What is the Statement of Cash Flows Direct Method? | Formula & Example

(Last Updated On: March 29, 2021)

What is the Statement of Cash Flows Direct Method?

Cash flow refers to the amount of cash flowing in and the amount of cash flowing out of a business. These financing activities are reported on financial statements known as income statements. There are two methods that are used to report cash flow. They are the direct method and the indirect method.

Also known as the income statement method, the statement of cash flows direct method is a detailed statement showing where cash is coming from or cash inflows and where it is going also known as cash outflow.

Direct Method vs. Indirect Method

The indirect method used in calculating cash flow from operations starts with the net income from the income statement and uses adjustments to convert the income into cash flow. The direct method only takes into consideration the cash transactions and details the cash flow from operational activity. The direct method focuses only on cash received and cash paid. The indirect cash flow method takes into account the non-cash transactions from the balance sheet accounts.

When To Use Each Method

The direct and indirect methods are both used to calculate net cash flow. Both end up with the same result. The difference is how each are calculated and what sources are used to get that result. The indirect method details why the net profit is different from the bank’s closing figure. These differences are spelled out through the adjustments. The indirect method is used to determine investment potential. The direct method captures insight as to where the cash originated since it is real cash moving in and out of your bank account. This comes in handy for analysis purposes and cash management, especially if you are trying to identify problems related to cash or opportunities as well. It also is a good tool to use for cash flow forecasting. The indirect cash flow will tell you what happened and the direct cash flow tells you why it happened.

Advantages and Disadvantages of the Direct Method

The direct method is easier to calculate because it only uses cash transactions to produce the cash flow statement while the indirect method starts with the net income and adds non-cash expenses to create the cash flow statement. One advantage to the indirect method is that net income is automatically converted into cash flow while with the direct method, a reconciliation of net income must be done to separate the cash flow. The cash flow statement produced with the direct method is extremely accurate since there are no adjustments while the cash flow statement using the indirect method is not as accurate since there are adjustments being made. Another disadvantage to the direct method is that it takes more amount of time to prepare and is more complex, especially for larger businesses with a large amount of cash receipts and cash payments from various origins. Also, all of these transactions affect not one but two accounts. More companies tend to use the indirect method for this reason. Very few companies use the direct method even though it is recommended by the Financial Accounting Standards Board (FASB).

Formulas of the Direct Method

Here are the formulas for the direct method if accounts receivable is used for credit sales and accounts payable is used for credit account purchases.

1. Cash Received from Customers = Net Sales + (Beginning Accounts Receivable – Ending Accounts Receivable).

2. Cash Paid to Suppliers = Purchases + (Ending Inventory – Beginning Inventory) + (Beginning Accounts Payable – Ending Accounts Payable).

3. Cash Payments to Employees = (Beginning Salaries Payable – Ending Salaries Payable) + Salaries Expense.

4. Cash Paid for Operating Expenses = Operating Expenses + Increase or Decrease in Prepaid Expenses + Decrease or Increase in Accrued Liabilities

5. Cash Interest Payments = (Beginning Interest Payable – Ending Interest Payable) + Interest Expense.

6. Cash Payments for Income Taxes = (Beginning Income Tax Payable – Ending Income Tax Payable) + Income Tax Expense.

The total of all of these reflect the net cash used in operating activities.

How do you prepare a direct cash flow statement?

The direct method starts with a list of operating cash receipts such as cash collected from customers as well as interest and dividends received and cash payments such as cash paid to employees and cash paid to suppliers in the operating activities section of the cash flow statement. Also, in this section are any interest paid on outstanding debt as well as all income taxes paid. The result is cash from revenue minus cash payments for expenses which ultimately produces the net cash flow from operating activities.

Example of a Cash Flow Statement Direct Method

CASH FLOW FROM OPERATING ACTIVITIES:

Cash Receipt from Customers                                         $1,000,000

Wages and Salaries                                                              (400,000)

Cash Paid To Vendors                                                          (450,000)

Interest Income                                                                      150,000

Income Before Income Taxes                                             $300,000

Interest Paid                                                                          (100,000)

Income Taxes Paid                                                                (125,000)

NET CASH FROM OPERATING ACTIVITIES                           $75,000