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Cash Flow Computations - Direct Method

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The Direct Method


The direct method is the preferred method under FASB 95 and presents cash flows from activities
through a summary of cash outflows and inflows. However, this is not the method preferred by most
firms as it requires more information to prepare.

Cash Flow from Operations


Under the direct method, (net) cash flows from operating activities are determined by taking cash
receipts from sales, adding interest and dividends, and deducting cash payments for purchases,
operating expenses, interest and income taxes. We'll examine each of these components below:

Cash collections are the principle components of CFO. These are the actual cash received
during the accounting period from customers. They are defined as:

Formula 6.7

Cash Collections Receipts from Sales


= Sales + Decrease (or - increase) in Accounts Receivable
Cash payment for purchases make up the
most important cash outflow component in CFO. It is
the actual cash dispersed for purchases from
suppliers during the accounting period. It is defined
as:

Formula 6.8

Cash payments for purchases = cost of goods sold + increase (or - decrease) in inventory +
decrease (or - increase) in accounts payable

Cash payment for operating expenses is the cash outflow related to selling general and
administrative (SG&A), research and development (R&A) and other liabilities such as wage payable
and accounts payable. It is defined as:

Formula 6.9

Cash payments for operating expenses = operating expenses + increase (or - decrease) in
prepaid expenses + decrease (or - increase) in accrued liabilities

Cash interest is the interest paid to debt holders in cash. It is defined as:

Formula 6.10

Cash interest = interest expense - increase (or + decrease) interest payable + amortization of
bond premium (or - discount)
Cash payment for income taxes is the actual cash paid in the form of taxes. It is defined as:

Formula 6.11

Cash payments for income taxes


= income taxes + decrease (or - increase) in income taxes payable

Frequently Asked Questions


How do Interest Rate Changes A ect the Profitability of
the Banking Sector?
Look Out!
Note: Cash flow from investing and financing are computed the same way it was calculated Can Working Capital be Negative?
under the indirect method.
What's the Di erences Between Chapter 7 and Chapter
11?

Issued Share Capital vs. Subscribed Share Capital


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The diagram below demonstrates how net cashReference Advisors is derived
flow from operations Markets Simulator
using the direct Academy Search News, Symbols, Terms

method.

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Candidates must know the following:

Though the methods used di er, the results are always the same.
CFO and CFF are the same under both methods.
There is an inverse relationship between changes in assets and changes in cash flow.
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Next: Free Cash Flow

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