13.15: The Direct Method
Learning Outcomes
- Calculate cash flows from operating activities by the direct method
Sales are great at your company, but cash flow is a mess! You are working on your cash flow statement trying to figure out what is going on. When you look at your income statement, you see sales of $20,000, which is an increase of 50 percent over last month! This is amazing. Why then, are you needing to take money out of your working capital line of credit to cover payroll? These are the questions a good cash flow statement can answer.
When working from the income statement and taking it back to cash basis from the accrual basis, some of the answers to these questions become very clear. Once you take a look you notice that payroll expense was higher to meet the higher sales demand. But since you offer net30 day terms to your customers, you are waiting on payment from them. The hope is this is a short term blip while your cash received from customers comes in to cover your line of credit payment. So what looks good on an income statement, could create temporary or long term cash flow issues!
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Let’s dig in a little further and discuss the direct method of preparing your cash flow statement. Stop back over and review this video for a quick reminder:
So the direct method, starts with the income statement and rebuilds it on the cash basis. Most companies operate on the accrual basis, where income is recognized when it is earned and expenses are recognized when they occur, so in order to see how much cash we spent or earned, we need to adjust those amounts to the actual cash we spent or received.
This is the method that will typically be used. Feel free to go back and watch the videos again for a review here!
In this method, we wouldn’t be concerned with changes in the accounts receivable balance. We would simply look at how much cash was paid by customers for the month. So, in our conversation about the indirect method, you noticed that the accounts receivable balance went down. If we look at this from a direct method:
- Cash received by customers: $10,000
- Cash spent on bills/expenditures: $5,000
- Cash paid for payroll: $3,000
- Net increase in cash for period: $10,000 − $5,000 − $3,000 = $2,000
So it wouldn’t matter if sales for the month was $20,000, purchases were $2,000 and payroll was $3,000 for the month right? What might that show? Well, if sales was $20,000 but we only received $10,000 in cash we either have difficulties collecting our accounts receivable, or we have net 30 and the sales last month was much lower than this month, right?
Cash flow can be a huge challenge, especially for small businesses. So, if we struggle with collection on our receivables, or if we have a low sales month, or an unexpected expense. This is where the cash flow statement can be very important to the health of a company.
Practice Questions