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
AMOUNT
FOR THE YEAR ENDED DEC 31, 20XX ($)
CASH FLOW FROM OPERATING ACTIVITIES
Cash Received from Customers 1,004,000
Cash Paid to Suppliers (369,000)
Cash Payments for Operating Expenses (100,000)
Cash Payments for Interest (12,000)
Cash Payments for Taxes (136,000)
NET CASH FLOW FROM OPERATING ACTIVITIES 387,000
CASH FLOW FROM INVESTING ACTIVITIES
Purchase of Property, Plant and Equipment (675,000)
NET CASH FLOW FROM INVESTING ACTIVITIES (675,000)
CASH FLOW FROM FINANCING ACTIVITIES
Proceeds from Borrowings 300,000
Payment of Dividends (36,000)
NET CASH FLOW FROM FINANCING ACTIVITIES 264,000
SUPERPOWER INC.
THE CASH FLOW STATEMENT
AMOUNT
FOR THE YEAR ENDED DEC 31, 20XX ($)
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.
If your wondering what to learn next - The Cash Flow Statement would be a great article to
read or just check out whatever you like on the Search box on top of the page.
If you want a multi media learning experience with a dash of humor and fun, check out
our video course.
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intended for educational and informational purposes only to help business owners
understand general accounting issues. The content is not intended as advice for a specific
accounting situation or as a substitute for professional advice from a licensed CPA.
Accounting practices, tax laws, and regulations vary from jurisdiction to jurisdiction, so
speak with a local accounting professional regarding your business. Reliance on any
information provided on this site or courses is solely at your own risk.
Tax and accounting rules and information change regularly. Therefore, the information
available via this website and courses should not be considered current, complete or
exhaustive, nor should you rely on such information for a particular course of conduct for an
accounting or tax scenario. While the concepts discussed herein are intended to help
business owners understand general accounting concepts, always speak with a CPA
regarding your particular financial situation. The answer to certain tax and accounting issues
is often highly dependent on the fact situation presented and your overall financial status.
PART 1 - An Overview of the Cash Flow Statement Indirect Method
How do we use the Indirect Method to calculate Cash Flows?
To understand how to calculate the Cash Flow from Operations using the Indirect Method,
you need to first be aware of all the inputs used to calculate it.
(Think of inputs as the Raw materials being used to create the Final Product).
The 5 major items (inputs) that you need to be aware of are -
1. Net Income
2. Non Cash Expenses (Depreciation, Amortization)
3. Gains (or Losses)
4. Movement in Current Assets
5. Movement in Current Liabilities
The above information is pretty easy to obtain from the companies latest Income
Statement and two simultaneous periods of the Balance Sheet.
Luckily, once you have these figures, the Calculation of The Indirect Method follows a set
pattern, a consistent Format.
Know the Format, and the calculation of Cash Flows becomes really easy.
So, what's the format?
Format of the Cash Flow Stat
ement Indirect Method
CASH FLOW FROM OPERATING ACTIVITIES:
Net Income (taken from the Income Statement)
Add back (+):
Any Non Cash Expenses (Depreciation and Amortization)
Any Losses that the Business has incurred on the Sale of Non Current Assets.
Any decrease that has taken place in Current Assets (Accounts Receivables, Prepaid
Expenses, Inventory etc. taken from the Balance Sheet)
Any increase in Current Liabilities (Accounts Payable, Accrued Liabilities, Income Tax Payable
etc taken from the Balance Sheet).
Minus (-):
Any Gains that the Business has incurred on the Sale of Non Current Assets.
Any Increase in Current Assets (Accounts Receivables, Prepaid Expenses, Inventory etc.
taken from the Balance Sheet)
Any decrease that has taken place in Current Liabilities (Accounts Payable, Accrued
Liabilities, Income Tax Payable etc taken from the Balance Sheet).
Equals:
The Net Cash Flow from Operating Activities.
Even though the Format above includes all the aspects that can impact the Cash Flow from
Operations using the Indirect Method - you will only apply what is relevant to the company
you are analyzing.
To illustrate, the a Real Life Cash Flow From Operations would look like below -
To illustrate, the a Real Life Cash Flow From Operations would look like below –
SUPERPOWER INC.
THE CASH FLOW STATEMENT
AMOUNT
FOR THE YEAR ENDED DEC 31, 20XX ($)
CASH FLOW FROM OPERATING ACTIVITIES
Net Income 70,000
Add (Deduct) non cash effects on Net Income
Depreciation applied to Fixed Assets 5,000
Gain on Sale of Land (5,000)
(Increase) Decrease in Current Assets:
(Increase) in Accounts Receivable (10,000)
Decrease in Inventory 20,000
Increase (Decrease) in Current Liabilities
Increase in Accounts Payable 5,000
NET CASH FLOW FROM OPERATING ACTIVITIES 85,000
Now, let's take a look at the break up of the major items individually and see why they get
added (or subtracted) from Net Income.
PART 2 - A Deep Dive into the Indirect Method
Why do we start the calculation with Net Income?
We all know Profits are important.
But the Profits reported in the Income Statement are not always representative of the
actual Cash that has come into the business when we use Accrual Accounting.
That's because Accrual Accounting includes
Sales made on Credit
Supplies purchased on Credit
Depreciation and Amortization Expenses
Expenses accrued but not yet paid (Example, Salaries owed but not yet paid).
While including the effect of the above transactions is great to give us an overall picture of
health of the Business - it does have drawbacks.
The main drawback includes the fact that when each non cash transaction is added to the
Income Statement - it builds a distance between the Net Income and Real Cash number of
the Business.
So, naturally, we start with the Net Income with the goal of remove all the non cash
elements that have been factored in its calculation (Kinda like peeling an Orange!)
Why do we add back Depreciation and amortization Expenses?
Although a book entry, Depreciation and amortization expenses DO NOT not represent real
uses of cash and are added back to Net Income.
For example, if a companies net income has been $500,000 on the Income Statement and
depreciation expenses are $100,000, the depreciation expenses of $100,000 do not mean
that actual cash of $100,000 has been used. It is simply a book entry and is therefore added
back to find the net cash flow from operations - which would then total $600,000.
If your relatively new to Accounting and aren't sure how Depreciation works - you can check
out an article on Depreciation here.
Why do Gains and Losses effect Net Income this way?
Technically, a Gain is an increase in the company value from something other than the
Revenues and day to day running of the Business.
For example, a Gain can occur when a company property increases in value and the
company sells it.
Despite the Sale increasing the Net Income figure, the Gain is not part of regular operations
of the Business and therefore showing it as normal Cash Flow from Operations would be
misleading.
Keeping that in mind, Gains are deduced from Net Income.
Similarly, Losses caused from Non Operating Activities (such as Lawsuits) reduce Net Income
for the period.
Since non operating Losses are occasional occurrences (Hopefully at least!) we add them
back to Net Income to show the true picture of Cash Flow from Operations.
Technical Stuff
RECORDING GAINS AND LOSSES
Asset purchases and sales are also considered investments, and the activity surrounding
these actions is also considered investing activity.
Therefore, Asset sales have a dual impact on the Cash Flow Statement.
The Cash from the Sale of Assets is recorded in the Cash Flow from Investing
Activities section of the cash flow statement as well as the Gain (or Loss) is recorded in the
operating section.
Specifically, in the investing section you retire the asset by recording the total amount of
sale proceeds you received for the assets whereas the Gains are deduced and Losses are
added to the Cash Flow from Operations as stated above.
Example
Say your construction company owns a Crane.
Your balance sheet shows an original value of $15,000 and accumulated depreciation of
$10,000. Thus, the net book value for the crane on your balance sheet is $5,000.
You sell the crane for $7,000.
To record this transaction, you show proceeds from the sale of the crane of $7,000 under
investing activity.
Under the Cash Flow from Operations, you deduct gain on the sale of the crane of $2,000.
How do Change in Current Assets effect Net Income?
You need to think about how changes in these accounts affect cash in order to identify what
way Net income needs to be adjusted.
Simple Logic can be used to calculate the impact of an increase or decrease in Current
Assets.
Impact of an increase in Current Assets
When an asset increases during the year, cash must have been used to purchase the new
asset.
Thus, a net increase in a current asset account actually decreases cash, so we need to
subtract this reduction in cash from the net income.
For Example, if Accounts Receivable increases during the year - the company has sold more
on credit during the year than it has collected in cash from customers.
The increase in Accounts receivable has been added to net income in the Income Statement
without a real increase in cash and therefore, needs to be subtracted from Net Income.
The opposite is true if you see a decrease in accounts receivable.
Impact of a Current Asset Decrease
The opposite is true about current asset decreases.
If an asset account decreases, cash must have come in exchange for the Asset decrease.
For Example, if Accounts Receivable goes from $20,000 to $10,000, cash has come into the
Business.
Similarly, If Inventory decreases from $20,000 to $10,000, Inventory has been sold and
therefore $10,000 of Cash has come in.
Here’s a general rule of thumb when calculating the cash flow from Operations using the
Cash Flow Statement Indirect Method.
Asset account increases: subtract the amount from Net income
Asset account decreases: add the amount to Net income
How do Change in Current Liabilities effect Net Income?
The liabilities section works the opposite of the assets section.
Impact of an increase in Current Liabilities
In other words, an increase in a Current liabilities needs to be added back into income.
Take accounts payable for example.
Accounts Payable in the balance sheet represent bills and invoices that the company has not
yet paid - but have still recorded as an expense in the Income Statement.
This means that though Net Income is reported as decreased in the process, in reality - the
cash has not been given out.
To see the real impact on Cash Flow, the increase in accounts payable must be added back
to Net Income.
The opposite holds true for a decrease in accounts payable.
Impact of a decrease in Current Liabilities
A decrease in accounts payable represents that cash has actually been paid to
vendors/suppliers.
In this case, Cash is deducted from Accounts Payable.
Here’s a general rule of thumb when calculating the cash flow from Operations using the
Cash Flow Statement Indirect Method.
Liability account increases: add the amount to Net income
Liability account decreases: subtract the amount from Net income
The rules for cash flow adjustments to net income are:
Summary
The Cash Flow Statement Indirect method is used by most corporations, begins with a net
income total and adjusts the total to reflect only cash received from operating activities.
These adjustments include deducting realized gains and other adding back realized losses to
the net income total.
As a General Rule of Thumb-
A Current Asset increase during the period decreases Cash Flow from Operating
Activities.
A Current Asset decrease during the period increases cash flow from operating
activities.
A Current Liability decrease during the period decreases Cash Flow from
Operating Activities.
A Current Liability increase during the period increases Cash Flow from Operating
Activities.
Final Thoughts
It would have been nice if we could think of the Net Income figure taken as it is as being a
quick and easy way to judge a company's overall performance but when is life easy?
The Silver Lining here is that if you understand how the Cash Flow Statement Indirect
Method works, you have just catapulted yourself forward into the world of Savvy Investors
and Business Owners who can truly tell what is going on in a company.
How's that for a Superpower!
