Cash Flow Statement Direct Method

The cash flow statement direct method refers to presenting the cash flow statement centered on the actual cash transactions happening inside the core operations of a company. It directly shows cash outflows and inflows impacting the financial position of a firm by giving a detailed and transparent view of cash transactions.

It needs more significant effort to prepare as it requires exact input on payments and cash receipts. It is more accurate than the indirect method as it overcomes distortions due to non-cash items. Most big companies use it as they involve a large number of cash transactions.

The cash flow statement direct method is an accounting method utilized to prepare the cash flow statement showing the accurate receipts and payments by a firm during a specified period. It has significant advantages over other methods as it calculates cash flow derived from operating activities after adjusting net income for the impacts of non-cash transactions. It offers a much more transparent and detailed overview of the cash flow situation of a company, leading to a better comprehension of its profitability and cash cycle as it is based on cash accounting principles. It allows enhanced comparative evaluation with rivals inside the same sector and simplified cash flow management.

It works by excluding depreciation in the cash flow statement direct method and listing all the cash receipts obtained from payments to employees, cash payments to employees plus suppliers, interest paid, income taxes paid, interest and dividends receipt, and customers. Unlike the indirect method, payment from the customer and payment to the supplier is recorded when these actually happen. As a result, it brings clarity to operating cash flows in contrast to the indirect methods. 

However, showing the uses and sources of cash streams enhances transparency, aiding the investors in well-informed decision-making. Further, it has encouraged accountability and transparency in the company's financial statements and impacted financial reporting standards. Nevertheless, companies rarely use it as their requirement for restructuring chart-of-accounts, which is complex.

Let us learn how to prepare the in steps as shown below:

• Step 1 -: First, scan all the transactions for a specific period to determine if they were cash outflow or inflow. 
• Step – 2: Then determine the net cash inflow for all operating activities.
• Step 3: Add up all cash inflows arising from various operating activities to get total cash inflows generated. It can formed of the actual cash transactions from sales by customers or accounts receivables. 
• Step -4: Record all transactions from operations subtracted from the total cash balance, such as suppliers' payments, accounts payable, cash payments made for taxes or interests, or any other operating expenses.
• Step 5: Finally, make the total cash flows minus the total cash outflows to obtain net cash flow from all operating activities.

Let's use a few examples to understand the topic.

Example #1

Let us consider the following cash flows of company X’s operating activities:

Income taxes paid= $ 1,500,000

Interest paid= $ 300,000

Cash receipts customers'= $ 50,000,000

Cash paid to suppliers= $ 30,000,000 

Cash paid to employees= $ 11,000,000

Hence, for calculating net cash flow from the above activities:

Net cash flow= total cash receipts - total cash payments

Total cash receipts= $ 5,000,0000

Total cash payments = $ 500,000 + $ 300,000 + $ 30,000,000 + $ 11,000,000 = $ 42,800,000

Net cash flow= $ 50,000,000 - $ 42,800,000 

          = $ 7,200,000

Hence, the above example clearly and comprehensively shows the minute details of company X's cash inflows and outflows.

Example #2

Let us assume XYZ Garments manufactures cloth for US markets. Presented below, one finds simplified cash flow statements related to the annual closure on December 31, 2022.

Hence,

A - Cash Flow due to all Operating Activities

Cash received from customers: $800,000 

Cash payment to suppliers: -$400,000 

Cash payment to wages & salaries:  -$200,000 

Net cash due to operating activities: $200,000 

B- Cash Flow from Investing Activities 

Equipment Purchase:  -$80,000 

Net cash put into investing activities: - 80,000

C- Cash Flow-Financing Activities 

Common stock Issuance:  $300,000

Dividends Payment: - $40,000 

Net cash concerning financing activities: $260,000

Therefore, total net cash flow = Net cash due to operating activities +Net cash concerning financing activities -Net cash put into investing activities 

=$200000 + $260000 - $80000

Total net cash flow: $380,000

The direct method of cash flow statement is the preferred method by the Financial Accounting Standards Board (FASB). The first one has to group the cash transactions into different types of cash receipts and payments. Then, these transaction groups make it easy to use the cash flow statement by using the below format or sample cash flow statement direct method or a template:

Group A

Cash Payment to Suppliers

Cash Receipts from Customers

Cash Payment for Operating Expenses Including Research and Development.

GROUP A: 

Interest Receipts

Interest Payment 

GROUP C: 

Income Tax Refund Receipts

Income Tax Refund Payment 

GROUP D: 

Other Cash receipts (payment)

The sum of the above groups provides the total cash utilized in various operating activities.

Let us know the pros and cons of the direct method of cash flow statement: