Direct vs Indirect Method Cash Flow Statement
The direct method and indirect method of preparation of cash flow statement differ in the way the cash flows from operating activities is calculated and presented. In the direct method of cash flow statement preparation, actual receipts from customers and actual payments to suppliers, service providers, employees, taxes, etc. are reported. While under the indirect method, the net income is adjusted for non-cash items and working capital changes to arrive at the net cash flows from operating activities.
Accounting standards allow users to present the cash flows from operating activities using either the direct method or the indirect method. Direct method is the preferred approach, but most companies use the indirect method for preparing cash flow statement because it is easier to implement. Further, IFRS requires a reconciliation between net income and cash flows from operating activities when direct method cash flow statement is prepared.
Direct Method
Direct method of cash flow statement shows the actual cash inflows and cash outflows from operating activities to arrive at the net cash flows from operating activities. In the direct method, the presentation of cash flows from operating activities section is the same as the cash flows from investing activities and cash flows from financing activities section.
Typical cash inflows related to operating activities include:
- Cash collected from customers for sales goods
- Cash collected for services rendered
- Cash inflows related to royalties, dividends and interest earned
Typical cash outflows from operating activities include:
- Cash paid to suppliers and service providers
- Other operating expenses paid
- Income taxes
- Interest paid
Indirect Method
Indirect method of cash flow statement reconciles the net income as reported on the income statement with net cash flows from operating activities:
- Adding interest expense and subtracting interest paid
- Add tax expense and subtracting tax paid
- Adding back non-cash expenses such as depreciation, bad debts
- Subtracting non-cash income such as gain on property, plant and equipment
- Adding decrease in current assets and subtracting increase in current assets
- Adding decrease in current liabilities and subtracting increase in current liabilities
Example
Let’s work out the cash flow statement using the indirect method given the following balance sheet:
| USD in million | 2017 | 2016 |
|---|---|---|
| Non-current assets | ||
| Fixed assets | 400 | 420 |
| Long-term investments | 120 | 65 |
| Total non-current assets | 520 | 485 |
| Current assets | ||
| Prepayments | 15 | 10 |
| Inventories | 50 | 35 |
| Accounts receivables | 60 | 70 |
| Cash and cash equivalents | 17 | 20 |
| Total current assets | 142 | 135 |
| Total assets | 662 | 620 |
| Common stock | 200 | 200 |
| Retained earnings | 102 | 70 |
| Total shareholders’ equity | 302 | 270 |
| Non-current liabilities | ||
| Long-term loans | 210 | 220 |
| Current liabilities | ||
| Accounts payable | 60 | 50 |
| Taxes payable | 55 | 30 |
| Interest payable | 20 | 25 |
| Accrued expenses | 15 | 25 |
| Total current liabilities | 150 | 130 |
| Total shareholders’ equity and liabilities | 662 | 620 |
Here’s the income statement for 2017:
| Income statement | USD in million |
|---|---|
| Revenue | 500 |
| Cost of sales (depreciation of $50 million) | (200) |
| Gross profit | 300 |
| Operating expenses | (150) |
| EBIT | 150 |
| Interest expense | (30) |
| EBT | 120 |
| Tax expense | (48) |
| Net income | 72 |
The following schedule shows the cash flows statement prepared using the indirect method. Each line item shows how it is calculated:
| Cash flow statement | USD in million | Source/calculation |
|---|---|---|
| Cash flows from operating activities | ||
| Net income | 72 | (a) |
| Add: interest expense | 30 | (a) |
| Add: tax expense | 48 | (a) |
| Add: depreciation expense | 50 | (a) |
| Add: increase in current liabilities | - | (b) |
| Less: increase in current assets | (10) | (c) |
| Less: interest paid | (35) | (d) |
| Less: taxes paid | (23) | (e) |
| Less: dividends paid | (40) | (f) |
| Net cash flows from operating activities | 92 | (g) |
| Cash flows from investing activities | ||
| Purchase of fixed assets | (30) | (h) |
| Acquisition of long-term investments | (55) | (i) |
| Net-cash flows from investing activities | (85) | (j) = (h) + (i) |
| Cash flows from financing activities | ||
| Repayment of loans | (10) | (k) |
| Net-cash flows from financing activities | (10) | |
| Net cash flows during the year | (3) | (l) |
| Opening cash and cash equivalents | 20 | (m) |
| Closing cash and cash equivalents | 17 | (n) |
- Income statement
- It is calculated by subtracting the opening balances of accounts payable and accrued expenses from their closing balances. We have not included interest payable and tax payable because these are separately shows below.
- Calculated by subtracting the opening balance of currents assets other than cash and cash equivalents from their closing balances. Cash and cash equivalents are excluded because a cash flow statement shows a reconciliation between opening and closing balance of cash and cash equivalents.
- It equals opening balance of interest payable plus interest expense minus closing balance of interest payable.
- It equals opening balance of tax payable plus tax expense minus closing balance of tax payable.
- It equals opening retained earnings plus net income minus closing retained earnings.
- Sum of all the aforementioned figures
- Closing balance of fixed assets plus depreciation minus opening balance.
- Closing balance of long-term investments minus opening balance.
- Sum of aforementioned values
- Closing balance of loans payable minus opening balance.
- Sum of net cash flows from operating activities, investing activities and financing activities
- Cash and cash equivalents balance last year
- Current year cash and cash equivalents closing balance.
by Obaidullah Jan, ACA, CFA and last modified on