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 collections are 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 purchases make 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 expenses is 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 expenses = operating expenses + increase (or - decrease) in prepaid expenses + decrease (or - increase) in accrued liabilities

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

             Formula 6.10

Cash interest = interest expense - increase (or + decrease) interest payable + amortization of bond premium (or - discount)

  • Cash payment for income taxes is the actual cash paid in the form of taxes. It is defined as:

             Formula 6.11

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


Look Out!

Note: Cash flow from investing and financing are computed the same way it was calculated under the indirect method.

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


Look Out!

Candidates must know the following:

  • Though the methods used differ, the results are always the same.
  • CFO and CFF are the same under both methods.
  • There is an inverse relationship between changes in assets and changes in cash flow.


Free Cash Flow

Related Articles
  1. Investing

    The Essentials Of Corporate Cash Flow

    Tune out the accounting noise and see whether a company is generating the stuff it needs to sustain itself.
  2. Investing

    Analyze Cash Flow The Easy Way

    Find out how to analyze the way a company spends its money to determine whether there will be any money left for investors.
  3. Investing

    Cash Flow From Investing

    Cash flow analysis is a critical process for both companies and investors. Find out what you need to know about it.
  4. Investing

    Fundamental Case Study: Is Amazon's Cash Flow Actually Solid? (AMZN)

    Review Amazon's cash flow situation, including its free cash flow yield, operating cash flow from organic growth and cash flow from debt financing.
  5. Investing

    Calculating Net Cash

    A company’s net cash is its total cash remaining after it subtracts all liabilities.
  6. Investing

    Analyze Cash Flow The Easy Way

    Cash flow statements reveal how a company spends its money and where that money comes from.
  7. Investing

    Cash Flow From Financing Activities (CFF)

    Cash flow from financing activities is typically the third and final section of the statement of cash flows. It shows changes to cash resulting from activities such as issuing stocks and bonds ...
  8. Investing

    Free Cash Flow Yield: A Fundamental Indicator

    Free cash flow can measure a business’s performance as if you’re looking at its net income line.
  9. Investing

    Cash: Can A Company Have Too Much?

    Cash is something companies love to have. But if they are not using it there could be problems.
Frequently Asked Questions
  1. Where else can I save for retirement after I max out my Roth IRA?

    The first option to explore is to determine if you can contribute to a 401(k), 403(b), or 457 plan at work. If your employer ...
  2. How did George Soros "break the Bank of England"?

    In Britain, Black Wednesday (September 16, 1992) is known as the day that speculators broke the pound. They didn't actually ...
  3. What counts as "debts" and "income" when calculating my debt-to-income (DTI) ratio?

    It's important to know your debt-to-income ratio because it's the figure lenders use to measure your ability to repay the ...
  4. Who are Monsanto's main competitors?

    Learn about Monsanto Company's two main operating divisions and its main competitors within each sector, including The Mosaic ...
Trading Center