In this video you'll learn how to prepare a cash flow statement using a
direct method example with the help of the
income statement and the balance sheet,
along with some T Accounts.
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Hey viewers, i'm James and welcome to Accounting Stuff.
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If you're a regular viewer here then we pick up from where we left off last time
with preparing a cash flow statement using a direct method example.
Previously, i showed you a cash flow statement for the
Chudley Cannons Quidditch team, along with its corresponding
income statement and balance sheet. But if you missed part one
there’s a link to that over here as well. In this video we're going to
rewind a bit and prepare that same cash flow statement using T Accounts,
and both of these reports. We're going to use the direct method
as we work out each number as we piece it together.
We're going to start off with the easy ones and move on to
the harder calculations as we progress,
so recommend watching this video through until the end to get a
clear picture of the whole process. Let's begin…
So here we have the cash flow statement for the
Chudley Cannons and the plan is we're going to recalculate all
of these numbers directly from the income statement and
balance sheet for the same period… the 31st of December.
We will start at the top with cash flow from operating activities
and work our way down through all three sections to
cash flow from financing activities. We're using the direct method today,
so cash flow from operating activities mirrors the layout of an
income statement prepared under the cash basis.
So we have cash receipts from customers at the top which
reflect our sales, and below that we have
cash paid to suppliers, employees, and the rest of the expense types.
Operating activities are the principle revenue generating activities
of a business. So this section shows the cash
that we receive or pay out during the course of our regular business.
The first line item that we're going to calculate is
cash receipts from customers, and to do this we're going to need
to look at the movement in our accounts receivable balance.
I said in the intro that we'll need some T Accounts
so let's draw those out.
Accounts receivable is an asset,
which is the A in DEALER, so it's a normal debit account.
That means our opening balance or our balance brought forward goes on
the left side of the T Account because debits always go on the left.
The accounts receivable balance increases as we make revenue
because when we credit sales we debit accounts receivable
so sales go on the left side as well. And finally,
the closing balance or the balance carried forward
also goes on the left because it's a normal debit account.
Opening and closing balances for normal debit and credit accounts
should always be on the same side as each other.
On the credit side of the T Account which is on the right,
we have cash receipts from customers. Cash received from customers
reduces our accounts receivable and this is what we're looking
to solve for because cash receipts from customers ties back to our
cash flow statement. Now we've laid out our T Account
let's enter some numbers… We get our opening balance from the
balance sheet for the previous year. In this case accounts receivable were
$98,000 as at 31st of December for the prior year,
so we can write this down in the T Account.
Sales come straight from the income statement.
This year the Cannons made sales of two hundred and fifty thousand dollars,
so we need to debit accounts receivable by 250.
And finally, our closing balance comes
from the balance sheet, this time from the current year.
Accounts receivable at the end of the current year were
one hundred and twenty thousand dollars so that goes on the Left at the
bottom of the T Account. Now we only have one missing value…
cash receipts from customers and we can work this out
using some basic maths. Our closing balance of a
hundred and twenty less our sales of 250
less our opening balance of ninety eight
gives us minus two hundred and twenty eight.
The negative sign signifies that this is a credit
so we write this down on the credit side of our T Account.
As you can see this ties back to the
two two eight that we have in our cash flow statement.
All as well. Next, I'm going to skip over
cash paid to suppliers and return back to a later
in this video because it's actually one of the harder balances
to calculate. So instead we move on to
cash paid to employees. The balance sheet account that
we're going to need for this one is salaries payable.
Salaries payable is a form of liability,
the L in DEALER. So it's a normal credit account.
That means our opening balance goes on the right hand side
of the T Account because credits always go on the right.
The balance on this account increases as the salaries expense
goes up because when we debit to the salaries expense
and credit salaries payable so these go on the right.
And lastly, the closing balance joins the
opening balance on the right hand side
because we have a normal credit account.
We are looking to solve the cash paid employees which will show
as a debit on the left hand side of this T Account,
because when we pay out cash to employees,
we reduce salaries payable. This is the only unknown value
for us at this stage because we can easily pull
the opening and closing balances from the prior and current year balance sheet
and we can get the salaries expense from the current year income statement.
So let's do that… the prior year balance sheet shows
a closing balance in salaries payable of 30.
The current year income statement shows a salaries expense of 80,
and the current year balance sheet shows a closing balance in
salaries payable of 42.
Let's write these down in the T Account
to work out cash paid to employees.
Our closing balance of -42,
less the salaries expense of 80, less the opening balance of 30
gives us cash paid to employees of 68. This number is positive so we
debit the T Account by 68. And does it tie back to
our cash flow statement?
Yes it does perfect.
Next up we need to work out interest paid.
We're going to run through this one a bit quicker because the
balance sheet account that we use to work this out is interest payable
which is also a liability. So the process is very similar to
cash paid to employees. That means that the opening balance,
the interest expense and the closing balance
all go on the right-hand side of the T Account,
because interest payable is a normal credit account.
On the left side, the debit side,
we are looking to solve for interest paid,
which should tie back to the cash flow statement.
We are again going to look for the opening and closing balances
in the respective balance sheets and for the interest expense
in the income statement. So here we go…
The prior-year balance sheet shows a closing balance in
interest payable of 2, the current year balance sheet
shows a closing balance in interest payable of 3,
and the current year income statement shows an
interest expense of 8.
So let's enter these into our
T Account to work out interest paid. Our closing balance of -3
less the interest expense of 8 less the opening balance of 2
gives us interest paid of 7. It's positive so we debit
the T Account by 7,000. When we check back against
the cash flow statement, we can also see interest paid
of 7,000 so it matches. The last line in
cash flow from operating activities is income taxes paid which we
will work out now. The balance sheet account
we're going to need for this one is income tax payable
and since that's also a liability, the process is going to
be very similar to the previous two examples.The opening balance,
the income tax expense, and the closing balance
go on the right-hand side of the T Account
because we are dealing with a normal credit account.
On the debit side we have income tax paid
which we're solving for. The opening and closing balances will
again come from the balance sheet and we will get the income tax expense
from the income statement. The prior-year balance sheet
shows a closing balance in income tax payable of 4,
the current year balance sheet shows closing balance of 6
and the income statement shows an income tax expense of 9.
We enter these into the T Account to work out income tax paid.
Our closing balance of -6 less the income tax expense of 9
less the opening balance of 4 gives us income taxes paid of 7.
So we debit the T Account by 7,000 and this ties back to income taxes paid
in the cash flow statement. Phew
How did you find that?
Brace yourselves because we're about to take on something
a bit more challenging.
We're going to head back to
cash paid to suppliers which we left out earlier and I'll show
you how to calculate it. The balance sheet account
that we need here is accounts payable, which is a liability.
Now you might be thinking…
But James, we just did three liability accounts…
isn't the process going to be exactly the same?
Bear with me for a moment
and I'll explain why it's different.
We lay out the accounts payable T Account
as we've done before… the opening balance,
inventory purchased and closing balance go on
the credit side and cash paid
which we're solving for again goes on the debit side.
We can easily pull the opening and closing balances from the prior and
current year balance sheet. In this case
we have an opening balance of 95 and a closing balance of 105.
So all we need
now is inventory purchased
and we're on our way! But how do we find inventory purchased?
There isn't an inventory expense in the income statement…All we have is cost
of goods sold. Bummer.
What we have to remember here is that we’re accounting using
the accrual basis. And under the accrual basis,
we apply the matching principle which states that revenue and all
expenses incurred in order to generate that revenue,
need to be recognised in the same accounting period.
Now what that
means for us in the context of this example is that when we
purchase goods from suppliers that we intend to sell
we can't immediately recognise an inventory expense in the
income statement. That's because our intention is to
sell our inventory in order to generate sales,
and if we’re generating sales, then the matching principle is
telling us that we need to recognise those sales,
and their related expenses in the same accounting period.
In order to do that we need the help of another account…
Inventory.
Having an inventory account means that we can store the
costs of all goods that are intended to be sold as a debit balance
in the balance sheet and when they are sold we
decrease inventory in the balance sheet and increase
cost of goods sold in the income statement.
Let me explain this using
an inventory T Account.
Inventory is a form of asset
which makes it a normal debit account so the opening balance,
inventory purchases and the closing balance
go in the debit side. On the credit side
we have cost of goods sold.
We can easily find the opening
and closing balances by referring to the prior and current year
balance sheet. Here we have an
opening balance of 68 and a closing balance of 94
which we will write down in our T Account.
And we can find cost of goods
sold in the income statement which
in this case is 60.
So we write 60 on the credit side
of the T Account because when we sell inventory we debit the
income statement to recognise the expense
and we credit inventory in the balance sheet
to reduce our assets.
That leaves us with inventory purchases,
which we can work out using the other numbers.
A closing balance of 94 less the opening balance of 68
and adding back cost of goods sold of 60 gives us inventory purchases of 86.
So we debit the T Account by 86.
You might have noticed already
that it was inventory purchases that we were looking for in
our accounts payable T Account.
So we can copy the 86 over
to the credit side of accounts payable because when we purchase inventory
we debit inventory to increase it and credit accounts payable
to increase the amount that we owe to suppliers.
Now that we've worked
out that number. We’re on the home straight
calculating cash paid to suppliers.
Our closing balance of -105
less inventory purchases of 86 less our opening balance of 95
gives us cash paid to suppliers of 76.
Which goes on the debit side
of the accounts payable T Account and ties back to our
cash flow statement. Ouch!
Did you survive that? Cash paid to suppliers is definitely one of
the hardest numbers to calculate on the cash flow from operating activities.
If you'd like to learn more about accrual accounting then I’ll throw
a link up here to a video that I made about it previously.
So that was cash flow from operating activities
and when we subtotal all of these numbers that we worked out
we can see that the Cannons have generated $70,000 of cash inflow
from their core operations.
But hold your horses we’re not done yet.
Next up we have
cash flow from investing activities. Investing activities most commonly
relate to the sale or purchase of non current assets
or investments in stocks and shares that sit outside of a business's
core operations. In this cash flow statement we have
cash flowing out of the business from the purchase of
Plant Property and Equipment or PPE for short,
and cash flowing back in from the sale of PPE.
You might have guessed it already, but the balance sheet account
that we need to calculate these numbers is plant property and equipment.
This account
is an asset which is the A in DEALER.
So it's a normal debit account and therefore our opening and closing
balances go on the left hand side. On the credit side we have the
depreciation expense because the value of non current assets
reduce as they depreciate.
Credit non current assets in the balance sheet
Debit depreciation expense in the income statement.
Now I don't want to over
complicate things in this tutorial so we're going to
keep PPE simple and make a few assumptions at this point.
We're going to ignore accumulated depreciation
assume no gain or loss on disposal and that all cash related to these
transactions has changed hands and finally that the Cannon’s
spent seventy thousand dollars purchasing PPE this year.
I know that's a lot of assumptions, but we don't have a fixed asset register
for this example so we'll leave it at that.
I'll probably do a whole video in the future covering fixed assets
and depreciation.
Now that we've cleared that up,
all that’s left to include are cash paid to purchase PPE
and cash receipts on sale of PPE.
The prior year balance sheet shows
a closing balance in PPE of 202. The current year balance sheet shows
closing balance of 234 and we can see that the
depreciation expense in the income statement was 23.
I just said that we can assume that the Cannon’s spent 70,000
on the purchase of PPE and that all their cash has changed hands.
So we would
credit cash by 70 to decrease it and debit PPE by 70 to increase it.
That leaves us with cash receipts from the sale of PPE
on the credit side which we now need to solve for.
A closing balance of 234 less cash paid of 70
less an opening balance of 202 and adding back
the depreciation expense of 23 gives us cash receipts on
the sale of PPE of 15. So cash would be debited by 15
to increase it and PPE would be credited by 15 to decrease it.
Both cash paid to purchase PPE and cash receipts on the sale of PPE
tie back to our cash flow statement and when we subtotal all of these
we see a cash outflow of 55,000 from investing activities.
Cash flow from investing activities is an important section of the
cash flow statement because it can significantly offset the cash flow
generated from operating activities.
Last up we have
cash flow from financing activities and don't worry we've got all
that hard work out of the way.
This section is going to be quick.
Financing activities
relate to transactions involving a businesses owners or lenders.
In this case we're dealing with lenders because we have proceeds
from long term borrowings of 20,000. And the number is very simple
to calculate.
We take the closing balance of long term borrowings in the
current year balance sheet of 100 and we take away the closing balance
from the previous year of 80. 100 less 80 is 20.
So we have a net cash inflow
of 20,000 from financing activities.
Now let's take the total of all these cash inflows and outflows that we
have worked out.
We can see that the Cannons have a
net cash increase of $35,000 for the current year.
Which ties to the movement in the cash balance
which we can see below and which we can get from the
balance sheet.
The closing cash balance for the current year of 185
less the closing balance from the prior year of 150
gives us a $35,000 increase in cash. So there we have prepared the
Chudley Cannons cash flow statement using the direct method.
Working out all of the numbers manually in the income statement and balance sheet.
Woah
That was hard work wasn't it?
And this is only a simple example.
You can imagine that this whole
process is more complicated for
larger companies with more complex transactions.
Which is why most of them actually avoid this process altogether
because it can be too expensive and time-consuming for
their accountants to work out cash flow using the direct method.
The majority of large corporations tend to opt for the
indirect method instead.
Which is the subject of our next video.
The indirect method has
the benefit of being much easier to prepare.
However it's less useful to investors and I'll explain why next time.
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