Methods of Cash Flow Statement Presentation: Direct vs. Indirect | CFA Level I FSA
Direct vs. Indirect Method of Cash Flow Presentation
Direct Method: Identifies actual cash inflows and outflows.
Comparison of Direct and Indirect Methods
The direct method converts an accrual-basis income statement into a cash-basis cash flow statement, while the indirect method converts net income from the income statement to operating cash flow by making adjustments for non-cash transactions.
Under the direct method, cash inflows and outflows are calculated by converting revenue and expenses accounted for on an accrual basis into actual cash received and expensed. The direct method begins with cash inflows from customers and then deducts cash outflows for purchases, operating expenses, interest, and taxes.
- Eliminating noncash expenses like depreciation and amortization.
- Nonoperating items like gains and losses.
- Changes in balance sheet accounts resulting from accrual accounting events.
Total cash flow from operating activities is the same under both methods.
Advantages of Direct and Indirect Methods
Direct method provides more information than the indirect method, while the indirect method focuses on the differences in net income and CFO, providing a useful link to the income statement when forecasting future CFO.
Preparing Cash Flow Statement from Financial Statements
Determine the cash received from customers:
Plugging in the figures, we get a total of $99,000 cash collected from customers.
Determine the cash paid to suppliers:
Plugging in the figures, we get a total of $34,000 paid to suppliers.
Calculate the cash paid for operations:
Cash Paid for Operations = SG&A – Increase in Accrued Liabilities
Plugging in the figures, we get a total of $8,500 cash paid for operations during this period.
Continue with the pattern for cash paid for interest and taxes.
Preparing Indirect Cash Flow Statement
Preparing the indirect cash flow statement is different from the direct statement. We begin with net income and adjust it for differences between accounting items and actual cash receipts and disbursements.
- Begin with net income.
- Eliminate depreciation and amortisation by adding them back. These are expenses where cash was not dispensed.
- Eliminate gains by deducting them, and losses by adding them back. These are CFI items, not CFO.
- Add or subtract changes to balance sheet operating accounts as follows.
By following these steps, you can calculate the CFO using the indirect method, which will give you the same result as the direct method. Analysts may find it easier to forecast net income and then derive the CFO by adjusting net income for the differences between accrual accounting and cash basis accounting.
Summary of Presentation Methods for CFI and CFF
The presentation for Cash Flow from Investing (CFI) and Cash Flow from Financing (CFF) is identical under both direct and indirect methods. In this passage, we will discuss in more detail how these cash flows are prepared and provide a comprehensive understanding of the process.
Investing Cash Flows (CFI)
Investing cash flows are determined by examining the changes in the gross asset accounts resulting from investing activities, such as plant, property and equipment (PP&E), land, intangible assets, and investment securities. Accumulated depreciation or amortization accounts are ignored since they do not represent cash expenses.
To calculate CFI, we must identify the cash paid for new asset purchases during the period. When working with net PP&E figures, the purchased new PP&E is the increase in net PP&E for the period, plus the depreciation expense, plus the cost of PP&E sold during the period. In the given example, the purchased new PP&E for the year is $25,000, which is a cash outflow. It is important to note that when working with gross PP&E, depreciation expense is ignored as it has not been factored into the gross PP&E computation.
When an asset is sold, cash is received, and it must be accounted for under CFI. To calculate the cash inflow from the sale of an asset, we use the sum of the gain or loss on the sale, plus the decrease in the asset account for the period. In the example, the cash inflow from the sale of land is $15,000.
Financing Cash Flows (CFF)
Financing cash flows are determined by measuring the cash flows occurring between the firm and its suppliers of capital. These suppliers include creditors who hold bonds issued by the firm and shareholders who hold common and preferred shares.
Cash flows between the firm and its creditors result from new borrowings and debt principal repayments. It is important to note that interest paid is technically a cash flow to creditors, but it is usually included in CFO under U.S. GAAP.
Cash flows between the firm and its shareholders occur when new shares are issued, shares are repurchased, or when cash dividends are paid.
For CFF, we examine the financial statements for clues where financing cash flows have occurred. In the example, cash inflows include $5,000 from bond issues. Cash outflows include $10,000 for stock repurchases and $3,500 for dividends paid out. The dividends payable account is an accrual account that accounts for dividends declared but not yet paid out. We calculate the dividends paid out during the period by rearranging the equation: beginning dividends payable, plus dividends declared, minus ending dividends payable.
Adding all items, we get a total CFF of -$8,500.
Lastly, the total cash flow is equal to the sum of Cash Flow from Operations (CFO), CFI, and CFF. In the example, the total cash flow is $24,000, which is consistent with the net change in cash for the year.
This lesson has provided a comprehensive explanation of the mechanics of preparing cash flow statements using both direct and indirect methods for CFI and CFF. Understanding these methods will help you analyze financial statements, make informed financial decisions, and evaluate a company’s financial performance and liquidity position.