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If both the direct cash flow method and the indirect method give you the same number in the end, why does the choice matter? It matters because the direct method shows you where the cash actually came from and where it went. The indirect method just reconciles your profit to your cash position. Same destination, different journey.
IAS 7 and ASC 230 (US GAAP) both allow the direct method, but most companies prefer presenting it the indirect way. Modern treasury software can pull the data automatically, which makes the direct method more practical than it used to be.
What is the statement of cash flows?
The cash flow statement sits alongside the income statement and balance sheet. It tracks cash entering and leaving your business through three channels: operating activities, investing activities, and financing activities.
The income statement measures profit on an accrual basis, which means it records revenue when earned rather than when cash arrives. The cash flow statement strips that away. Cash in. Cash out. That's it.
You can present the operating activities section using either the direct method or the indirect method. The investing and financing sections stay the same regardless.
What is the direct cash flow method?
The direct method is straightforward. It shows cash received from customers, cash paid to suppliers, salaries paid, taxes paid, interest paid. Real transactions. Instead of starting with profits and reverse-engineering your way to cash, you're watching the money move.
Direct cash flow example and formula
Formula: Net Cash Flow (Direct Method) = Cash Received from Customers – Cash Paid to Suppliers – Cash Paid for Operating Expenses – Cash Paid for Interest – Cash Paid for Taxes
Example: Say a business receives £50,000 in cash sales and £10,000 from collecting receivables. It pays £20,000 to suppliers and £15,000 in wages.
| Item | Amount |
| Cash received from customers | £60,000 |
| Cash paid to suppliers | (£20,000) |
| Cash paid for wages | (£15,000) |
| Net Cash Flow from Operating Activities | £25,000 |
You can see exactly where the money came from and where it went.
Benefits of the direct method
Clearer picture: It reveals precisely where funds originate and vanish, making it simpler for board members, investors and project managers.
Better short-term planning: Treasury teams gain useful information for daily or weekly cash flow predictions, helping to inform decisions about payment scheduling and prompt payment rebates.
Regulators prefer it: IAS 7 specifically promotes the direct method because it provides information useful for predicting future cash flow.
Disadvantages of the direct method
It is more work to prepare (historically): Tracking individual transactions takes documentation, especially for companies with high volumes.
Greater technological requirements: Most bookkeeping and accounting setups are based on accrual accounting. Getting direct payment flow data often requires workarounds or custom reports.
However, new treasury software tools that connect bank feeds, accounting systems, and payment platforms through APIs have reduced the manual burden. Platforms like Embat automate bank reconciliation and categorise transactions, which makes the direct method more feasible than it was five years ago.
What is the indirect cash flow method?
The indirect method starts with the earnings reported in the profit and loss account and adjusts them for non-cash expenses, changes in working capital, and gains or losses from investing or financing activities. The aim is to start with and convert accrual-based profits or losses into operating cash flow.
Common adjustments include reversing non-cash expenses such as depreciation charges, excluding non-operating items such as gains or losses on property sales, and adjusting for changes in working capital such as increases in accounts receivable or payable.
Indirect cash flow example
Formula: Net Cash Flow (Indirect Method) = Net Income + Depreciation + Provisions + Changes in Working Capital + Other Non-Cash Adjustments
Example:
| Item | Amount |
| Net Income | £150,000 |
| Add: Depreciation | £20,000 |
| Add: Increase in Trade Debtors | £5,000 |
| Less: Increase in Trade Debtors | (£8,000) |
| Add: Decrease in Inventory | £3,000 |
| Add: Other Adjustments | £6,000 |
| Net Cash Flow from Operating Activities | £176,000 |
Advantages of the indirect approach:
Ease and speed: The numbers for earnings, and working capital figures already exist in your books and ERP. There is no need to track individual receipts.
Requires fewer resources: Particularly important for large companies with complex transaction streams.
Links earnings to funds: Auditors and stakeholders can see why profit doesn't match cash flow, which is important for assessing earnings quality and other metrics.
Widespread acceptance: Listed firms typically use it, making comparisons easier.
Disadvantages of the indirect approach:
Less clarity: It does not reveal where money truly originates from. Non-accountants or non-finance people may find the adjustments confusing.
Limited understanding: It's more difficult to apply to everyday cash management or instant cash flow forecasting.
However, for big-picture planning, and long-term liquidity projections, the indirect technique often works well.
Understanding Direct vs Indirect Method Cash Flow: Key Differences
As already mentioned, both methods produce the same net cash flow from operations. The difference lies purely in how that number is presented in the operating section. Investing and financing sections are identical.
| Feature | Direct Method | Indirect Method |
| Starting Point | Actual cash transactions (receipts, payments) | Net Income (from Income Statement) |
| Data Source | Bank statements, APIs, real-time transaction feeds | Income Statement and Balance Sheet |
| How it is calculated | Cash received minus cash paid | Net income plus non-cash items, adjusted for working capital |
| Best for | Operational liquidity, short-term forecasting, spotting problems early | Year-end reporting, audits, long-term planning |
| Visibility | High. Shows exactly where cash moved | Medium. Shows reconciliation between profit and cash |
| Regulatory view | Allowed by both IAS 7 (IFRS) and ASC 230 (US GAAP) | Permitted and used by most public listed companies |
| Preparation complexity | High if manual; low with automation (Open Banking APIs) | Low. Uses existing accounting and ERP data. |
| Best suited for | Startups, retail, fast-growing companies, teams with automated treasury systems | Large multinationals, legacy systems, statutory reporting |
How to choose the right cash flow method
There's no one-size-fits-all answer. It depends on your situation.
- Company size: Smaller businesses often find the direct method manageable; larger corporates often prefer the indirect method's efficiency.
- Treasury priorities: If daily liquidity management is critical, the direct method may be valuable. If strategic planning dominates, the indirect method typically works well.
- Stakeholder expectations: Investors typically expect the indirect method for public reporting. Banks may appreciate the direct method's transparency.
- Technology maturity: If you have modern treasury systems with real-time bank connectivity and ERP integration, the direct method may become far more practical.
The IAS 7 and US GAAP oddity
Here's something worth noting: IAS 7 allows the direct method and ASC 230 in the US (US GAAP) says the same thing. And yet companies choose the indirect method to save time.
Looking ahead: The IASB has signalled a broader review of IAS 7. While IFRS 18 (effective from January 2027) will standardise the operating profit figure that can be used as a starting point for the indirect method, a more fundamental update to cash flow reporting is still under discussion.
