Cash-Flow Statement: Direct Method

Direct method of operating activities cash flows is one of the two main techniques that may be used to calculate the net cash flow from operating activities in a cash flow statement, the other being indirect method.

The direct method works by directly calculating each of the components of operating cash flows, such as cash receipts from customers, cash paid to suppliers, cash paid for salaries, etc. Once the values for these individual components have been calculated, these are summed together in the cash flow from operating section of a cash flow statement.

The calculations of the components of operating cash flow are based on the double entry accounting principles. Therefore, the aim is to calculate the movement in cash under each component using the beginning and ending balances of various accounts and other available information. The exact formulas to calculate various cash inflows and outflows therefore vary and are derived with intuition.

T-accounts may also be used for each item in the balance sheet that affects the cash flow. For example, cash receipts from customers may be calculated using the t-account for accounts receivable. Once all available information such as opening balance, closing balance, credit sales made during the period, etc. have been entered into the t-account, we can calculate the cash receipts from customers as the balancing figure in the t-account. Similar approach may be adopted for all items affecting operating cash flow.

Formulas

The most important ones are given below:

Cash Receipts from Customers =
+ Net Sales
+ Beginning Accounts Receivable
− Ending Accounts Receivable

Cash Payments to Suppliers =
+ Purchases
+ Ending Inventory − Beginning Inventory
+ Beginning Accounts Payable
− Ending Accounts Payable

Cash Payments to Employees =
+ Beginning Salaries Payable
− Ending Salaries Payable
+ Salaries Expense

Cash Payments for Purchase of Prepaid Assets =
+ Ending Prepaid Rent, Prepaid Insurance etc.
+ Expired Rent, Expired Insurance etc.
− Beginning Prepaid Rent, Prepaid Insurance etc.

Interest Payments =
+ Beginning Interest Payable
− Ending Interest Payable
+ Interest Expense

Income Tax Payments =
+ Beginning Income Tax Payable
− Ending Income Tax Payable
+ Income Tax Expense

In the formulas given above, it is assumed that accounts receivable are only used for credit sales. It is also assumed that all sales are on credit. If there are cash sales as well, then receipts from cash sales must be included in the cash receipts from customers to obtain a correct figure of cash flow from operating activities.

Similarly, it is assumed that accounts payable are used merely for purchases on account and that all purchases are on credit. If there are cash purchases as well, then cash payments for them must be included in the cash paid to suppliers. It is important to note that there may be receipts and payments other than those discussed above.

Once all the cash inflows and outflows from operating activities are calculated, they are added together in the operating section of the cash flow statement to obtain the net cash flow from operating activities.

Example

The following example shows the format and calculation of cash flows from operating activities using direct method.

Prepare the cash flows from operating activities section of a cash flow statement by direct method using the following information:

December 3120112010
Accounts Receivable$34,130$28,410
Prepaid Rent20,00025,000
Prepaid Insurance6,8006,000
Inventory23,03015,450
Accounts Payable14,59031,300
Salaries Payable8,3105,120
Interest Payable700360
Income Tax Payable2,3400
   
Year Ended December 312011
Net Sales64,970
Salaries Expense8,610
Rent Expense5,000
Insurance Expense3,200
Interest Expense1,650

Solution

Cash Flow from Operating Activities:
Cash Receipts
From Customers (1)$59,250
Cash Payments
To Suppliers (2)−24,290
To Employees (3)−5,420
For Purchase of Prepaid Assets (4)−4,000
Interest (5)−1,310
Income Tax (6)−0
Net Cash Flow from Operating Activities24,230

Calculations

  1. Customers: 59,250
    = 64,970 + 28,410 − 34,130
  2. Suppliers: 24,290
    = 23,030 − 15,450 + 31,300 − 14,590
  3. Employees: 5,420
    = 5,120 − 8,310 + 8,610
  4. Purchase of Prepaid Assets: 4,000
    = 20,000 + 6,800 + 5,000 + 3,200 − 25,000 − 6,000
  5. Interest: 1,310
    = 360 − 700 + 1,650
  6. Income Tax: 0
    = 0 − 2,340 + 2,340

by Irfanullah Jan, ACCA and last modified on

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