There are two methods of calculating cash flow: the direct method and the indirect method.
Direct Cash Flow Method
The direct method adds up all of the various types of cash payments and receipts, including cash paid to suppliers, cash receipts from customers, and cash paid out in salaries. This method of CFS is easier for very small businesses that use the cash basis accounting method. These figures can also be calculated by using the beginning and ending balances of a variety of asset and liability accounts and examining the net decrease or increase in the accounts. It is presented in a straightforward manner.
Indirect Cash Flow Method
Most companies use the accrual basis accounting method, where revenue is recognized when it is earned rather than when it is received. This causes a disconnect between net income and actual cash flow because not all transactions in net income on the income statement involve actual cash items. Therefore, certain items must be reevaluated when calculating cash flow from operations.
With the indirect method, cash flow is calculated by adjusting net income by adding or subtracting differences resulting from non-cash transactions. Non-cash items show up in the changes to a company’s assets and liabilities on the balance sheet from one period to the next. Therefore, a company’s accountant will identify the increases and decreases to asset and liability accounts that need to be added back to or removed from the net income figure, in order to identify an accurate cash inflow or outflow.