# Direct Method in Cash Flow

Managing cash flow is an essential part of running a successful business. It allows you to keep track of your incoming and outgoing cash and helps you make informed decisions. One method for calculating cash flow is the direct method. In this blog, we’ll explore what the direct method is, how it differs from the Indirect Method, and the pros and cons of using it.

## What is the direct method?

The direct method is a cash flow calculation method that shows the actual cash inflows and outflows of a business during a specific period. It’s a straightforward approach that involves recording all cash transactions, including receipts from customers, payments to suppliers, and operating expenses. The direct method is used to report cash flow from operating activities, which is a crucial component of the cash flow statement.

## Understanding direct vs indirect method cash flow

The indirect method is another cash flow calculation method that’s widely used. It calculates cash flow from operating activities by adjusting net income for non-cash items such as depreciation and amortization, changes in working capital, and other non-operating items. The main difference between the direct and indirect methods is how they calculate operating cash flow. While the direct method uses actual cash transactions, the indirect method starts with net income and makes adjustments.

## Direct method

Let’s take a closer look at the direct method. As mentioned earlier, the direct method involves recording all cash transactions. This includes cash receipts from customers, cash payments to suppliers, and operating expenses paid in cash. To calculate cash flow from operating activities using the direct method, you need to deduct cash payments from cash receipts.

### Direct method example

Here’s an example of how the direct method works:

Cash receipts from customers = \$100,000
Cash payments to suppliers = \$50,000
Operating expenses paid in cash = \$20,000

Cash flow from operating activities = \$100,000 – \$50,000 – \$20,000 = \$30,000

In this example, the business had a cash inflow of \$100,000 from customers, made cash outflows of \$50,000 to suppliers and \$20,000 for operating expenses, resulting in a net cash inflow of \$30,000.

## Indirect method

Now, let’s look at the indirect method. The indirect method starts with net income and makes adjustments to calculate operating cash flow. It adds back non-cash expenses such as depreciation and amortization and adjusts for changes in working capital, such as changes in accounts receivable and accounts payable.

### Indirect method example

Here’s an example of how the indirect method works:

Net income = \$80,000
Depreciation and amortization = \$10,000
Decrease in accounts receivable = \$5,000
Increase in accounts payable = \$2,000

Cash flow from operating activities = \$80,000 + \$10,000 + \$5,000 – \$2,000 = \$93,000

In this example, the business had net income of \$80,000, added back depreciation and amortization of \$10,000, and adjusted for a decrease in accounts receivable of \$5,000 and an increase in accounts payable of \$2,000, resulting in a net cash inflow of \$93,000.

## Pros and cons of using the cash flow direct method

The direct method has several advantages. It provides a clear picture of the actual cash inflows and outflows of a business. This can be helpful in identifying potential cash flow problems, managing cash balances, and making informed decisions. It’s also relatively easy to understand and calculate, making it a useful tool for small businesses with limited accounting resources.

However, the direct method also has some drawbacks. It can be time-consuming to track all cash transactions, and it may not provide enough information to identify the root causes of cash flow problems. Additionally, some businesses may find it challenging to separate cash flows from operating, investing, and financing activities.

## Deciding which method to use

Deciding which method to use depends on the specific needs and resources of your business. While the direct method provides a more accurate and detailed view of cash flow, the indirect method may be easier to use, particularly for businesses with more complex operations.

If you’re unsure which method to use, it’s always a good idea to consult with an accountant or financial advisor. They can help you evaluate your options and choose the method that’s best suited for your business.