How to calculate Cash From Operating Activities (or CFOA) using the direct method.
Let me explain to you how to construct a cash flow statement in this short video.
This video covers the direct method of cash flow reporting, the companion video that I
will link to in the description below covers the indirect method.
Start off with reviewing the inputs to your assignment.
What I am showing here are the inputs that I gave to participants in one of my "finance
for non-financial managers" courses, to have them construct the income statement, balance
sheet, and cash flow statement for year 2 of an exercise.
So we started off with the year 1 financial statements, and with this list of inputs,
they constructed year 2 financial statements.
In this video, we focus on the cash flow statement, and we use the direct method to construct it.
What happens to the company in year 2?
Revenue doubles.
Gross Profit % stays the same.
Headcount increases by 50%, at same average salary.
Collections of receivables equal new invoices issued.
Purchases of chocolate from supplier: 250.
Payments to supplier: 200.
No new investments in P&E.
Debt level (the amount borrowed from the bank) is unchanged.
No new equity issued.
In order to transfer these inputs into numbers, let's construct the year 2 income statement,
and then we will select the relevant items from there to help build the cash flow statement.
On the left is the prior year (year 1) income statement, and each of the inputs from the
prior page helps you to construct the current year (year 2) income statement on the right.
If revenue doubles, then it goes from 200 to 400.
If Gross Profit as % of revenue stays the same, then Cost Of Sales goes to 200, and
Gross Profit goes to 200.
Headcount increases by 50% at the same average salary, so it goes from 20 to 30.
No new investments in P&E and using the same depreciation schedule keeps depreciation at 20.
EBIT goes from 60 to 150 due to operating leverage.
The interest amount stays the same if the debt level and the interest rate are unchanged,
and taxes go up proportionally if Profit Before Tax goes up.
20% of 140 is 28.
Now which ones of these items are important for us if we want to construct the cash flow
statement using the direct method?
Revenue is important, and we saw in the inputs that collections of receivables equal new
invoices issued.
Note that in real life this is very rarely the case!
In this example, cash received from customers in year 2 is therefore 400.
Cost of Sales is interesting, but it does not directly give us the amount of cash payments
to suppliers.
Cost of Sales may be higher or lower than that, due to inventory and/or payables increasing
or decreasing.
On the previous page, we saw that payments to suppliers are 200, so by accident these
are equal to Cost of Sales.
Once again, in real life this is very rarely the case!
Cash paid to employees often equals the total Compensation and Benefits booked in the P&L
(employees get paid in the month in which they work), unless you record expenses for
bonuses and commissions that you accrue for this year, but only pay next year.
Interest paid usually equals the amount of interest booked in the P&L.
Income taxes paid in real life rarely equals the amount of income taxes booked in the P&L,
but in this example it does (to keep things simple).
Let's summarize the items we have found so far.
In the direct method of cash flow reporting, you start off with cash received from customers
of 400, you deduct cash paid to suppliers 200, you deduct cash paid to employees 30,
interest paid 10, and income taxes paid 28.
Total net cash provided by operating activities, calculated using the direct method is 132,
which should be the same if you calculate it by using the indirect method (which would
reconcile from net income to CFOA by adjusting for non-cash items in the P&L plus changes
in working capital).
To complete this example, and build the full cash flow statement, let's look for any clues
on the lines of Cash From Investing Activities (CFIA) and Cash From Financing Activities (CFFA).
In this example, to keep it simple, nothing is happening in either of those lines.
In real life, for a mature and successful company, there would probably be a CapEx cash
outflow in CFIA, and a dividend cash outflow in CFFA.
If you add up the three categories, Cash From Operating Activities, Cash From Investing Activities
and Cash From Financing Activities, you get to the net increase or decrease in cash.
Please note that you have not yet completed the full cash flow statement!
An important step is to check on the balance sheet what the amounts were of the opening
cash balance and the closing cash balance.
Opening cash was 60, closing cash was 192.
The net increase or decrease in cash that you calculated should be the difference between
those two balances.
The last step in constructing your cash flow statement is to show just that: the net increase
in cash of 132, plus the opening cash of 60, equals the closing cash balance of 192.
Done!
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