Business owners know that a company doesn't pay its bills with revenue, or even with profits. It pays them with cash, and in a company that uses accrual accounting, cash flow may be considerably different from reported revenue and expenses. That's why the cash flow statement is so important. Businesses have two methods for constructing a cash flow statement: direct and indirect.

Statement Basics

Cash flow statements explain how the company's cash balance changes between balance sheet dates. For example, if the balance sheet prepared on March 31 (the end of the second quarter) shows you have $10,000 in cash, and the balance sheet from June 30 (the end of the second quarter) shows $12,000 in cash, then the cash flow statement for the third quarter will explain where that $2,000 increase came from. Statements group cash flows in three categories: operating activities, investing activities and financing activities.

Direct Method

In theory, the direct method is the simpler of the two methods. To use it, you just add up all the cash flows in each of the categories. For operating cash flow, you'd add up all the cash received as revenue and all the cash paid out as expenses. Subtract cash going out from cash coming in, and that's operating cash flow. For investing cash flow, you'd add up the money spent to purchase long-term assets and the money received from selling such assets. Subtract money spent from money received to get investing cash flow. For financing cash flow, add up the cash the company took in from investors (including yourself) and lenders. Then add up the cash the company paid out to investors and to lenders. Subtract cash paid out from cash taken in to get financing cash flow.

Direct's Problem

The fact that the direct method is simpler doesn't necessarily mean it's easier. The more transactions your company handles, the more complicated and time-consuming it becomes to assemble a cash flow statement using the direct method. That's because each transaction has to be analyzed to see whether it involved an actual transfer of cash. In fact, the authors of the basic text "Financial Accounting for MBAs" report that more than 98 percent of corporations use the indirect method. In the indirect method, financing and investing cash flows are presented the same way as in the direct method, because a typical company has relatively few of these transactions. Operating cash flow, however, is handled much differently.

Indirect Method

When reporting operating cash flow using the indirect method, you start with your company's net income for the period – the profit from the month, quarter, year or whatever time frame is being examined. You then add or subtract balance sheet items that affected profit without affecting actual cash flow, or that affected cash flow without affecting profit. Depreciation is a typical example. Say your company reported a $20,000 depreciation expense during the period. Depreciation reduces your profit, but it's a non-cash expense. You didn't actually pay out $20,000 in cash during the period. Instead, you reported $20,000 worth of depreciation on an asset you already purchased. Therefore, when building your cash-flow statement, you would add back $20,000 to your reported net income for the period.

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