Question

Describe “Direct” and “Indirect” method of ascertaining cash flow from operating activities.

Answer 1

Computation of Cash Flow From Operating Activities

The first section of cash flow statement, known as cash flow from operating activities, can be prepared by two methods known as direct method and indirect method.

(i) Direct Method - In the direct method format, each line of the operating activities section represents a sum of all cheques or deposits in a particular category. e.g., the operating activities section would include such items as cash received from customers; cash paid to suppliers; cash paid for interest; cash paid for wages; cash paid for research and development; cash paid for selling, general, and administrative costs; and any other relevant summary lines.

Direct Method Format - Cash flow from operating activities is calculated by direct method as follows

$\begin{array}{cc}\text{Cash Flows from Operating Activities}& \\ \text{(a) Cash Receipts from Customers}=& \\ \text{Net Sales + Beginning Accounts Receivable}& \\ -\text{Ending Accounts Receivable}& \\ & =\text{xxx}\\ \text{(b) Cash Payments to Suppliers}& \\ \text{Purchase + Ending Inventory - Beginning Inventory}& \\ \text{+ Beginning Accounts Payable - Ending Accounts Payable}& \\ & =\text{xxx}\\ \text{(c) Cash Payments to Employees}& \\ \text{Beginning Salaries Payable - Ending Salaries Payable}& \\ \text{+ Salaries Expense}& \\ & =\text{xxx}\\ \text{(d) Cash Payments for Purchase of Prepaid Assets}& \\ \text{Ending Prepaid Rent, Preapid Insurance etc + Expired Rent, Expired}& \\ \text{Insurance etc - Beginning Prepaid Rent, Prepaid Insurance etc.}& \\ & =\text{xxx}\\ \text{(e) Interest Payments}& \\ \text{Beginning Interest Payable - Ending Interest Payable}& \\ \text{+ Interest Expense}& \\ & =\text{xxx}\\ \text{(f) Income Tax Payments}& \\ \text{Beginning Income Tax Payable - Ending Income Tax Payable}& \\ \text{+ Income Tax Expense}& \\ & =\text{xxx}\\ \text{(g) Other Receipts and Payments - There may be receipts and payments}& \\ \text{other than those discussed above.}& \end{array}$

(ii) Indirect Method - In indirect method, the net income figure from the income statement is used to calculate the amount of net cash flow from operating activities. Since income statement is prepared on accrual basis in which revenue is recognised when earned and not when received therefore net income does not represent the net cash flow from operating activities and is necessary to adjust EBIT for those items which effect net income although no actual cash has been paid or received against them.

Indirect Method Format- Following is the indirect method formula which is used to calculate cash flow from operating activities

Indirect Method
$\begin{array}{cc}\text{Net Profit/Loss before Tax and Extraordinary items}& \\ \text{(+) Deductions already made in Profit and Loss on account of}& \text{xxx}\\ \text{Non-Cash items such as Depreciation, Goodwill to be Written-off.}& \\ \text{(+) Deductions already made in Profit and Loss on Account of}& \text{xxx}\\ \text{Non-operating items such as Interest.}& \\ \text{(-) Additions (incomes) made in Profit and Loss on Account of Non-operating}& \text{xxx}\\ \text{items such as Dividend Received, Profit on Sale of Fixed Assets.}& \\ \text{Operating Profit before Working Capital Changes}& \\ \text{Changes in Working Capital:}& \\ \text{(+) Increase in Current Liabilities}& \text{xxx}\\ \text{(+) Decrease in Current Liabilities}& \text{xxx}\\ \text{(-) Increase in Current Assets}& \text{xxx}\\ \text{(-) Decrease in Current Liabilities}& \text{xxx}\\ \text{Cash Flows from Operating Activities before Tax and Extraordinary Items.}& \\ \text{(-) Income Tax Paid}& \text{xxx}\\ \text{(+/-) Effects of Extraordinary items}& \text{xxx}\\ \text{Net Cash from Operating Activities}& \text{xxx}\end{array}$