Business owners and company managers are required to conduct financial analyses of a company's performance, as part of their leadership responsibilities with an organization. Anyone who has run a small business knows that cash flows are the lifeblood of any for-profit venture.
Having cash on hand is critical to keep your operations moving and bills paid. But managing that cash effectively also presents firms the opportunity to invest in your business to grow it.
A big part of a business owner or manager's role calls for them to understand and account for cash flows. Specifically, they must understand the difference between a statement of cash flows or the indirect method of accounting for operating activities, and a cash-flow statement or the direct method, according to the Financial Accounting Standards Board (FASB).
There are several differences between the two. The first among them is that a majority of corporations prefer to use the indirect method. Most companies find that the indirect method uses readily available information about financial performance, which is easier to work with. For example, companies adjust net income to convert it from accrual to a cash basis by adding back non-cash expenses like depreciation, amortization and a loss on the sale of a fixed asset.
Using the cash-flow statement or direct method, cash receipts and cash disbursements related to the operating activities are reported directly and separately. The direct method “calculates operating cash flow as a product of actual cash flow in and out,” according to Tim Reason, author and Deputy Editor & Director at Bain & Company.
While the indirect method is the most widely used by companies, several scholars, such as Charles Mulford, a professor and the Director of the Financial Reporting & Analysis Lab at Georgia Institute of Technology and Donald Nicolaisen, the former Chief Accountant of the Securities and Exchange Commission believe that using the direct method of creating cash-flow statements improves financial disclosures of companies.
Net operating cash flow (NOCF) is estimated when using the statement of cash flows according to the FASB Standards No. 95 indirect method. It takes earnings after tax and adjusts them for noncash items that aren’t related to a firm’s operating activities. It also requires firms to include interest expense, which is considered a financing activity when using the direct method.
Check out some ways to improve your business' cash flow:
Send out invoices immediately after receipt of goods or services
Change your payment terms from 60 to 30 days
Consider using your business credit card to pay suppliers and make purchases
Opening a high-interest business savings account
“The relevant measure of cash flow is generated by operations is net operating cash flow," according to Gabriel Hawawini and Claude Viallet the authors of the book Finance for Executives: Managing for Value Creation. "It is the net cash flow generated by running the business, not by selling some of its assets or borrowing from banks."
The difference between the net cash flow from operating activities using the indirect method, and the net operating cash flow used in the direct method is the calculating of net interest expense.
The most relevant financial analysis is the direct method for a number of reasons. First, each of the three business activities – operating, investing and financing – are treated separately. Second, the most relevant measure of the cash flow generated by operations is net operating cash flow (NOCF).