The Cash Flow Statement - Direct Method
The Cash Flow from Operations in the Cash Flow Statement represent Cash transactions that have to do with a company's core operations and is therefore an extremely important measure of the health of a Business.
There are two ways in which we calculate the Cash Flow From Operations.
They are -
1. The Direct Method and
2. The Indirect Method
An Introduction to the Direct Method
The Direct Method is the method preferred by the Financial Accounting Standards Board (FASB) because it gives deeper insights into the movement of Cash in a Business.
It does so by GROUPING Cash Transactions into major classes of cash receipts and cash payments.
These Grouped Transactions make the Cash Flow Statement much more detailed and user friendly.
The figure below illustrates the a Framework of the major groupings using the Direct Method.
A Framework of the Direct Method
CASH FLOW FROM OPERATING ACTIVITIES
GROUP 1:
Cash Received from Customers
Cash Paid to Suppliers
Cash Paid for Operating Expenses (Includes Research and Development)
GROUP 2:
Interest Received
Interest Paid
GROUP 3:
Income Tax Refund Received
Income Tax Refund Paid
GROUP 4:
Other Cash received (paid)
The Total of these give the net cash provided (used) in operating activities.
Caution
Obviously, the words GROUPED written above are not mentioned in the Cash Flow Statement and are for your understanding only.
An in depth look at Formulas of the Direct Method
Each segment in the groups mentioned above can be derived using a Formula.
The Formulas are summarized below.
Formulas of the Direct Method
CASH FLOW FROM OPERATING ACTIVITIES
GROUP 1:
Cash Received from Customers = Sales + Decrease (or - Increase) in Accounts Receivable.
Cash Paid to Suppliers = Cost of Goods Sold + Increase (or - Decrease) in Inventory + Decrease (or - Increase) in Accounts Payable
Cash Paid for Operating Expenses (Includes Research and Development) = Operating Expenses + Increase (or - decrease) in prepaid expenses + decrease (or - increase) in accrued liabilities.
GROUP 2:
Cash Interest = Interest Expense - increase (or + decrease) in interest payable + amortization of bond premium (or - discount).
GROUP 3:
Cash Payments for Income Taxes = Income Taxes + Decrease (or - increase) in Income Taxes Payable.
Income Tax Refund Paid
GROUP 4:
Other Cash received (paid)
The Total of these give the net cash provided (used) in operating activities.
Keep in mind that these formulas only work if accounts receivable is only used for credit sales and accounts payable is only used for credit account purchases.
Example of a Cash Flow Statement Direct Method
An example of a Cash Flow Statement Direct Method computed with the above formulas looks something like below.
SUPERPOWER INC. THE CASH FLOW STATEMENT FOR THE YEAR ENDED DEC 31, 20XX | AMOUNT ($) |
|---|---|
CASH FLOW FROM OPERATING ACTIVITIES | |
Cash Received from Customers | 1,004,000 |
Cash Paid to Suppliers | (369,000) |
Cash Payments for Operating Expenses | (100,000) |
Cash Payments for Interest | (12,000) |
Cash Payments for Taxes | (136,000) |
NET CASH FLOW FROM OPERATING ACTIVITIES | 387,000 |
CASH FLOW FROM INVESTING ACTIVITIES | |
Purchase of Property, Plant and Equipment | (675,000) |
NET CASH FLOW FROM INVESTING ACTIVITIES | (675,000) |
CASH FLOW FROM FINANCING ACTIVITIES | |
Proceeds from Borrowings | 300,000 |
Payment of Dividends | (36,000) |
NET CASH FLOW FROM FINANCING ACTIVITIES | 264,000 |
NET INCREASE (DECREASE) IN CASH FOR THE PERIOD | (24,000) |
Cash at the beginning of the period | 98,000 |
CASH AT THE END OF THE PERIOD | 74,000 |
As you can see above, the Cash Flow Statement Direct Method reveals a great deal of detail about Cash Flows of a Company such as the Cash it pays to Suppliers and Employees, Income Tax Payments etc.
Fortunately, the calculation of the other two types of Cash Flow i.e. The Cash Flow from Investing and Financing are similar across all companies and much more straightforward.
It is only in the calculation of the Cash Flow from Operations that the company accountants must make a choice between the Direct Method and the Indirect Method.
Apart from this, Accountants are also required to prepare a reconciliation of net income and net cash flow from operating activities in a separate schedule.
As a result, due it's laborious nature, it is NOT the preferred choice for most Accountants and sparingly seen in Cash Flow Statements.
Summary
There are two ways to calculate the Cash Flow from Operations which are the Direct Method and the Indirect Method.
The Direct Method or the Indirect Method only apply to the Cash Flow from Operations and do not effect the Cash Flow from Investing or Cash Flow from Financing sections of the Cash Flow Statement.
The Direct Method is the preferred method by FASB but due to its laborious nature, most Accountants prefer the Indirect Method.
Final Thoughts
In theory, the Cash Flow Statement should be the most straightforward.
After all, it's just Cash inflows minus Cash Outflows, right?
Reality though is a bit different.
The Cash Flow Statement takes time to understand and master so if you stumble a bit in learning it, it's OK, we've all been there.
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