Definition: The direct method is a way to present and prepare the statement of cash flows by listing the operation cash receipts and payments in the cash from operations section. In other words, the direct method calculates the net cash operating activities by subtracting the total operating cash payments from the total cash receipts.
What Does Direct Method Mean?
This method is called the direct method because it calculates the net cash flows from operations in a much more straightforward fashion than the indirect method. The direct method uses a simple income statement style approach by adding up the income and subtracting the expenses. This is a pretty common sense way to present this section.
The indirect method, on the other hand, starts with the net income from the income statement and adds back all of the non-cash activities to arrive at the ending net cash from operating activities. As you can see, this is a little more of a round about way of calculating the same number.
Both methods will arrive at the same number, but they are presented differently. The direct method actually lists the major cash receipts and payments on the statement of cash flows. For example, cash receipts are often listed from customers, commissions, and tenants. Cash payments are usually broken out into several categories like payments for inventory, payroll, interest, rent, and taxes. Categorizing these inflows and outflows can be time consuming since they are not categorized like this on any other financial statement.
This is why the indirect method is a much more popular presentation of the cash flows statement. These categories aren’t necessary since the indirect method can be calculated from the balance sheet. Although the direct method does give external users more information about how the company is receiving and spending cash it is more time consuming and cumbersome to create.