Cash flow statement direct method


How to calculate Cash From Operating Activities
(or CFOA) using the direct method. Let me explain to you how to construct a cash
flow statement in this short video. This video covers the direct method of cash
flow reporting, the companion video that I will link to in the description below covers
the indirect method. Start off with reviewing the inputs to your
assignment. What I am showing here are the inputs that
I gave to participants in one of my “finance for non-financial managers” courses, to have
them construct the income statement, balance sheet, and cash flow statement for year 2
of an exercise. So we started off with the year 1 financial
statements, and with this list of inputs, they constructed year 2 financial statements. In this video, we focus on the cash flow statement,
and we use the direct method to construct it. What happens to the company in year 2? Revenue doubles. Gross Profit % stays the same. Headcount increases by 50%, at same average
salary. Collections of receivables equal new invoices
issued. Purchases of chocolate from supplier: 250. Payments to supplier: 200. No new investments in P&E. Debt level (the amount borrowed from the bank)
is unchanged. No new equity issued. In order to transfer these inputs into numbers,
let’s construct the year 2 income statement, and then we will select the relevant items
from there to help build the cash flow statement. On the left is the prior year (year 1) income
statement, and each of the inputs from the prior page helps you to construct the current
year (year 2) income statement on the right. If revenue doubles, then it goes from 200 to 400. If Gross Profit as % of revenue stays the
same, then Cost Of Sales goes to 200, and Gross Profit goes to 200. Headcount increases by 50% at the same average
salary, so it goes from 20 to 30. No new investments in P&E and using the same
depreciation schedule keeps depreciation at 20. EBIT goes from 60 to 150 due to operating
leverage. The interest amount stays the same if the
debt level and the interest rate are unchanged, and taxes go up proportionally if Profit Before
Tax goes up. 20% of 140 is 28. Now which ones of these items are important
for us if we want to construct the cash flow statement using the direct method? Revenue is important, and we saw in the inputs
that collections of receivables equal new invoices issued. Note that in real life this is very rarely
the case! In this example, cash received from customers
in year 2 is therefore 400. Cost of Sales is interesting, but it does
not directly give us the amount of cash payments to suppliers. Cost of Sales may be higher or lower than
that, due to inventory and/or payables increasing or decreasing. On the previous page, we saw that payments
to suppliers are 200, so by accident these are equal to Cost of Sales. Once again, in real life this is very rarely
the case! Cash paid to employees often equals the total
Compensation and Benefits booked in the P&L (employees get paid in the month in which
they work), unless you record expenses for bonuses and commissions that you accrue for
this year, but only pay next year. Interest paid usually equals the amount of
interest booked in the P&L. Income taxes paid in real life rarely equals
the amount of income taxes booked in the P&L, but in this example it does (to keep things
simple). Let’s summarize the items we have found so
far. In the direct method of cash flow reporting,
you start off with cash received from customers of 400, you deduct cash paid to suppliers
200, you deduct cash paid to employees 30, interest paid 10, and income taxes paid 28. Total net cash provided by operating activities,
calculated using the direct method is 132, which should be the same if you calculate
it by using the indirect method (which would reconcile from net income to CFOA by adjusting
for non-cash items in the P&L plus changes in working capital). To complete this example, and build the full
cash flow statement, let’s look for any clues on the lines of Cash From Investing Activities
(CFIA) and Cash From Financing Activities (CFFA). In this example, to keep it simple, nothing
is happening in either of those lines. In real life, for a mature and successful
company, there would probably be a CapEx cash outflow in CFIA, and a dividend cash outflow
in CFFA. If you add up the three categories, Cash From Operating Activities, Cash From Investing Activities and Cash From Financing Activities,
you get to the net increase or decrease in cash. Please note that you have not yet completed
the full cash flow statement! An important step is to check on the balance
sheet what the amounts were of the opening cash balance and the closing cash balance. Opening cash was 60, closing cash was 192. The net increase or decrease in cash that
you calculated should be the difference between those two balances. The last step in constructing your cash flow
statement is to show just that: the net increase in cash of 132, plus the opening cash of 60,
equals the closing cash balance of 192. Done! Thank you for watching! If you enjoyed this example of how to construct
a cash flow statement, then please press the “like” button for me, and share it with friends
and colleagues! On this end screen, there are a few suggestions
of videos you can watch next. Please subscribe to the Finance Storyteller
channel, and stay up-to-date on new videos! Thank you!

5 thoughts on “Cash flow statement direct method

  1. Hello, as a business owner I would like to have an understanding of how banks cash flow my business and run spreads to determine if the business cash flows for a loan and suggested amount. Do you have a video for this? Thanks

  2. Enjoyed this video? Then please subscribe to the channel, and watch my related video on preparing the cash flow statement using the indirect method: https://www.youtube.com/watch?v=2tr_6D2SE3w

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