Indirect Method Cash Flow to Direct Method

Cash flow statement prepared under the indirect method can be converted to the cash flow statement under the direct method. All we need to do is to translate the cash flows from operating activities section from reconciliation format to the cash inflows and outflows format.

Cash collections from customers equal opening balance of receivables plus revenue minus closing balance of receivables.

Cash paid for inventories can be determined by first finding out the inventories purchased. Inventories purchases equal closing balance of inventories plus cost of goods sold (excluding any non-cash items such as depreciation) minus the opening balance of inventories. Cash paid to suppliers equals the opening balance of accounts payable plus inventory purchases minus the closing balance of accounts payable.

Cash paid for other operating expenses equals opening accrued expenses plus closing prepayments plus operating expenses minus closing accrued expenses minus opening prepayments.

Cash paid for income taxes, interest and dividends can also be calculating using the associated liability accounts i.e. income tax payable, deferred tax asset and deferred tax liability, interest payable and dividends payable.

Example

Following is the cash flows from operating activities section of the cash flow statement prepared under the indirect method:

Cash flow statement USD in million
Cash flows from operating activities
Net income 72
Add: interest expense 30
Add: tax expense 48
Add: depreciation expense 50
Add: increase in current liabilities -
Less: increase in current assets (10)
Less: interest paid (35)
Less: taxes paid (23)
Less: dividends paid (40)
Net cash flows from operating activities 92

And here is the associated balance sheet:

USD in million 2017 2016
Non-current assets
Fixed assets 400 420
Long-term investments 120 65
Total non-current assets 520 485
Current assets
Prepayments 15 10
Inventories 50 35
Accounts receivable 60 70
Cash and cash equivalents 17 20
Total current assets 142 135
Total assets 662 620
Common stock 200 200
Retained earnings 102 70
Total shareholders’ equity 302 270
Non-current liabilities
Long-term loans 210 220
Current liabilities
Accounts payable 60 50
Taxes payable 55 30
Interest payable 20 25
Accrued expenses 15 25
Total current liabilities 150 130
Total shareholders’ equity and liabilities 662 620

And the income statement:

Income statement USD in million
Revenue 500
Cost of sales (depreciation of $50 million) (200)
Gross profit 300
Operating expenses (150)
EBIT 150
Interest expense (30)
EBT 120
Tax expense (48)
Net income 72

We need to find the cash collected from customers:

Cash receipts USD in million
Opening balance of accounts receivable 70
Add: sales 500
Less: closing balance of accounts receivable (60)
Equals: cash collected from customers 510

Put another way, $510 million is collected from customers because accounts receivable decreased by $10 million which means that more cash is collected than sales are made.

Next, we need to find inventories purchased and eventually the cash paid to suppliers:

Cash paid to suppliers USD in million
Closing balance of inventories 50
Add: COGS (less depreciation) i.e. ($200 - $50) 150
Less: opening balance of accounts receivable (35)
Equals: inventories purchases 165
Add: opening accounts payable 50
Less: closing accounts payable (60)
Equals: cash paid to suppliers 155

We can club the rest of the expenses together with prepayments and accruals to find out cash paid for other operating expenses:

Cash paid for other expenses USD in million
Opening accrued expenses 25
Add: closing prepayments 15
Add: operating expenses (less non-cash charges) 150
Less: closing accrued expenses (15)
Less: opening prepayments (10)
Equals: cash paid for other operating expenses 165

Because we already have the figures for interest, taxes and dividends paid, we are now in a position to prepare the cash flows from operating activities section using the direct method:

Cash flows from operating activities – direct method USD in million
Cash receipts 510
Cash paid to suppliers (155)
Cash paid for other operating activities (165)
Interest paid (35)
Taxes paid (23)
Dividends paid (40)
Net cash flows from operating activities 92

The net cash flows from operating activities is the same regardless of which method we use for its preparation. However, the direct method offers information in a way that can be easily forecasted and analyzed.

Written by Obaidullah Jan, ACA, CFA and last modified on