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

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