses one format and its audited statements use the other.
The Same Cash Flow, Two Presentations
Consider a company with $1,000 of revenue, $600 of cost of goods sold, $200 of other operating expenses excluding depreciation and $85 of net income. During the year its receivables rose by $50, inventory by $30, payables by $20, accrued expenses by $10 and taxes payable by $5; it recorded $50 of depreciation, paid all of its $20 of interest, and recognized $45 of tax expense. Under the direct method, operating cash flow is built from the cash itself:
| Line item | Year |
|---|---|
| Cash collected from customers | 950 |
| Cash paid to suppliers | (610) |
| Cash paid for operating expenses | (190) |
| Interest paid | (20) |
| Income taxes paid | (40) |
| Net cash from operating activities | 90 |
Customer collections are revenue of 1,000 less the 50 increase in receivables. Supplier payments are cost of goods sold of 600 plus the 30 inventory increase less the 20 payables increase. Operating expense payments are 200 less the 10 accrued expenses increase; taxes paid are 45 less the 5 taxes payable increase.
The indirect method reaches the same $90 from the other direction: $85 of net income, plus $50 of depreciation, less the $50 increase in receivables and $30 increase in inventory, plus the $20 increase in payables, $10 in accrued expenses and $5 in taxes payable. The two presentations are arithmetic mirrors. The direct method shows the size of each cash stream; the indirect method shows why the cash differs from the profit. The indirect reconciliation is walked through in detail in cash flow from operations: the indirect method.
- Direct method
A presentation of cash flow from operating activities that reports major classes of gross cash receipts and payments, such as cash collected from customers and cash paid to suppliers, employees, lenders and tax authorities, rather than adjusting net income.
Why Almost Everyone Uses the Indirect Method
US generally accepted accounting principles (US GAAP) prefer the direct method in principle. Deloitte's roadmap on the form and content of the statement of cash flows explains that Accounting Standards Codification (ASC) 230 encourages entities to report major classes of gross operating receipts and payments, but that a reconciliation of net income to operating cash flow must be presented regardless of the method chosen. A company using the direct method therefore has to produce both, while a company using the indirect method produces only one.
The practical reasons follow from that. Accounting systems are built around the general ledger, which records revenue and expenses on an accrual basis, so deriving gross cash receipts and payments by category requires extra work. Analyst models have long been built around the indirect format, even though investor groups have pushed for direct-method figures, as the CFA Institute's letter on improving the statement of cash flows shows. And the reconciliation itself carries information that a list of receipts and payments does not show on its own: how much of earnings came from non-cash items and how much was absorbed by working capital. The result is that the direct method is rare in US annual reports, though receipts-and-payments reporting remains common inside corporate treasury teams.
When the Direct View Is Useful to Bankers
Even though published statements use the indirect method, the direct view is the natural format for short-term cash forecasting. A thirteen-week cash flow forecast, standard in restructurings and liquidity crises, lists expected receipts from customers and payments to suppliers, payroll, rent, interest and taxes week by week, because that is how management and lenders monitor whether a company can meet its obligations. Bankers advising a stressed company, or lenders monitoring a covenant, work in that format and then reconcile it back to accrual earnings. Restructuring teams build that forecast line by line, as described in the 13-week cash flow model restructuring bankers rely on.
Whichever format a company uses, the total operating cash flow is the same and ties to the rest of the cash flow statement, as explained in how the cash flow statement works. The choice of method changes the story the operating section tells, not the cash it reports.
