The main source of funds for the enterprise is the proceeds from the sale of products/services and profits. The absolute value of these indicators, as well as their dynamics for the reporting period, characterize the efficiency of the enterprise.
Revenue means the accounting income from the ordinary and other types of activities of the enterprise for the reporting period. Profit refers to the difference between accounting income and costs associated with the production and sale of products. However, profit does not reflect the actual availability of funds available for spending.
At the same time, the entity needs not only to have free funds to pay off current liabilities, but also to keep records of their actual receipt and expenditure. Free funds are the most limited resource, and the financial condition of a business largely depends on their availability in sufficient volume and effective use.
To analyze the solvency of an organization, it is important to study and predict the flow of funds, to identify how the money came into the business and the main directions of their spending. A Cash flow statement provides users with information about an organization’s cash flows, reflecting the sources of cash flows and the directions of their use.
In the process of analyzing cash flows, it is possible to find out the reasons for changes in the inflow and outflow of funds. Effectively organized cash flows are the most important indicator of its financial health, a prerequisite for ensuring sustainable growth and achieving high final results of its financial and economic activities in general.
Such a significant impact of cash on the organization’s life explains the existence of a certain interest in information about its movement, which is a continuous process and is defined by the concept of cash flow. There are two methodologies for reporting the movement of cash within the organization: direct and indirect.
Although these two methods are more similar than dissimilar because the goal for both is exactly the same, we are going to point out the differences in direct vs indirect cash flow reports.
Advantages and Disadvantages
When comparing direct vs indirect cash flow, it is useful to look at the advantages and shortcomings of each method. The direct approach to reporting allows to:
- identify the main sources of inflow and directions of cash outflow
- establish the relationship between money received from sales and actual cash
- present the budget in a visual and understandable form for a non-financier
- use simple methods of budget control.
The downside is that it does not reveal the relationship between the expected profit and changes in cash flows. The advantages of the alternative method:
- Shows the sources of the formation of the company’s profit and the direction of investment of actual cash
- Allows identifying problem areas (accumulations of frozen funds) in the activities of the organization, as well as the reasons for the lack of funds.
This method also has its shortcomings. These include a labor-intensive budgeting process and the form of information presentation is not always clear for a non-financier.
There is one important aspect to note: cash flows obtained using both methods are equivalent. Thus, each method has its own advantages and disadvantages. The best option for generating cash flow is a combination of two methods.