The cash flow statement is a financial statement that summarizes the cash inflows and outflows of a company during a specific period. The cash flow statement is one of the most important financial statements as it helps investors and stakeholders understand the liquidity of the company. In this article, we will discuss the direct method of preparing the cash flow statement, including the formulas used to calculate the different components of the cash flow statement.
What is the Direct Method of Cash flow?
The direct method is one of the two methods used to prepare the cash flow statement. In the direct method, the cash inflows and outflows are directly reported. This means that the direct method reports the actual cash received and paid during the period, rather than using accrual accounting to estimate the cash flows.
Formulas of the Direct Method of Cash flow
The direct method uses the following formulas to calculate the different components of the cash flow statement:
Cash Received from Customers = Sales - (Increase) in Accounts Receivable
Cash Paid for Operating Expenses (Includes Research and Development) = Operating Expenses - (Decrease) in Prepaid Expenses - (Increase) in Accrued Liabilities
Cash Paid for Income Taxes = Income Taxes Paid
Cash Paid for Interest = Interest Paid
Cash Paid for Dividends = Dividends Paid
Explanation of the Formulas
Cash Received from Customers
The formula for cash received from customers is calculated by subtracting the increase in accounts receivable from the total sales revenue. Accounts receivable represents the money that the company is owed by its customers, and an increase in accounts receivable means that the company has not yet received payment for sales made during the period. By subtracting the increase in accounts receivable from the total sales revenue, we can calculate the actual cash received from customers during the period.
Cash Paid for Operating Expenses
The formula for cash paid for operating expenses is calculated by subtracting the decrease in prepaid expenses and adding the increase in accrued liabilities from the total operating expenses. Prepaid expenses represent expenses that have been paid in advance, and a decrease in prepaid expenses means that the company has used some of the prepaid expenses during the period. Accrued liabilities represent expenses that the company has incurred but has not yet paid, and an increase in accrued liabilities means that the company has incurred more expenses during the period. By subtracting the decrease in prepaid expenses and adding the increase in accrued liabilities from the total operating expenses, we can calculate the actual cash paid for operating expenses during the period.
Cash Paid for Income Taxes, Interest, and Dividends
The formulas for cash paid for income taxes, interest, and dividends are straightforward. These components represent the actual cash payments made by the company during the period for income taxes, interest, and dividends.
Example of Cash flow (Direct Method)
| Cash Flow from Operating Activities | |||
|---|---|---|---|
| Cash Receipts | |||
| From Customers | $500,000 | ||
| Cash Payments | |||
| For Operating Expenses | ($300,000) | ||
| For Income Tax | ($50,000) | ||
| For Interest | ($10,000) | ||
| For Dividends | ($20,000) | ||
| Net Cash Flow from Operating Activities | $120,000 | ||
| Cash Flow from Investing Activities | |||
| Cash Flow from Financing Activities | |||
| Net Increase in Cash and Cash Equivalents | $120,000 | ||
| Beginning Cash and Cash Equivalents | $50,000 | ||
| Ending Cash and Cash Equivalents | $170,000 |
Conclusion
The direct method of preparing the cash flow statement is a straightforward approach that reports the actual cash inflows and outflows of the company during the period. By using the formulas discussed in this article, we can calculate the different components of the cash flow statement and understand the liquidity of the company. The direct method provides valuable information to investors and stakeholders and should be considered when preparing the cash flow statement.
