The direct and the indirect method for the statement of cash flows

Statement of cash flows is a critical part of financial reports, which are tools that help investors, creditors, and others to make informed decisions about a company. Understanding how a company manages its cash flow means you can better gauge how the business will perform in the future.

In this tutorial, we will look at the direct and indirect methods for calculating cash flows for companies. The direct method is used to calculate cash flows for a single year and the indirect method is used to calculate cash flows for a range of years. The direct method can be used for a single year of cash flows, but it does not give the true figure and it is not appropriate for cash flows for several years.

Home » Bookkeeping » The vertical balance sheet

Jul 29, 2020
Bookkeeping by Adam Hill

Seeing the horizontal analysis of every item allows you to more easily see the trends. It will be easy to detect that over the years the cost of goods sold has been increasing at a faster pace than the company’s net sales.

The amounts from five years earlier are presented as 100% or simply 100. The amounts from the most recent years will be divided by the base year amounts. For instance, if a most recent year amount was three times as large as the base year, the most recent year will be presented as 300. If the previous year’s amount was twice the amount of the base year, it will be presented as 200.

It can also be used to project the amounts of various line items into the future. To conduct a vertical analysis of balance sheet, the total of assets and the total of liabilities and stockholders’ equity are generally used as base figures. All individual assets (or groups of assets if condensed form balance sheet is used) are shown as a percentage of total assets.

Horizontal analysis is the comparison of historical financial information over a series of reporting periods, or of the ratios derived from this information. It is used to see if any numbers are unusually high or low in comparison to the information for bracketing periods, which may then trigger a detailed investigation of the reason for the difference.

The income statement also uses this presentation with revenue entries referencing total revenues and expense entries referencing total expenses. Vertical analysis makes it much easier to compare the financial statements of one company with another, and across industries. This is because one can see the relative proportions of account balances. ABC Company’s income statement and vertical analysis demonstrate the value of using common-sized financial statements to better understand the composition of a financial statement. It also shows how a vertical analysis can be very effective in understanding key trends over time.

From the balance sheet’s horizontal analysis you may see that inventory and accounts payable have been growing as a percentage of total assets. Horizontal analysis of financial statements can be performed on any of the item in the income statement, balance sheet and statement of cash flows. For example, this analysis can be performed on revenues, cost of sales, expenses, assets, cash, equity and liabilities. It can also be performed on ratios such as earnings per share (EPS), price earning ratio, dividend payout, and other similar ratio.

The current liabilities, long term debts and equities are shown as a percentage of the total liabilities and stockholders’ equity. To calculate the quick ratio, locate each of the formula components on a company’s balance sheet in the current assets and current liabilities sections.

The ratio tells creditors how much of the company’s short term debt can be met by selling all the company’s liquid assets at very short notice. Cash ratio(also calledcash asset ratio)isthe ratio of a company’s cash and cash equivalent assets to its total liabilities. Cash ratio is a refinement of quick ratio and indicates the extent to which readily available funds can pay off current liabilities.

Plug the corresponding balance into the equation and perform the calculation. The quick ratio measures the dollar amount of liquid assets available against the dollar amount of current liabilities of a company. The balance sheet uses this presentation on individual items like cash or a group of items like current assets. Cash is listed as an individual entry in the assets section with the total balance being listed on the left and its percentage of total assets being listed on the right.

Indeed, sometimes companies change the way they break down their business segments to make the horizontal analysis of growth and profitability trends more difficult to detect. Accurate analysis can be affected by one-off events and accounting charges. Horizontal analysis is used in financial statement analysis to compare historical data, such as ratios, or line items, over a number of accounting periods. Horizontal analysis of financial statements involves comparison of a financial ratio, a benchmark, or a line item over a number of accounting periods. Horizontal analysis allows the assessment of relative changes in different items over time.

Using horizontal analysis

Generally accepted accounting principles (GAAP) are based on consistency and comparability of financial statements. Consistency is the ability to accurately review one company’s financial statements over a period of time because accounting methods and applications remain constant.

The quick ratio is an indicator of a company’s short-term liquidity position and measures a company’s ability to meet its short-term obligations with its most liquid assets. Since it indicates the company’s ability to instantly use its near-cash assets (assets that can be converted quickly to cash) to pay down its current liabilities, it is also called the acid test ratio. An acid test is a quick test designed to produce instant results—hence, the name.

Example of Horizontal Analysis

Quick assets include those current assets that presumably can be quickly converted to cash at close to their book values. Quick ratio is viewed as a sign of a company’s financial strength or weakness; it gives information about a company’s short term liquidity.

Potential creditors use this ratio as a measure of a company’s liquidity and how easily it can service debt and cover short-term liabilities. The most basic definition of acid-test ratio is that, “it measures current (short term) liquidity and position of the company”. To do the analysis accountants weight current assets of the company against the current liabilities which result in the ratio that highlights the liquidity of the company.

It also indicates the behavior of revenues, expenses, and other line items of financial statements over the course of time. Horizontal analysis allows investors and analysts to see what has been driving a company’s financial performance over a number of years, as well as to spot trends and growth patterns such as seasonality. It enables analysts to assess relative changes in different line items over time, and project them into the future. A business may have a large amount of money as accounts receivable, which may bump up the quick ratio. This may include essential business expenses and accounts payable that need immediate payment.

Horizontal analysis of the income statement is usually in a two-year format, such as the one shown below, with a variance also shown that states the difference between the two years for each line item. An alternative format is to simply add as many years as will fit on the page, without showing a variance, so that you can see general changes by account over multiple years. A third format is to include a vertical analysis of each year in the report, so that each year shows expenses as a percentage of the total revenue in that year.

Comparability is the ability to review side-by-side two or more different companies’ financials. Horizontal analysis not only improves the review of a company’s consistency over time directly, but it also improves comparability of growth in a company to that of its competitors as well.

Implementing vertical analysis

Vertical analysis restates each amount in the income statement as a percentage of sales. This analysis gives the company a heads up if cost of goods sold or any other expense appears to be too high when compared to sales. Reviewing these comparisons allows management and accounting staff at the company to isolate the reasons and take action to fix the problem(s). Understanding horizontal and vertical analysis is essential for managerial accounting, because these types of analyses are useful to internal users of the financial statements (such as company management), as well as to external users. If analysis reveals any unexpected differences in income statement accounts, management and accounting staff at the company should isolate the reasons and take action to fix the problem(s).

Comparative retained earnings statement with horizontal analysis:

The most common use of vertical analysis is within a financial statement for a single reporting period, so that one can see the relative proportions of account balances. Vertical analysis is also useful for trend analysis, to see relative changes in accounts over time, such as on a comparative basis over a five-year period. For example, if the cost of goods sold has a history of being 40% of sales in each of the past four years, then a new percentage of 48% would be a cause for alarm. Horizontal analysis is used in financial statement analysis to compare historical data, such as ratios or line items, over a number of accounting periods. The quick ratio is ameasure of a company’s ability to meet its short-term obligations using its most liquid assets (near cash or quick assets).{“@context”:”https://schema.org”,”@type”:”FAQPage”,”mainEntity”:[{“@type”:”Question”,”name”:”What is the difference between the direct and indirect methods of the statement of cash flows?”,”acceptedAnswer”:{“@type”:”Answer”,”text”:” The direct method of the statement of cash flows provides the cash inflows and outflows of the company in a single statement. The indirect method of the statement of cash flows provides the cash inflows and outflows of the company in two separate statements.”}},{“@type”:”Question”,”name”:”What is the indirect method of statement of cash flows?”,”acceptedAnswer”:{“@type”:”Answer”,”text”:” The indirect method of statement of cash flows is a method of calculating cash flows from operating activities.”}},{“@type”:”Question”,”name”:”How do you do the direct method of cash flow statement?”,”acceptedAnswer”:{“@type”:”Answer”,”text”:” The direct method of cash flow statement is a cash flow statement that uses the direct method to calculate the net cash inflow from operating activities.”}}]}

Frequently Asked Questions

What is the difference between the direct and indirect methods of the statement of cash flows?

The direct method of the statement of cash flows provides the cash inflows and outflows of the company in a single statement. The indirect method of the statement of cash flows provides the cash inflows and outflows of the company in two separate statements.

What is the indirect method of statement of cash flows?

The indirect method of statement of cash flows is a method of calculating cash flows from operating activities.

How do you do the direct method of cash flow statement?

The direct method of cash flow statement is a cash flow statement that uses the direct method to calculate the net cash inflow from operating activities.