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The main difference between the direct method and the indirect method involves the cash flows from
operating activities. There is no difference at all in how the cash flow from investing activities or financing
activities are calculated under both methods.
Operating Activities
Whether this calculated through the direct method or the indirect method, the total cash from operating
activities will be the same and the only difference is in the format in which it is presented.
The operating section starts with the net income that has been calculated under accrual basis accounting
and principles of matching and recognition. Therefore, this net income needs to be adjusted to remove
the non-cash items.
Non-cash items such as depreciation & amortization expense, gains and losses from disposal of fixed
assets, provisions for future losses, impairment expenses, deferred income taxes, etc. are added back to
the net income. This is because, these non-cash items have previously impacted income statement which
it would not have if the net income had been calculated on a cash basis from the beginning.
Next, the net income is also adjusted for changes in current asset, current liability and income tax
accounts appearing on the balance sheet. An increase in the current asset accounts including accounts
receivables, inventory, prepaid expenses, etc. will have a negative impact on cash flows and need to be
subtracted from the net income. An increase in the current liability accounts including accounts payable,
current portion of long-term debt, etc. will have a positive impact on cash flows and need to be added to
the net income.
Investing Activities
As suggested by the name itself, these include acquisition and disposal of any non-current assets or any
other investments. Understanding the nature of cash flows in this category is important for analysis of
financial statements. While a negative cash flow from operating activities is an indication of poor
performance by a company, a negative cash flow from investing activities could mean that the company
has made fixed long-term investments that will eventually help its long-term health.
Purchase of fixed assets such as property, plant and equipment (PP&E) – a negative cash flow
activity.
Investment in long-term securities like stocks or bonds – a negative cash flow activity.
Lending money to other individuals or institutions – a negative cash flow activity.
Sale of fixed assets such as property, plant and equipment (PP&E) – a positive cash flow activity.
Sale of investments – a positive cash flow activity.
Proceeds from loans or insurance claim payouts – a positive cash flow activity.
If balance sheets of two period are compared side by side and there is a difference in the values of its
non-current assets, then it means that there has been an investing activity with-in the period.
Financing Activities
These are activities that change the size of borrowings or equity for a company. Financing activities could
include the following: