Direct method cash flow statement versus indirect method cash flow statement.
So far, I have only come across one company that presents their cash flow
using the direct method: CVS Health.
I find the direct method easy to understand and intuitive.
Let me show you!
Who are CVS Health?
CVS Health is an integrated pharmacy health care company in the US
with a network of 9,700 retail locations,
revenue of $178B, operating profit of $10B
and net income of $5B in 2016.
Let's zoom in to their cash flow statement in this video!
CVS Health started the year with $2.5B in cash and cash equivalents, and ended the year
with $3.4B. The total cash flow was therefore a net cash inflow of $900 million.
What were the sources and uses of cash, that add up to this $900 million net cash inflow?
Cash From Operating Activities was an inflow of $10.1B.
Cash From Investing Activities was an outflow of $2.5B.
Cash From Financing Activities was an outflow of $6.7B.
Now we go one level deeper, discussing each of the three cash flow categories.
CVS presents CFOA using the direct method!
Isn't that exciting?
Thank you!
The direct method is exactly that: direct.
How much did CVS Health receive in payments from customers in 2016? $172B.
How much did CVS pay to suppliers for inventory and prescriptions? $143B.
How much did CVS pay to other suppliers and employees? $16B.
How much did CVS pay in interest? $1.1B.
How much did they pay in income taxes? $3.1B.
All of these are cash inflows and cash outflows
related to normal day-to-day operating activities.
The total of the cash inflows and cash outflows is a net positive of $10.1B.
Now let's look at the same numbers, but presented using the indirect method.
I find this method far less intuitive, and it takes a bit more effort to process this
information.
The essence of the indirect method of cash flow reporting is: you start with the net
income, and then make adjustments to reconcile that net income to CFOA.
First off, you add back items from your profit and loss statement that have a profit impact
but not a cash flow impact.
The big line item for most companies in this section is depreciation and amortization,
$2.5B in 2016 for CVS Health.
This number was deducted as a cost when net income was calculated in the profit and loss
statement, but as you do not pay depreciation and amortization to anybody (it is what we
call in finance a "non-cash expense"), you have to add back the amount if you want to
get to a cash flow based view.
The other line items of significant size in the reconciliation to CFOA are related primarily
to working capital.
The main item that stands out for CVS Health
is the line "accounts payable and claims and
discounts payable".
If you check the balance sheet, you find that the claims and discounts payable balance has
gone up by almost $2B year-over-year.
If that liability goes up, then it has a positive effect on cash flow.
Total cash from operating activities presented under the indirect method is $10.1B.
The direct method of cash flow reporting gave us $10.1B from identifying the specific amount
of cash in from customers, and cash out mainly to suppliers, employees, and the government.
Using the indirect method of cash flow reporting, you reconcile from net income to net cash
provided by operating activities, by adding back non-cash expense items such as depreciation
and amortization, as well as changes in working capital balance sheet line items.
Same number, different approach!
Time to move to the next section of the cash flow statement: Cash From Investing Activities,
a net cash outflow of $2.5B in 2017.
The main line item in most years for most companies is the very first one: CapEx spending,
or Capital Expenditures.
For CVS Health in 2016, this was mainly related to fixtures and equipment, and leasehold improvements.
I have a very good video on the difference between CapEx and OpEx on the Finance Storyteller
channel, I think you should watch that one next!
Third section of the cash flow statement: Cash From Financing Activities, a net cash
outflow of $6.7B. At the top, there is activity of issuing new debt, and repaying old debt.
The next item of significance is dividends paid: $1.70 per share, $1.8B in total.
The largest line item in Cash From Financing Activities is repurchase of common stock,
or share buy-backs, of $4.5B.
Back from the detail to the high level cash
flow statement overview.
CVS Health started the year with $2.5B in cash and cash equivalents, and ended the year
with $3.4B. The total cash flow was a net cash inflow of $900 million.
Cash From Operating Activities was an inflow of $10.1B, as incoming payments from customers
far exceeded the outgoing payments to suppliers, employees and the government.
Cash From Investing Activities was an outflow of $2.5B, mainly for CapEx spending.
Cash From Financing Activities was an outflow of $6.7B, mainly share-buybacks and dividends.
That's how a cash flow statement works!
If you know of any other companies that use the direct method of cash flow statement preparation,
please mention them in a comment, I would really appreciate it!
Speaking of cash flow, 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 the cash flow statements of Shell,
Tesla and Walmart.
I think the best way to learn how to read a cash flow statement is to go through as
many real-life examples as you can!
Thank you for watching!
If you enjoyed this example of how to review a cash flow statement, then please press the
"like" button for me, and share it with friends and colleagues!
On this end screen, there are a few suggestions of videos you can watch next.
Please subscribe to the Finance Storyteller channel, and when doing so please hit the
"bell" icon, so you receive automatic notifications when I post new videos!
Thank you.