Ok accounting people, you may have heard that when doing a cash flow statement, there are multiple methodologies that can be used to come up with the actual total cash flow change in the period. When building this logic in a 3 statement model in Excel, with formulas, this consideration is relevant and important. I'll talk about what method I use in every single model you see on this site.
I use the Direct Method for all of these financial modeling templates. I think it is easier that way, rather than starting with net income and then adjusting that accordingly.
I would note that preparing financial statements of actuals is different than building pro forma financial statements that are based on assumptions rather than actual transactions.
The final cash flow change in the period will be the same no matter which method is used, but I've chosen the direct method so there is no need to add back things on the income statement that are non-cash or belong in activities from investing such as the profit from the sale of a building hitting net income. With the direct method, you still see many add-backs and adjustments that still have to happen on the cash flow statement (like zeroing out cogs inventory expenses and then adding in the actual inventory purchases based on payment terms). All of those things will depend on the exact type of business the model is for, but I felt the direct method was a better approach in general.
The cash flow statement, one of the core financial statements, reports the cash generated and used by a company during a specific period. It is crucial for assessing the liquidity, flexibility, and overall financial performance of an entity. There are two methodologies for preparing the cash flow statement: the direct method and the indirect method. Both approaches aim to provide the same end result, which is an understanding of cash inflows and outflows, but they differ significantly in their presentation and preparation processes.
Direct Method
- Presentation: The direct method lists the major categories of gross cash receipts and payments. This includes cash collected from customers, cash paid to suppliers, cash paid for salaries, etc. Essentially, it presents the operating cash flows by reporting the cash transactions as they occur.
- Preparation: To prepare a cash flow statement using the direct method, a company must adjust its income statement from the accrual basis to the cash basis of accounting. This involves identifying the cash received from customers by adjusting sales revenue and other operating cash receipts, and cash paid to suppliers and employees by adjusting cost of goods sold and other operating expenses. One model that does this well is the made-to-order manufacturing template. In it, you have a selector for accrual basis or cash basis and you can see how the cash flow statement and income statement change based on that. Normally, in most of the startup 3 statement model Excel templates I build, the assumption is that everything is in cash basis, however if the income statement is pulling non-cash items or showing items when they are earned rather than when the cash is actually collected, I will have all the adjustments that need to happen on the cash flow statement (dealing with receivables / payables mostly).
- Advantage: Provides more useful information to stakeholders by showing exactly how cash is being received and spent by the business.
- Disadvantage: More labor-intensive to prepare since it requires a detailed analysis of the company’s transactions.
Indirect Method
- Presentation: The indirect method starts with net income (from the accrual basis income statement) and adjusts for changes in balance sheet accounts to arrive at cash provided by operating activities. This includes adjustments for non-cash transactions (such as depreciation and amortization), changes in working capital items (like receivables, inventories, payables), and sometimes non-operating gains and losses (like selling real estate).
- Preparation: It is generally easier to prepare compared to the direct method because it builds upon the existing accrual-based income statement. Companies adjust net income for the effects of accrual accounting to reflect the cash transactions.
- Advantage: Easier to prepare using information that companies already collect and report under the accrual basis of accounting. It helps in reconciling net income with the cash generated from operating activities.
- Disadvantage: Provides less detailed insight into the specific cash flows from operating activities, making it less useful for understanding exactly how and where cash is generated and spent in operations.
Regulatory Preference
Many accounting standards (such as GAAP in the United States) allow both methods but express a preference for the direct method while also requiring a reconciliation of net income to net cash provided by operating activities (which essentially requires an indirect method presentation as well).
IFRS (International Financial Reporting Standards) also permits both methods but does not express a preference for one over the other.
Despite these differences, both methods arrive at the same total figures for net cash provided by (or used in) operating, investing, and financing activities. The choice between methods often comes down to the level of detail a company wishes to provide and the resources it has available for financial statement preparation.
If you want to get down into the nitty gritty, I did build a financial statement generator template that works for both accrual or cash basis and for that I did use something closer to the indirect method. It runs off a transaction log and produces monthly/quarterly/annual Income Statement, Balance Sheet, and Cash Flow Statement.
You may also find these accounting tools useful.
Article found in Accounting and Finance.
