What are the differences between preparing a cash flow statement using the direct method
versus preparing a cash flow statement using the indirect method?
Let's review that in this short video.
What the direct method and the indirect method cash flow statement have in common, is that
they have three main categories: Cash From Operating Activities,
Cash From Investing Activities and Cash From Financing Activities.
Together these form the net increase or decrease in cash during the year.
You then sum that net increase or decrease with the cash balance at the beginning of
the year, and you should reconcile to the cash balance at the end of the year.
Accounting statement FAS95 has examples with numbers of the direct method (on the left)
and the indirect method (on the right).
The difference between the methods is purely in the section called CFOA,
or Cash From Operating Activities, at the top.
We will zoom in on those red boxes to see the detail.
For the sections at the bottom, the direct method and the indirect method use the same
line items.
In Cash From Investing Activities, the main line items are capital expenditures, proceeds
from selling factories or buildings, and business acquisitions or divestments.
In Cash From Financing Activities, the main line items are dividends paid, shares issued
or repurchased, and issuances or repayments of debt.
Here's the example from FAS95 on reporting CFOA using the direct method.
You start off with cash received from customers of 13.9 billion (a positive number, cash inflow),
you deduct cash paid to suppliers and employees 12 billion (a negative number, cash outflow),
and then account for smaller items such as interest paid 220 million and
income taxes paid 325 million.
Total net cash provided by operating activities, calculated using the direct method is 1.4
billion, which should be the same if you calculate it by using the indirect method.
Here's the example from FAS95 on reporting CFOA using the indirect method.
When you use the indirect method, you start off with net income, or net profit.
In this example, net income is 760 million.
Next step in the indirect method is to look for any non-cash items from the P&L.
In this example, the main non-cash item is depreciation and amortization,
which is 445 million.
You deducted depreciation as an expense in order to report the correct amount of EBIT
and profit before tax in the income statement, and to calculate
the correct amount of corporate income taxes.
For cash flow purposes, you will have to add back that same amount of depreciation.
The next four items work in a similar way: you make adjustments for items that are treated
differently when you recognize profit or costs versus when you record cash receipts
or cash disbursements of a company.
A key section of the indirect method is in the middle of the page: increases or decreases
of working capital items on the balance sheet.
If accounts receivable goes up, then cash goes down, in this case 215 million.
If inventory decreases, then cash goes up, in this case 205 million.
Etcetera.
Total net cash provided by operating activities, calculated using the indirect method
is 1.4 billion.
So why would you use the direct method (which in some countries is rare)?
First of all, FAS95 encourages (but doesn't mandate) companies to report gross cash receipts
and gross cash payments.
Two of the FASB members arguing in favor of mandatory use of the direct method at the
time FAS95 was being discussed and reviewed, said that it is more informative and more
consistent with the primary purpose of a statement of cash flows.
FAS95 mentions that the direct method may help investors to estimate future operating
cash flows based on historical detail.
Lastly, International Accounting Standard 7 (the FAS95 equivalent in IFRS) has similar
wording: "encouraging companies to use the direct method".
I have a lot of material available on the Finance Storyteller YouTube channel that can
help you get a good understanding of the topic of cash flow and related items.
For example, I have full walk-throughs for you of both direct method and indirect method
cash flow statements!
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