Direct vs. indirect cash flow: key differences and how to choose

In my work with FP&A teams across various industries, the question of whether they should use direct or indirect cash flow often starts with the question of which method is better. What they usually want to know is which method best fits their current infrastructure. And that’s a good way to look at it. 

Choosing the right method is important because it will impact your financial reporting as well as how you do cash flow forecasting and analysis. 

In this guide, I’ll explain both methods, explain their key differences, and show you some side-by-side examples to give you a clear framework for deciding which approach fits where you’re at right now.

What is a cash flow statement?

The cash flow statement is one of the three primary financial statements, along with the P&L (aka income statement) and balance sheet, which are collectively known as the three-statement model. The other two statements in the model are the profit and loss (P&L) statement and the balance sheet. 

The figure below shows how the cash flow statement connects to the other financial statements.

The cash flow statement provides a clear picture of the company's liquidity and ability to meet its financial obligations. It tracks all the cash coming in and going out of the business for both operating and non-operating activities, like investing and financing. Non-cash items such as depreciation and amortization appear as adjustments in the operating section under the indirect method because they affect net income but not cash.

The three components of cash flow 

Cash flow statements include three key categories.

Of the three, operational cash flow (OCF) plays a far more significant role in determining a company's financial stability than investing and financing cash flows because it measures the primary source of cash generation in the business. 

There’s only one method for calculating investing cash flow (ICF) and only one for financing cash flow (FCF). But there are two for tracking cash flow resulting from operational activities—direct cash flow vs. indirect cash flow. 

Why two? 

Because OCF is tied to accrual accounting (revenue and expenses that can be recognized before or after the cash actually moves). This makes tracking it a lot more complicated than cash flows from investing and financing activities, which typically involve a single, point-in-time transaction. 

What is the direct cash flow method?

The direct cash flow method starts at the account level and involves listing all the operating transactions (cash receipts and payments) during the period. 

It includes cash received from customers or paid to suppliers against invoices, employees against salaries, and all other transactions related to operating activities. 

How to use the direct cash flow method to determine operating cash flow

1. Calculate the cash received from customers

Add up all the cash that the business actually received from customers. If you have a report of actual customer payments from your accounting system, you can use that. 

If you’re working with financial statements, plug the revenue shown on the P&L and the beginning and ending AR shown on the balance sheet into the following formula: 

Cash received from customers = Revenue + Beginning AR - Ending AR

Step 2. Calculate cash paid to suppliers

This step applies mainly to businesses that buy inventory or direct inputs (e.g., retailers and manufacturers). If your business doesn’t hold inventory, you can skip this step. You’ll capture the cash paid for purchases in “other operating expenses” (Step 5).

The information you need to calculate cash paid to suppliers will come from the P&L, your inventory records, and the balance sheet. AP records will come in handy if you want transaction-level detail or need to verify the numbers.

First, use the following formula to calculate the purchases made during the period: 

Purchases = COGS + ending inventory - beginning inventory

This formula adjusts the COGS for the total inventory purchases made during the period. Since all those purchases may not have been paid for during the period, you next need the information from the balance sheet to calculate the cash actually paid to suppliers for the period:

Cash paid to suppliers = Purchases + Beginning AP - Ending AP

Step 3. Calculate cash paid to employees

This step captures cash paid for employee-related costs during the period, including wages, salaries, and other employee-related costs.

The information you need to calculate this comes from payroll records, the P&L, the balance sheet, and payment records. If you want transaction-level detail or need to verify the numbers, you can use payroll reports from your accounting system.

One way to calculate this is to add up all the cash paid to employees during the period using your payroll payment records.

If you’re working from financial statements, start with the related payroll expenses on the P&L. Then adjust for any payroll-related amounts still owed at the start and end of the period shown on the balance sheet.

Cash paid to employees = Payroll expenses + Beginning amounts owed to employees − Ending amounts owed to employees

If you’re combining several employee-related expense categories, you can apply this logic to each major category.

Step 4. Calculate cash paid for other operating expenses 

This step captures other operating cash payments, such as rent, software, utilities, insurance, office costs, and payments to service providers.

One way to calculate cash paid for these expenses is to simply use payment records from your accounting system and add them up. 

If you’re working from financial statements, you need the P&L and balance sheet. You can also use expense records or AP records if you want transaction-level detail or need to verify the numbers.

Start with the related expenses on the P&L, then adjust for any related amounts paid ahead of time or accrued expenses shown on the balance sheet. These changes reflect amounts still owed or paid ahead of time: 

Cash paid = Category expenses, adjusted for related balance sheet changes 

If you’re combining several expense categories, you can apply this logic to each major category. 

Step 5. Calculate other operating cash receipts

For most businesses, most of the cash flowing in comes from customer payments. Other cash inflows in this section can include things like commissions, royalties, fees, refunds, and other operating receipts.

One approach is to use cash receipts records to total the cash received directly. 

Alternatively, you can use financial statements. The information you need comes from the P&L, the balance sheet, and bank records. If you want transaction-level detail or need to verify the numbers, you can also use cash receipts reports from your accounting system or ledger detail. 

If you’re working from financial statements, here’s the basic formula for a single category.

Cash received = Category income, adjusted for related balance sheet changes 

With this approach, you start with the related income line on the P&L, then adjust for any related receivables or deferred income shown on the balance sheet. The balance sheet changes in the formula reflect amounts not yet collected or cash received before the income is recorded. 

If you’re combining several income categories, apply this logic to each major category. 

Step 6. Calculate the net cash flow from operating activities

The last step is to add up all operating cash received from customers and other operating income related to normal business operations, then subtract all operating cash payments for the period. The result is your net cash flow from operating activities: 

‍Net cash flow from operating activities = Total operating cash receipts − Total operating cash payments

Key things to remember when using the direct method

The direct method tracks when cash is actually received or paid, while the P&L tracks when revenue and expenses are recorded. 

Because of that timing difference, it’s important to remember that amounts shown on the P&L do not always match operating cash flow line items. 

This is why direct-method calculations often require balance sheet information, such as accounts receivable, accounts payable, inventory, and other accrued or prepaid balances. 

Depending on your reporting framework, the direct method also requires a separate reconciliation from net income to net cash from operating activities.

Advantages and disadvantages of the direct cash flow method

The direct method builds operating cash flow from actual cash collected and paid. It’s a highly detailed approach that offers some important advantages, but those come at a cost. 

‍Advantages

• Provides a detailed view into day-to-day cash movements
• Easier for non-accountants to understand
• Can be very useful for cash planning and management
  

Disadvantages

• Requires gathering all transactional data, often from multiple systems
• Can be complex, sometimes requiring a separate reconciliation to net income
• Can be time-consuming, especially for businesses with a high volume of transactions

What is the indirect cash flow method?

The indirect cash flow method starts with the net income from the P&L statement and adjusts for all non-cash transactions plus any changes in balance sheet items. Non-cash transactions might include depreciation, changes in working capital, deferred taxes, and any stock-based compensation to shareholders.

How to use the indirect cash flow method to determine operating cash flow

Step 1. Start with net income 

The indirect method starts with the net income shown on the P&L. This makes calculating operating cash flow easier, but it can also be less intuitive because it doesn’t calculate each cash inflow and outflow separately. Instead, it adjusts net income to show the cash generated or used by operations during the period.

Step 2. Add back non-cash expenses

Non-cash expenses reduce net income without using cash during the period. The most common examples are depreciation and amortization. 

The information you need for this step will come from the P&L and any supporting schedules, such as fixed asset or amortization schedules.

Step 3. Remove non-operating gains and losses

The net income on the P&L includes non-operating gains and losses resulting from investing and financing activities. Common examples include gains or losses from the sale of equipment or other assets. 

These activities aren’t considered part of normal business operations. They’re covered in other sections on the cash flow statement. So, you need to adjust the net income on the P&L accordingly: 

• Gains need to be subtracted. 
• Losses need to be added back.

The information you need for this step comes from the P&L and, if needed, fixed asset schedules, records of equipment sales, general ledger detail, and journal entries showing gains and losses that don’t belong in operating activities.

Step 4. Adjust for changes in working capital

With the indirect method, you also need to adjust for timing differences between when revenue and expenses were recorded and when the related cash was actually collected or paid.

The information you need for this step comes from the balance sheet. The most common items are accounts receivable, inventory, accounts payable, accrued expenses, and amounts paid ahead of time. 

To figure out what adjustments are needed, compare the current asset and liability balances on the beginning balance sheet with those on the ending balance sheet. The adjustments shown in the table below convert net income from accounting timing to cash timing:

If…	Then…	Why
Accounts receivable increased	Subtract the difference	Reflects new sales but cash hasn’t been collected yet
Accounts receivable decreased	Add the difference	Reflects cash collected for past sales
Inventory increased	Subtract the difference	The business bought more inventory than it used/sold
Inventory decreased	Add the difference	The business used/sold more inventory than it bought
Accounts payable increased	Add the difference	Reflects new expenses that haven’t been paid yet
Accounts payable decreased	Subtract the difference	Reflects payments on bills for prior expenses

How to determine the adjustments needed for working capital.

Step 5. Calculate the net cash flow from operating activities

Once you’ve adjusted net income for non-cash items, non-operating items, and working capital changes, the end result is your net cash flow from operating activities.

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Advantages and disadvantages of the indirect cash flow method

The indirect method builds operating cash flow by adjusting net income for non-cash items and timing differences. In comparison to the direct method, this approach has some distinct advantages, but it also has some drawbacks.

Advantages

• Easier and faster to prepare because it doesn’t require as much transaction data 
• Uses information companies already have in their financial statements 
• A straightforward approach to understanding overall cash flow
• Shows how net income is adjusted to arrive at operating cash flow
• Easier to see how non-cash items and working capital changes affect operating cash flow

Disadvantages

• Less intuitive because it starts with profit, not cash
• Can be harder for non-accountants to follow
• Less useful for understanding where cash actually came from and went