Cash Flow Analysis Using Direct Method

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Cash flow analysis using the direct method is rarely used by companies. Knowing how to put together a cash flow statement using the direct method can be extremely useful, especially if you are looking for a thorough and more insightful analysis of the sources and uses of cash. Most companies, especially fortune 500 firms, prefer to use the indirect method due to the fact that it’s less time consuming and require fewer resources.  Although both methods will provide a certain level of insight, the direct method is a bit more detailed in showing the inflows and outflows of cash for a particular reporting period.

Regardless of which method is used, the basic structure (anatomy) of the statement of cash flows is very similar in both cases. Sources and uses of cash is examined at 3 very high levels. They are outlined below:

Cash flow from operating activities – this section of the statement shows details behind the cash provided by and used by the core business, or day to day operational activities. Strong performance [net (+) cash provided by operations] is indicative of a company that is profitable at the main things they do. On the other hand, should the net dollar figure in this section be (-), meaning “net cash used by operations”, that would indicate a company that is struggling. Note that newer companies looking to establish themselves might be running a deficit in early stages, but that doesn’t mean that the company is being mismanaged.

Cash flow from investing activities – any company that expects to remain competitive in the marketplace has to invest in itself. This section will outline how the company is poising itself for growth. Purchasing long term assets to support core business activities will be reflected here, should the company makes any investments during the period. It’s not uncommon to see “net cash used by investing activities” since investments are mostly uses of cash.

Cash flow from financing activities – provides details of how capital was raised and disbursed during the period. Capital can be raised through long-term debt, issuing equity (common and preferred stocks) or obtaining some form of hybrid financing. Disbursements in this section often include dividends paid to shareholders.

Similarities and Differences between the Direct and Indirect Methods of Cash Flow Analysis:

Similarities:

The procedure for deriving dollar figures and presentation format for the investing and financing sections are the same for both the direct and indirect methods. To come up with these figures, a look at the changes in balance sheet accounts from the prior period pertaining to these two sections have to be examined. The income statement is also necessary (net income) in order to figure out how much dividends were paid out.

So lets say for a moment that you have the following information from the income statement and balance sheet:

INCOME STATEMENT FOR CASH FLOW ANALYSIS USING DIRECT METHOD
ABC Company
Income Statement
Fiscal Year Ended 2009
in ($000′s)
Revenue 20,678
Cost of Sales 8,987
Gross Margin 11,691
Operating Expenses
Advertising & Promotion 2,273
Salaries 4,549
Employee Benefits 721
Travel & Entertainmnet 57
Insurance 44
Legal Fees 101
Rent Expense 346
Consulting Fees 185
Communication Fees 16
Other OPEX 202
Total 8,494
Operating Income 3,197
Other Expenses
Depreciation Expense 117
Interest Expense 592
Total 709
Income Before Taxes 2,488
Income Taxes* 1,642
Net Income 846
* Tax Rate = 35% – FY2009 Includes Deferred Tax
Tax associated with currenty year =  871
Deffered Tax from Prior Periods = 771

 

BALANCE SHEET FOR CASH FLOW ANALYSIS USING DIRECT METHOD
ABC Company
Comparative Balance Sheet – December 31, 2009
  31-Dec-09 31-Dec-08       31-Dec-09 31-Dec-08
Assets (in $000′s)  (in $000′s)   Liabilities & S.H. Equity (in $000′s) (in $000′s)
Current Assets       Current Liabilities    
Cash 649 423   A/P 382 366
A/R 1,212 902   Accrued Expenses 203 137
Inventory 3,035 2,652   Income Taxes Payable 255 643
Prepaid. Exp 89 49   Total Current Liabilities 840 1,146
Total Cur. Assts. 4,985 4,026        
        Long Term Liabilities    
Prop. Plant & Equip.       Long Term Debt 2,464 1,991
PP&E 3,115 2,763   Total L-T Liabilities 2,464 1,991
Acc. Depreciation 672 555        
Net PP&E 2,443 2,208   Total Liabilities 3,304 3,137
             
Other Assets       Shareholders’ Equity    
Intangible Assets       Preferred Stock 541 272
Patents 51 14   Common Stock 1,090 803
Trademarks 36 7   Add. Paid in Capital 1,953 1,364
Goodwill 189 189   Retained Earnings 816 868
Tot. Other Assets 276 210   Total S.H. Equity 4,400 3,307
             
Total Assets 7,704 6,444   Total Liabilities + S.H. Equity 7,704 6,444

 

Using information from the two financial statements above, the investing and financing sections of the cash flow statement can be put together for BOTH the direct and indirect methods in the same manner. To see cash flow analysis based on the indirect method, see here.

Lets take a look at the investing section first. Everything needed for this section can be found on the Assets side starting from Property, Plant & Equipment (excluding accumulated depreciation which is a contra non-cash account). If the year over year dollar figures in the long-term assets accounts (PP&E and Intangible Assets) increased, that means there was a use of cash to increase these accounts. Essentially, the company purchased additional assets. Should the opposite situation be the case, where year over year changes are lower, then it would be a source of cash since the investment has decreased.

This is what the cash flow from investing activities looks like based on the balance sheet information above:

CASH FLOW ANALYSIS FOR INVESTING ACTIVITIES
Investing Activities Source (Use) of Cash   Notes
(in $000′s)
Purchase of PP&E (352) 09 increased to 3,115 from 2,763 in ’08 – use of cash
Patents (37) 09 increased to 51 from 14 in ’08 – use of cash
Trademarks (29) 09 increased to 36 from 7 in ’08 – use of cash
Goodwill 0 09 remained unchanged from 08
 Cash Provided (Used) by Investing (418) 

 

Using similar logic, the financing section can also be compiled. As noted earlier, financing (capitalization) includes changes to long-term debt balances and changes to the equity accounts. If you noticed, there is no obvious mention of the dividends paid to shareholders in the financial statements presented above. However, this number can be derived using net income from the income statement and year over year changes in retained earnings . See the formula in the notes section below.

 

CASH FLOW ANALYSIS FOR FINANCING ACTIVITIES
Financing Activities  Source (Use) of Cash Notes
(in $000′s)
Long Term Debt 473 09 increased to 2,464 from 1,991 in 08 – source of cash
Preferred Stock 269 09 increased to 541 from 272 in 08 – source of cash
Common Stock 287 09 increased to 1,090 from 803 in 08 – source of cash
Additional Paid in Capital 589 09 increased to 1,953 from 1,364 in 08 – source of cash
Dividends *** (898) *** Net Income + 08 Retained Earnings – 09 Retained Earnings
Cash Provided (Used) by Financing 720

 

That’s as far as the similarities go with regards to both the direct and indirect methods of compiling a cash flow statement. The difference between the two lies in the Operating Activities section. Here is a comparison between the two methods for determining Cash provided (used) by operating activities:

Difference:

CASH FLOW ANALYSIS COMPARISON BETWEEN DIRECT & INDIRECT METHODS
DIRECT METHOD
Operating Activities  
Cash Receipts from Customers # $xxxx
Cash Payments  
To Suppliers ## (xxx)
For Operating Expenses ### (xxxx)
To Lenders (Interest) (xx)
Taxes (xxx)
Sub-total (xxxx)
Net Cash Provided (Used) By Operations $xx
   
# A/R , Sales
## A/P, Inventory, COGS
### Prepaid, All Payables except A/P, Depreciation / Amortization
INDIRECT METHOD
Operating Activities  
Net Income $xxx
Add Non-Cash Transactions  
Depreciation / Amortization xxx
Sub-total xxxx
Changes in  Current Assets & Liabilities  
Current Asset Accounts (I.E., Inventory, A/R) * (xxx)
Curr. Liab. Accts (I.E., A/P, Accrued Exp.) ** xxx
Sub-total xx
Net Cash Provided (Used) By Operations $xxxx
   
* Increase in current asset accounts is a use of cash and vice versa
** Increase in curr. liabilities accounts is a source of cash and vice versa

Essentially, the direct method provides information on cash receipts and payments for all income statement accounts, whereas, the indirect method reconciles net income with cash transactions related to operations. If you wanted to learn more about the indirect method, see this tutorial on cash flow analysis.

Cash Flow Analysis of Operating Activities Using the Direct Method

Cash Receipts

Cash receipts from customers – to figure this out, Revenue (from the income statement) and the change in Accounts Receivable period to period is needed. If Accounts Receivable increased year over year, a deduction is made from Revenue. If it decreased, that figure is added to revenue to come up with cash receipts. So from the financial statements presented above, this is what you’d get for Cash Receipts.

CASH FLOW ANALYSIS OF CASH RECEIPTS FROM CUSTOMERS
Notes
Revenue 20,678
(-) Increase in A/R -310 -[1,212 - 902]
Cash Receipts 20,368

Cash Payments:

To Suppliers – It’s a 2 step process. First figure out what purchases were. Then, with purchases as the base, account for the changes in Accounts Payable year over year to derive cash payments to suppliers.

Step 1: start with Cost of Sales (from income statement) and account for the change in Inventory (from balance sheet). If there is an increase in inventory period to period, add it to Cost of Sales to figure out what purchases were. If there is a decrease, deduct it from Cost of Sales.

CASH FLOW ANALYSIS OF CASH PAYMENTS TO SUPPLIERS
Step 1 – Purchases Notes
Cost of Sales 8,987
(+) Increase in Inventory 383 [3,035 - 2,652]
Total Purchases 9,370

 

Step 2: using Total Purchases above as the base, deduct changes in Accounts Payable from period to period (if there is an increase) or add to Total purchases if there is a decrease.

CASH FLOW ANALYSIS OF CASH PAYMENTS TO SUPPLIERS
Step 2 – Cash Payments To Suppliers Notes
Purchases 9,370
(-) Increase in A/P -16 -[382-366]
Payments To Suppliers 9,354

 

For Operating Expenses – using total Operating Expenses from the Income Statement, account for changes in the Prepaid Expenses and Accrued Expenses Payable accounts. If Prepaid Expenses increased, add to OPEX. If it decreased, deduct from OPEX. As far as Accrued Expenses Payables go, deduct an increase or add a decrease from period to period.

CASH FLOW ANALYSIS OF CASH PAID FOR OPERATING EXPENSES
Notes
Operating Expenses 8,494
(+) Increase in Prepaid Exp. 40 [89-49]
(-) Increase in Accrued Exp. -66 -[203-137]
Cash Paid for OPEX 8,468

 

To Lenders (Interest Payments) – begin with Interest Expense (from the I/S) and deduct the change in Interest Payable if there is an increase year over year. Should there be a decrease from period to period, add it to Interest Expense.

CASH FLOW ANALYSIS OF INTEREST PAYMENTS
Interest Expense 592
(-) Increase in Interest Payable OR 0
(+) Decrease in Interest Payable 0
Cash Interest Payments 592

 

Cash Paid for Taxes – taking the Income Taxes dollar figure from the I/S, account for changes in the Income Taxes Payable account year over year. If there is an increase in Income Taxes Payable from prior period, deduct the difference from Income Taxes. If there is a decrease year over year, add it to Income Taxes.

CASH FLOW ANALYSIS OF INCOME TAXES PAID
Notes
Income Tax Expense 1,642
(-) Increase in Income Tax Payable OR 0
(+) Decrease in Income Tax Payable 388  - [255-643]
Cash Paid for Taxes 2,030

 

Now that all the pieces of the operating activities section is calculated, a cash flow statement based on the direct method of cash flow analysis can be put together. Here is what that looks like.

Statement of Cash Flows – Using Direct Method

ABC Company
Statement of Cash Flows
Fiscal Year Ended 2009
Operating Activities Notes
Cash Receipts from Customers 20,368
Cash Payments
To Suppliers (9,354)
For Operating Expenses (8,468)
To Lenders (Interest) (592)
Taxes (2,030)
Sub-total (20,444)
Net Cash Provided (Used) By Operations (76)
Investing Activities
Purchase of PP&E (352)
Patents (37)
Trademarks (29)
Goodwill 0
Net Cash Provided (Used) By Investing (418)
Financing Activities
Long Term Debt 473
Preferred Stock 269
Common Stock 287
Additional Paid in Capital 589
Dividends (898)
Net Cash Provided (Used) By Financing 720
Increase (Decrease) in Cash 226 Operating + Investing + Financing
Cash at Beginning of Period 423 08 Cash Balance – see balance sheet
Cash at End of Period 649 Increase (Decrease) in Cash + Cash at Beginning of Period

 

Compare this statement with that provided by the indirect method of cash flow analysis. You’ll see that while the presentation and the way in which the statements were put together were completely different, the end results from both types of cash flow analysis yield the same result.

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