In order to prepare cash flow statements, there are two options to present the cash flow from operating activities, direct method and indirect method. Here, we are going to discuss the direct method and its implications.
In direct method, cash flows are listed from operating activities on the basis of the inflow source such as customers and outflow sources such as suppliers and employees. After the identification and listing, the net effect is calculated to compute the net cash flow from operating activities.
Specimen Format
Cash flow from Operating Activities
Received payments from customers
Payment made to creditors
Payment made to staff/ employees
Income tax paid
Interest paid on loans
Advantage
As you can see, one can easily judge how to company is managing the operations of the company by collecting its receivables and paying to suppliers and staff. This is a clear image and that is why, FASB recommends entities to use this method.
Disadvantage
Unfortunately, this method is quite time consuming and requires a lot of work and a better accounting record. Most of the companies do not record information separately for every customer and supplier. In this, it gets very difficult to arrange for these sorts of data.
Important Formulas
These formulas are very important to prepare cash flow statement using direct method:
- Amount collected from customers = net sales + accounts receivable opening balance – accounts receivable closing balance
- Amount paid to suppliers = Purchases + closing stock/ inventory – opening stock/ inventory + accounts payable opening balance – accounts payable closing balance
- Amount paid to employees = Salaries payable opening balance + salaries expense – salaries payable closing balance
- Amount paid for income tax = Income tax payable opening balance + income tax expense – income tax payable closing balance
- Amount paid for interest = Interest payable opening balance + interest expense – interest payable closing balance
Note:These formulas are valid if there are only credit sales and purchases. If the entity is also making cash sales and purchases, then you cannot take support from these formulas. That is why, companies avoid using the direct method of cash flows because of the complexity, they have to face and the time required doing the same.
Example # 1
ABC Company
Staement of Cash Flows
For the Year Ended 30th June, 2015
| $ millions | |
| Cash flow from operating activities | |
| Amount received from customers | 100 |
| Amount paid to vendors | (50) |
| Amount paid to staff/employees | (20) |
| Amount paid for interest on loan | (5) |
| Amount paid for income tax | (3) |
| Net cash provided by operating activities | 22 |
| Cash flow from investing activities | |
| Paid for the purchase of machinery | (8) |
| Sale proceed from sale of computers | 4 |
| Net cash used in investing activities | (4) |
| Cash flow from financing activities | |
| Received loan from directors | 5 |
| Paid installment of long term bank loan | (2) |
| Net cash provided/ (used) in financing activities | 3 |
| Net increase (decrease) in cash | 21 |
| Cash and Cash Equivalent – Opening balance | 10 |
| Cash and Cash Equivalent – Closing balance | 31 |
Example # 2
TFC is a private limited company operating in textile sector. It is a well established entity and has gained a lot of momentum during the last 05 years. The success of TFC largely depends upon its efficient supply chain process which has cut down unnecessary activities which were causing a lot of losses to the company. The following data is available for TFC for year ended 31stDecember, 2016.
Income statement
For the year ended 31stDecember, 2016 (All figures are in $000)
Sales revenue 444
Operating expenses 312
Operating profit 132
Interest expenses 18
PBT – Profit before tax 114
Income tax 42
PAT – Profit after tax72
The details of operating expenses amounting to $312 are as follows:
Salaries 72
External audit fees 12
Depreciation expenses 84
Gain on sale of fixed assets 60
Rent Income from property 18
Material consumed 222
Total312
The details of receivables, payables and inventories are as follows:
20162015
Accounts receivables 48 42
Accounts payables 30 18
Inventories 42 24
Required
Prepare the cash flow from operating activities of TFC using direct method.
Solution
Before going to prepare cash flow using direct method, we need to do some workings as follows:
Payments to creditors
Materials consumed 222
Opening inventories (24)
Closing inventories 42
Materials purchased in 2016 240
Opening balance – payables 18
Closing balance – payables (30)
Total payment made to creditors228
Recovery from customers
Sale for the year 2016 444
Accounts receivables – opening balance 42
Accounts receivables – closing balance (48)
Cash collection from customers438
As we have done necessary workings, it is the time to prepare cash flow:
Recovery from customers 438
Rent income from property 18
Payment to creditors (228)
Salaries (72)
External audit fees (12)
Net cash flow from operating activities144
