What is Cash Flow Direct Method: Steps and Example

Introduction

A cash flow statement provides a summary of the cash and cash equivalents entering and leaving a company over a specific period. It helps stakeholders get a clear picture of the liquidity, financial flexibility, and overall financial health of a company. It can be calculated by using two methods: direct and indirect.

The cash flow statement direct method directly lists major cash receipts and payments from operating activities, while the indirect method starts with net income and adjusts for changes in non-cash items and working capital. Both methods provide insights into a company’s liquidity and financial health, but the direct method offers more transparency and better comparability, 

In this blog, we will deep dive into the direct method to calculate cash flow statements, understand its advantages, and the steps to follow with some real-world examples. 

What is the Cash Flow Direct Method?

The cash flow direct method involves detailing the specific cash inflows and outflows from operating activities when preparing the cash flow statement. This method provides a transparent and easily understandable view of the cash movements within a set timeframe. It offers in-depth details on the precise sources of cash inflows, like payments from clients, and the detailed destinations of cash outflows, such as payments to suppliers and staff. 

When is the Cash Flow Statement Direct Method Used?

The direct approach is commonly utilized in preparing the cash flow statement to offer a more thorough breakdown of cash inflows and outflows related to operational activities. It requires documenting all cash inflows and outflows from core business operations such as income from sales, payments to vendors, and salaries to workers. This approach offers a more comprehensive and clear picture of operating cash flow. 

Complexities of the Cash Flow Direct Method

While the direct method offers transparency and a detailed view of cash flows from operating activities, it also comes with several complexities:

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  Detailed record-keeping 

  
  

  The direct method requires skilled accounting professionals to accurately capture all cash flows related to operating activities with a high level of detail. This can be time-consuming and resource-intensive, especially for companies with complex operations.

  
  
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  Difficulty in segregation 

  
  

  Separating cash flows into operating, investing, and financing activities can be challenging, especially for transactions that involve multiple activities. This may result in classification errors if not handled carefully.

  
  
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  Dependency on cash transactions

  
  

  The direct method relies heavily on cash transactions, which may not always reflect the economic reality of a transaction. Accountants may overlook important non-cash operating activities such as depreciation, amortization, and changes in working capital. Adjustments may be needed to account for these non-cash items, adding complexity to the cash flow statement preparation.

  
  
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  Lack of reconciliation

  
  

  The cash flow direct method does not reconcile directly with the company’s income statement or balance sheet. Direct methods can be challenging in terms of identifying the difference between the cash flow statement and other financial statements. This can also lead to errors in financial analysis. 

  
  
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  Increased expenses

  
  

  Implementing the direct method may require additional resources, including personnel training, accounting software upgrades, and ongoing maintenance of detailed accounting records. Small businesses or organizations with limited resources may find it challenging to adopt the direct method effectively.

  
  

Examples of the Cash Flow Direct Method

Here are some examples of the cash flow direct method: 

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  Cash receipts from customers

  
  

  Cash received from customers is directly reported as a cash inflow from operating activities.

  
  
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  Cash payments to suppliers

  
  

  Cash payments made to suppliers for inventory purchases or raw materials are directly reported as cash outflows from operating activities.

  
  
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  Cash payments to employees

  
  

  Cash payments made to employees for wages and salaries are directly reported as cash outflows from operating activities.

  
  
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  Cash interest and dividend receipts:

  
  

  Cash received from interest and dividend income is directly reported as cash inflows from operating activities.

  
  
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  Cash payments for operating expenses:

  
  

  Cash payments for operating expenses such as rent, utilities, and advertising are directly reported as cash outflows from operating activities.

  
  

How to Build a Direct Method Cash Flow Statement? 

Here’s a guide to help you build a cash flow statement using the direct method: 

Step 1: Identify cash inflows from operating activities 

Start by listing all cash inflows from operating activities. This includes cash received from customers for sales, cash received from interest and dividends, and any other cash receipts directly related to the company’s core operations.

Step 2: Identify cash outflows from operating activities 

Now that there is a cash inflow, list all the cash outflows from operating activities. Cash outflows could involve providing payments to suppliers and employees and covering operating expenses such as rent, utilities, and advertising with cash.

Step 3: Calculate net cash flow from operating activities:

Finally, subtract the cash outflows from the cash inflows to calculate the net cash flow. This will give you the net cash generated or used by the company’s core business operations. 

Advantages of the Direct Method of Cash Flow

The direct method of cash flow offers a transparent and detailed approach to reporting cash flows from operating activities, providing stakeholders with valuable insights into a company’s cash flow dynamics and operational performance. Here are some of the advantages: 

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  Enhanced transparency 

  
  

  The direct method provides a clear and transparent view of how cash is generated and used in a company’s operating activities. It breaks down cash inflows and outflows in a straightforward manner, making it easier for business stakeholders to understand.

  
  
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  Detailed insights 

  
  

  This method offers a more detailed breakdown of cash receipts and payments related to operating activities compared to the indirect method. It provides a granular view of cash flows, which can be valuable for management decision-making and financial analysis.

  
  
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  Better comparability 

  
  

  The direct method allows for easier comparison of cash flows across companies and industries since it provides a common format for reporting cash flows from operating activities. This enhances comparability and facilitates benchmarking analysis.

  
  
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  Cash flow clarity 

  
  

  By directly reporting cash inflows and outflows from operating activities, the direct method provides clarity on the sources and uses of cash within the business. This can help identify areas where cash is being generated or utilized most effectively.

  
  

How Does HighRadius Help in Improving Your Cash Flow Strategies 

Most businesses are still dependent on Excel for cash flow analysis, with limited scalability. Due to the lack of automation and robust tracking mechanisms, treasury professionals often spend considerable time tracking cash transactions. They do so by manually reconciling the expected cash transactions with the bank statements, which often leads to inaccurate results, a lack of cash visibility, and decreased productivity. 

HighRadius’ Cash Management Solution automates this manual cash-to-bank reconciliation. It auto-generates and posts general ledger entries for bank transactions, enables customized rules creation and provides real-time visibility into cash flows. It enables businesses to reconcile the prior day’s planned cash transactions vs bank transactions at the click of a button. It also identifies discrepancies between actuals vs expected and handles unmatched bank transactions or cash transactions using an easy-to-use interface. 

Leveraging our solutions, businesses can automate critical cash flow processes, improve efficiency, and gain better visibility into their daily cash positions. By streamlining cash-related activities and utilizing advanced features, businesses are able to accelerate cash inflows, enhance cash management productivity and optimize cash utilization. 

FAQs

1) How to calculate cash flow from operating activities using the direct method? 

To calculate cash flow from operating activities using the direct method, first, sum up cash receipts from customers and then subtract cash payments to suppliers, employees, and operating expenses. You also need to adjust for any other cash inflows or outflows directly related to core business operations.

2) Does the direct and indirect method give the same cash flow? 

Yes, the direct and indirect methods ultimately give the same net cash flow from operating activities. The difference is in how the cash flow is presented. Direct method specifies cash inflows and outflows from operating activities, while indirect method starts with net income and adjusts for non-cash items and changes in working capital to arrive at the net cash flow.

3) What is the direct cash flow formula? 

The direct cash flow formula is:

Net Cash Flow from Operating Activities = Cash Receipts from Customers + Other Cash Receipts – Cash Payments to Suppliers – Cash Payments to Employees – Other Cash Payments

4) What is the difference between the direct method and the accrual method?

The direct method, used for cash flow statements, lists actual cash receipts and payments, showing clear cash inflows and outflows. The accrual method, used for income statements and balance sheets, records revenues and expenses when they are earned or incurred, not when cash is exchanged, giving a comprehensive view of financial performance.