In order to manage your finances and to protect your business, understanding cash flow is essential. Cash flow is the money that comes into your business and the money that goes out. There are two methods to calculate your businesses cash flow: direct and indirect. If you are a business owner, you likely use both direct and indirect cash flow to report your net income and to make informed decisions about your business.
What Is Direct Cash Flow?
Direct cash flow is the money that flows directly into and out of your business. This includes revenue, expenditures, or payments made in the normal course of doing business. Direct cash flow considers cash payments and receipts, while direct expenses include payments such as payroll costs and rent. Additionally, it is important to note that the direct cash flow method does not begin its calculations from the net income of a company. Therefore, it calculates only what has been received after outgoings have been deducted, which is also referred to as the income statement method.
What Is Indirect Cash Flow?
Indirect cash flow refers to any expense that relates to a cost incurred in the past or a cost that could be incurred in the future. This includes long-term costs such as insurance or depreciation, as well as sales that are still in accounts receivable. Indirect cash flow takes the net income generated by the company within a period and adds or subtracts any changes in assets and liabilities accounts. This results in an implied cash flow, and this interaction is closely monitored by investors, creditors and other stakeholders. Using the indirect cash flow method in accounting involves reporting income for the period it was earned, rather than when the income was received.
A complex component that arises when utilizing the direct cash flow method is that the Financial Accounting Standards Board (FASB) requires the disclosure of the reconciliation of net income to the cash flow from operating activities. On the other hand, it would have been reported if the indirect method had been used instead to prepare the statement of cash flows (Investopedia, 2020).
These two types of cash flow serve different and important purposes. Direct cash flow represents the money that comes into your business and is used to operate day-to-day. Indirect cash flow, on the other hand, tells you about expenses that could be incurred in the future. By using both direct and indirect cash flow, you can estimate the financial health of your company and make decisions accordingly. At Petrucelli, Piotrowski & Co., Inc., we can help you utilize efficient financial planning strategies to enhance the recording of your expenses to ensure a clear overview of cash that flows in and cash that flows out of your business.