A statement of cash flows can be prepared by either using a direct method or an indirect method. A direct method is easier to interpret as it simply lists all the major operating cash receipts and payments during the period.
Money coming into the business, usually from customers, are listed under cash inflows. Money going out from the business,—typically in payment to employees, suppliers, etc—are listed under cash outflows.
After all cash sources are listed, the cash outflows are subtracted from the cash inflows to arrive at the net cash flow from operating activities. After this, the cash flows from investing and financing activities are added to arrive at the net increase or decrease in cash.
Direct Method Statement of Cash Flows Template
Throughout this series on financial statements, you can download the Excel template below for free to see how Bob’s Donut Shoppe uses the statement of cash flows to evaluate the performance of his business.
Components of Direct Cash Flow Statement
The main difference between the direct method and the indirect method involves the cash flows from operating activities. There is no difference at all in how the cash flow from investing activities or financing activities are calculated under both methods.
This is the first component of a cash flow statement. Instead of starting with the net income and adjusting it to a cash basis using an indirect cash flow method, the direct method uses a more straight forward approach. It simply calculates the net income using cash basis.
It will include accounting for all the cash inflows and outflows of a business during the course of daily operations. These include:
- Cash receipts from customers: This generally will exclude all sales that are made on credit and only record sales made on a cash basis.
- Cash payments to suppliers: These include all payments made to vendors or suppliers for the cost of goods sold on a cash basis.
- Cash payments for operating expenses: All selling and administrative expenses including sales personnel salaries, utilities, factory rent, etc. which have been paid in cash during the operating period.
- Cash payments for interest expense: Debt servicing is an important part of the expenses of any business. All debt repayments and interest repayments made on a cash basis will be subtracted from the total cash inflows generated by the company operations.
- Cash payments for income taxes: The tax paid by a company can differ significantly as compared to what is in the accounting books of a company. Therefore, the tax expense paid in cash is subtracted from the net inflows generated by a company.
Adjustments Rules for the Direct Method
These rules might be necessary to apply for companies that have done their accounting on an accrual basis throughout the period.
The following steps can be used to convert items from accounting to a cash basis:
- Sales revenue: Add decreases or deduct increases in accounts receivable.
- Cost of goods sold: Add increases or deduct decreases in inventory.
- Operating expenses: Add increases or deduct decreases in prepaid expenses.
- Depreciation expense: Do not include as it is a non-cash expense.
- Interest expense: Deduct increases or add decreases in interest payable.
- Gain or loss on sale of equipment: Do not include as it is a non-cash expense.
- Income tax expense: Deduct increases or add decreases in income tax payable.
As suggested by the name itself, these include acquisition and disposal of any non-current assets or any other investments. Understanding the nature of cash flows in this category is important for analysis of financial statements. While a negative cash flow from operating activities is an indication of poor performance by a company, a negative cash flow from investing activities could mean that the company has made fixed long-term investments that will eventually help its long-term health.
Typical examples will include:
- Purchase of fixed assets such as property, plant and equipment (PP&E) – a negative cash flow activity.
- Investment in long-term securities like stocks or bonds – a negative cash flow activity.
- Lending money to other individuals or institutions – a negative cash flow activity.
- Sale of fixed assets such as property, plant and equipment (PP&E) – a positive cash flow activity.
- Sale of investments – a positive cash flow activity.
- Proceeds from loans or insurance claim payouts – a positive cash flow activity.
If balance sheets of two period are compared side by side and there is a difference in the values of its non-current assets, then it means that there has been an investing activity with-in the period.
These are activities that change the size of borrowings or equity for a company. Financing activities could include the following:
- Issuing new common stock – a positive cash flow activity.
- Issuing new debt offering – a positive cash flow activity.
- Stock repurchases – a negative cash flow activity.
- Dividend payments – a negative cash flow activity.
- Repaying borrowing or debt – a negative cash flow activity.
Advantages and Disadvantages of a Direct Method
Both methods are useful and whether one method is given preference over the other will depend on the requirement of the company. The following are some of the advantages and disadvantages of preparing the cash flow statements using the direct method:
- The direct method might be easier to use for smaller companies that have fewer cash-based transactions.
- The direct method provides a more accurate picture for investors to determine the cash flow situation of a company.
- The direct method could prove to be time-consuming and a very cumbersome process for larger organizations that may have many cash-based transactions and is difficult to sift through all of them.
Direct Method Statement of Cash Flows Example
We have already seen Bob’s Donut Shoppe cash flow statement prepared under an indirect method. Let’s see how the cash flow statement prepared through the direct method would look: