Cash Flow from Operating Activities: Direct Method

The direct method to calculate cash flow from operating activities involves determination of various types of cash receipts and payments such as cash receipts from customers, cash paid to suppliers, cash paid for salaries, etc. and then putting them together under the cash flow from operating section of cash flow statement. These figures are calculated using the beginning and ending balances of various accounts of the business and the net increase or decrease in the account. The exact formulas to calculate various cash inflows and outflows vary. The most importan ones are given below:

Formulas

Cash Receipts from Customers =
+Net Sales
+Beginning Accounts Receivable
Ending Accounts Receivable
 
Cash Payments to Suppliers =
+Purchases
+Ending Inventory
Beginning Inventory
+Beginning Accounts Payable
Ending Accounts Payable
 
Cash Payments to Employees =
+Beginning Salaries Payable
Ending Salaries Payable
+Salaries Expense
 
Cash Payments for Purchase of Prepaid Assets =
+Ending Prepaid Rent, Prepaid Insurance etc.
+Expired Rent, Expired Insurance etc.
Beginning Prepaid Rent, Prepaid Insurance etc.
 
Interest Payments =
+Beginning Interest Payable
Ending Interest Payable
+Interest Expense
 
Income Tax Payments =
+Beginning Income Tax Payable
Ending Income Tax Payable
+Income Tax Expense

In the formulas given above it is assumed that accounts receivable are only used for credit sales. It is also assumed that all sales are on credit. If there are cash sales as well, then receipts from cash sales must be included in the cash receipts from customers to obtain a correct figure of cash flow from operating activities.

Similarly, it is assumed that accounts payable are used merely for purchases on account and that all purchases are on credit. If there are cash purchases as well, then cash payments for them must be included in the cash paid to suppliers. It is important to note that here may be receipts & payments other than those discussed above.

Once the all the cash inflows and outflows from operating activities are calculated, they are added in the operating section of cashflows to obtain the net cashflow from operating activities.

The following example shows the format and calculation of cash flows from operating activities using direct method.

Example

Prepare the cash flows from operating activities section of cash flow statement by direct method using the following information:

December 3120112010
Accounts Receivable$34,130$28,410
Prepaid Rent20,00025,000
Prepaid Insurance6,8006,000
Inventory23,03015,450
Accounts Payable14,59031,300
Salaries Payable8,3105,120
Interest Payable700360
Income Tax Payable2,3400
   
Year Ended December 312011
Net Sales64,970
Salaries Expense8,610
Rent Expense5,000
Insurance Expense3,200
Interest Expense1,650

Solution:

Cash Flow from Operating Activities:
Cash Receipts
From Customers (1)$59,250
Cash Payments
To Suppliers (2)−24,290
To Employees (3)−5,420
For Purchase of Prepaid Assets (4)−4,000
Interest (5)−1,310
Income Tax (6)−0
Net Cash Flow from Operating Activities24,230
Working Notes
1) 64,970 + 28,410 - 34,130
2) 23,030 - 15,450 + 31,300 - 14,590
3) 5,120 - 8,310 + 8,610
4) 20,000 + 6,800 + 5,000 + 3,200 - 25,000 - 6,000
5) 360 - 700 + 1,650
6) 0 - 2,340 + 2,340

Written by Irfanullah Jan