# 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 31 2011 2010 Accounts Receivable $34,130$28,410 Prepaid Rent 20,000 25,000 Prepaid Insurance 6,800 6,000 Inventory 23,030 15,450 Accounts Payable 14,590 31,300 Salaries Payable 8,310 5,120 Interest Payable 700 360 Income Tax Payable 2,340 0 Year Ended December 31 2011 Net Sales 64,970 Salaries Expense 8,610 Rent Expense 5,000 Insurance Expense 3,200 Interest Expense 1,650

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 Activities 24,230
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