In this tightened credit market, it is critical for business owners to have a clear grasp of the financial standing of their business before applying for a business loan. One of the key ways to chart out this financial picture is by preparing a cash flow statement. However, the question arises: which method is the most suitable for its preparation, the direct or indirect approach?

A cash flow statement plays a crucial role in evaluating the financial performance of a business. It can be prepared using either the direct method or the indirect method. The indirect method, which relies on existing financial documentation, is generally favored by businesses and accountants due to its simplicity and widespread preference.

What is a Cash Flow Statement?

A cash flow statement (CFS) is a financial document that businesses use to measure incoming and outgoing cash and cash equivalents (CCE) over a set period of time. A cash flow statement is important for internal purposes, as it enables you to evaluate the financial health of your business and can help guide strategy. A CFS also serves an important purpose externally, like demonstrating your business’s ability to pay debts and expenses to potential investors or lenders. 

The components of a cash flow statement encompass various financial activities:

1. Operating activities: This includes cash inflows and outflows that are directly associated with a business's day-to-day operations. It involves the production, distribution, and sale of products or services.

2. Investing activities: These involve cash flows related to long-term assets and investments. Examples include loans granted, securities purchased, and capital expenditures for expanding or enhancing the business.

3. Financing activities: This category encompasses cash inflows and outflows associated with funding the business. It includes equity financing, dividend payments, and debt financing.

It is important to note that a cash flow statement differs from a profit and loss statement. While a profit and loss statement focuses on measuring profitability, a cash flow statement provides insights into the current financial state of the business. This distinction is crucial for lenders and investors, as it helps them understand both the potential profit and the actual cash flow situation of the business.

The Indirect Method: Unraveling the Mysteries of Cash Flow Statements

Have you ever wondered how businesses create cash flow statements? Enter the indirect method, a powerful tool that utilizes accrual accounting to paint a comprehensive picture of a company's financial health. By analyzing historical data rather than real-time finances, this method allows businesses to evaluate their cash flow by starting with net income and adjusting for additional income and expenses.

Pros of the Indirect Method

One of the key advantages of the indirect method is its simplicity. By leveraging existing financial documents, businesses can easily prepare cash flow statements without the need for income to be paid before accounting for it. This method is also widely embraced, as it aligns with the accrual accounting practices already in place for many businesses. Plus, it allows for the consideration of credit transactions and depreciating assets, providing a more complete financial snapshot.

Cons of the Indirect Method

While the indirect method offers valuable insights, it does have limitations. One of these limitations is its reliance on historical data, which means it may not accurately represent the current cash flow of a business. Additionally, cash flow statements, regardless of the method used, only show cash flow for a specific period of time. This lack of detail can hinder transparency when it comes to specific cash transactions and sources.

The indirect method of preparing cash flow statements is a powerful tool for businesses to evaluate their financial standing. By understanding its pros and cons, you can make informed decisions about which method best suits your business needs. Whether you choose the direct or indirect approach, the ultimate goal remains the same: gaining a comprehensive understanding of your business's cash flow to drive strategic decision-making.

Direct vs. Indirect Cash Flow Methods

When preparing cash flow statements, businesses have the option to use either the direct method or the indirect method. The direct method, which relies on cash accounting instead of accrual accounting, offers a more precise reflection of real-time cash flow. However, it is important to note that the resulting cash flow statement usually does not differ significantly from an indirect statement. Due to the added complexity involved in calculating each individual cash transaction, most businesses and accountants prefer the indirect method for preparing cash flow statements. The indirect method, which is based on accrual accounting and existing balance sheets and income statements, provides a simpler and more widely embraced approach.

Preparing a Cash Flow Statement Using the Indirect Method

The indirect method is a straightforward approach to creating a cash flow statement, making it suitable for businesses of all sizes. Whether you're a single business owner or managing a larger enterprise, the indirect method can provide valuable insights into your financial health. Utilizing accounting software, such as Lili's Accounting Software, can further simplify the process by automatically generating your cash flow statement as you categorize your income and expenses.

To help you navigate the preparation of a statement of cash flows using the indirect method, follow these step-by-step instructions:

1. Gather the Necessary Financial Documents

Begin by collecting the financial documents essential for calculating your cash flow. You'll need a balance sheet that outlines your assets and liabilities, as well as an income statement that details your expenses and revenue. These documents should pertain to the specific accounting period for which you're creating the cash flow statement.

For example, let's consider Sam, the owner of a local music store. To determine her cash flow using the indirect method, Sam collects her balance sheet and income statement from the previous year, which will serve as the foundation for her cash flow statement.

2. Record the Net Income

Referencing your income statement, record the net income for the relevant accounting period. This figure should appear as the first line of your cash flow statement, representing your initial income before factoring in operating, investing, and financing activities.

In Sam's case, she determines that her net income for the accounting period was $10,000, which she includes at the top of her cash flow statement.

3. Input and Calculate Operating Activities

On your cash flow statement, list both cash and non-cash income and expenses, totaling these adjustments as "net cash from operating activities." This category may encompass various activities, such as ordering supplies and managing inventory.

For instance, based on her balance sheet, Sam determines that her fixed assets depreciated by $500. Additionally, her accounts payable decreased by $20,000, while her accounts receivable and inventory increased by $25,000. By subtracting decreases and depreciations and adding asset increases, Sam determines her net cash from operating activities to be $14,500 in cash and cash equivalents (i.e., inventory).

4. Include Investing Activities

Next, itemize all cash gained or lost through investing activities. This can involve transactions related to the purchase and sale of stocks, securities, loans, or long-term assets. Summarize these items as "net cash from investing activities."

In Sam's case, although she didn't engage in stock trading, she did spend $100,000 on purchasing a property and furnishings when she opened her music store last year. This $100,000 represents Sam's net cash from investing activities.

5. Account for Financing Activities

Outline any cash collected from or paid towards financing activities, such as equities, dividends, and loans. Record the total amount as "net cash used in financing activities." Be sure to subtract any payments made towards outstanding debts before calculating the net cash figure.

For example, to establish her business, Sam took out a property loan of $80,000 for her storefront and a small business loan of $15,000 to cover expenses related to furnishings, inventory, and supplies. As she didn't begin making payments towards these loans in the first year of business, her net cash used in financing activities amounts to $95,000.

6. Calculate the Net Total

Combine the net cash from operating activities with the net cash from investing activities (subtracting any negative figures). Then, subtract the net cash used in financing activities to determine your net increase or decrease in cash, known as the net total.

Following this calculation, Sam adds her net income from operating activities ($14,500) and her net cash from investing activities ($100,000), and then subtracts her net cash used in financing activities ($95,000):

$14,500 + $100,000 - $95,000 = $19,500

7. Determine the Net Cash Flow

To obtain the net cash flow, add the net total to your net income. If the net income is a negative number, it will decrease the total. The resulting figure represents your final cash balance. A positive number indicates a healthy cash flow, while a negative number may signal an unsustainable cash flow.

In Sam's situation, she adds her net income from line 1 of her cash flow statement ($10,000) to the net total ($19,500):

$10,000 + $19,500 = $29,500 final cash balance

What if My Final Cash Balance is Negative?

If your cash flow statement reveals a negative final cash flow, it may be a red flag indicating that your business is facing financial challenges and should consider taking steps to reduce costs and improve cash management.

However, it's important to consider the context of the negative cash flow. If you have used the direct cash flow method, the negative balance could be a result of the timing of income and expenses during the accounting period. For example, if you have a substantial outstanding invoice from a customer that is not yet paid within the cash flow accounting period, but you still have to cover various bills during that same period, it could contribute to the temporary negative cash flow.

On the other hand, the indirect method takes into account future earnings such as inventory and other cash equivalents. Therefore, a negative cash flow may not accurately reflect the current state of your business's overall financial health.

Ultimately, understanding the reasons behind a negative cash flow and considering the specific circumstances of your business is crucial in determining the appropriate actions to take to improve your financial situation.