The direct method cash flow statement is one way to show the cash flow from operating activities of a business. The statement effectively converts each line of the accruals based income statement into a cash based format.
Typically the direct method cash flow statement discloses gross cash receipts and payments for each of the following line items.
- Cash received from customers
- Other cash received
- Cash paid to suppliers for goods and services
- Cash paid to employees for wages and salaries
- Interest paid
- Income tax paid
- Other cash paid
Direct Method Cash Flow Example
Suppose a business reports the following income statement and beginning and ending balance sheet extracts for a financial year.
| Sales revenue | 85,600 |
| Cost of goods sold | 35,300 |
| Gross profit | 50,300 |
| Wages expense | 22,400 |
| Depreciation | 5,900 |
| Operating income | 22,000 |
| Interest expense | 2,300 |
| Income before tax | 19,700 |
| Income tax expense | 4,100 |
| Net income | 15,600 |
| Beginning | Ending | |
|---|---|---|
| Accounts receivable | 16,700 | 20,500 |
| Inventory | 12,100 | 10,800 |
| Accounts payable | 14,200 | 11,300 |
| Wages payable | 5,400 | 6,100 |
To prepare the operating activities section of the direct method cash flow statement we consider each line of the accruals based income statement in turn and convert it to a cash basis.
Sales Revenue to Cash Received From Customers
Sales revenue represents goods and services sold to customers and will include both cash sales and on-account sales if credit terms are given to customers.
To convert the accrual based sales revenue figure from the income statement to a cash received basis the business needs to adjust for the movement on accounts receivable during the year as shown below.
The ending balance on accounts receivable (AR) is given by the following formula.Ending AR = Beginning AR + Sales - Cash received from customersBy rearranging this formula we get.Cash received from customers = Sales + Beginning AR - Ending ARCash received from customers = 85,600 + 16,700 - 20,500 = 81,800
The gross cash received from customers during the year is 81,800.
Cost of Goods Sold to Cash Paid to Suppliers
Cost of goods sold (COGS) represents the cost of supplying goods and services to customers.
To convert the accrual based cost of goods sold figure from the income statement to a cash paid basis the business needs to adjust for balance sheet movements on inventory, and accounts payable.
Inventory
The cost of goods sold is adjusted to reflect any balance sheet inventory movements in order to calculate the amount of purchases from suppliers.
The ending balance on inventory is given as follows.Ending inventory = Beginning inventory + Purchases - COGSBy rearranging this formula we get.Purchases = COGS - Beginning Inventory + Ending InventoryPurchases = 35,300 - 12,100 + 10,800 = 34,000
The business purchased 34,000 from suppliers.
Accounts Payable
The next step is to convert the purchases figure to a cash paid basis by adjusting for the movement on accounts payable during the year.
The ending balance on accounts payable (AP) is given by the following formulaEnding AP = Beginning AP + Purchases - Cash paid to suppliersBy rearranging this formula we get.Cash paid to suppliers = Purchases + Beginning AP - Ending APCash paid to suppliers = 34,000 + 14,200 - 11,300 = 36,900
The gross cash paid to suppliers for the year (sometimes referred to as cash flow to creditors) is 36,900.
Cash Paid for Expenses
In this example wages is used to represent expenses in the income statement. The calculations shown below could equally apply to any type of expense.
To convert the accrual based wage expense from the income statement to a cash paid basis the business needs to adjust for the movement on the wages payable balance during the year.
The ending balance on wages payable (WP) is given by the following formula.Ending WP = Beginning WP + Wages expense - Cash paid to employeesBy rearranging this formula we get.Cash paid to employees = Wage expense + Beginning WP - Ending WPCash paid to employees = 22,400 + 5,400 - 6,100 = 21,700
The cash paid to employees in respect of wages is 21,700.
Other Income Statement Line Items
The other line items in the income statement above are depreciation, the interest expense, and income tax expense.
Depreciation is a non-cash item in that it is an accounting entry and does not involve the movement of cash, as such it can be excluded from the direct method cash flow statement.
Both the interest and income tax expenses should be adjusted in the same manner as any other expense (as demonstrated for the wages in the calculations above). In this example there are no balance sheet movements in relation to these two items and therefore the interest and income tax expenses shown in the income statement are the same as the interest paid (2,300) and income tax paid (4,100) during the year.
Statement of Cash Flows Direct Method
Using the information above the direct method cash flow statement can be constructed as follows.
| Cash received from customers | 81,800 |
| Cash paid to suppliers | -36,900 |
| Cash paid to employees | -21,700 |
| Interest paid | -2,300 |
| Tax paid | -4,100 |
| Cash flow from operating activities | 16,800 |
The direct method cash flow shows that the cash flow into the business from operating activities is 16,800.
The cash flow from operating activities is one part of the direct method cash flow statement which also includes cash flows from investing and financing activities. An example format for a direct method cash flow statement is shown below.
Direct Method Cash Flow vs Indirect Method Comparison
The direct method cash flow statement shows the gross cash receipts and payments from a business. In contrast the indirect method cash flow statement starts with the net income of a business and then adjusts this for non-cash items and movements in working capital.
It is important to understand that only the presentation differs between the direct method cash flow and the indirect method cash flow, the amount of cash flow from operating activities of the business will be the same in both cases.
To demonstrate this the information used in the direct method cash flow example above is set out below in the indirect cash flow statement format.
The first step is to calculate the balance sheet movements as shown below.
| Movement | |
|---|---|
| Accounts receivable | 3,800 |
| Inventory | -1,300 |
| Accounts payable | -2,900 |
| Wages payable | 700 |
These movements are then used to present the indirect cash flow statement as follows.
| Net income | 15,600 |
| Depreciation | 5,900 |
| Increase in Accounts receivable | -3,800 |
| Decrease in inventory | 1,300 |
| Decrease in accounts payable | -2,900 |
| Increase in wages payable | 700 |
| Cash flow from operating activities | 16,800 |
The net income of the business is adjusted by adding back the non-cash depreciation and by adjusting for the balance sheet movements to convert the accruals based net income to a cash basis.
It should be noted that in both cases the cash flow from operating activities is 16,800.
Last modified March 29th, 2021 by Michael Brown
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.
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March 29, 2021
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