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Financial Statements - Cash Flow

Computations - Direct Method

The Direct Method

The direct method is the preferred method under FASB 95 and presents cash flows from

activities through a summary of cash outflows and inflows. However, this is not the

method preferred by most firms as it requires more information to prepare.

Cash Flow from Operations

Under the direct method, (net) cash flows from operating activities are determined by

taking cash receipts from sales, adding interest and dividends, and deducting cash

payments for purchases, operating expenses, interest and income taxes. We'll examine

each of these components below:

Cash collectionsare the principle components of CFO. These are the actual

cash received during the accounting period from customers. They are defined as:

Formula 6.7

Cash Collections Receipts from Sales

= Sales + Decrease (or - increase) in Accounts Receivable

Cash payment for purchasesmake up the most important cash outflow

component in CFO. It is the actual cash dispersed for purchases from suppliers

during the accounting period. It is defined as:

Formula 6.8

Cash payments for purchases = cost of goods sold +increase (or - decrease) in inventory + decrease (or - increase) in accounts payable

Cash payment for operating expensesis the cash outflow related to selling

general and administrative (SG&A), research and development (R&A) and other

liabilities such as wage payable and accounts payable. It is defined as:

Formula 6.9

Cash payments for operating epenses = operating epenses +increase (or - decrease) in prepaid epenses + decrease (or - increase) in accrued liabilities

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Cash interest isthe interest paid to debt holders in cash. It is defined as:

Formula 6.10

Cash interest = interest epense !increase (or + decrease) interest payable + amorti"ation of bond premium (or - discount)

Cash payment for income taxesis the actual cash paid in the form of taxes. It is

defined as:

Formula 6.11

Cash payments for income taes

= income taxes + decrease (or - increase) in income taxes payable

The diagram below demonstrates how net cash flow from operations is derived using the

direct method.

Though the methods used differ, the results are always the same.

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CFO and CFF are the same under both methods.

There is an inverse relationship between changes in assets and changes in cash

flow