Operating Activities: Direct Method: Videos & Practice Problems

The Direct Method for calculating Operating Cash Flows involves summing cash inflows and outflows directly related to operating activities. Key components include cash received from customers, cash paid to suppliers, and cash paid for operating expenses. T accounts for accounts receivable and accounts payable help determine cash flows. For example, cash received is calculated by adjusting accounts receivable, while cash paid to suppliers requires analyzing inventory and accounts payable. Understanding these relationships is crucial for accurate cash flow statements and effective financial management.

Direct Method: Cash Received from Customers

All right. Now let's discuss the Direct Method for Operating Cash Flows. The Direct Method directly finds the operating activities by summing all relevant cash flows. Instead of starting with net income and then adjusting it, we just determine how much cash we collected from customers, how much we paid our suppliers, how much we paid for interest, and all the different operating activities. I want to note that whether we're using the indirect or the direct method, we're only dealing with operating activities. When we get to investing and financing activities, they're their own separate categories. We only talk about indirect or direct in the context of operating activities.

Let's go through the most relevant T accounts that you would see in the direct method. The first one here is cash received from customers. This is a cash flow, and since we are in operations to sell things to customers, we generate cash from them. However, sometimes we sell things on credit. To understand cash received, we need to review our Accounts Receivable T account.

If I make our T account here for Accounts Receivable, we can consider what happens. We have our beginning balance in the account. Then, whenever we make a sale, often on credit, our sales go into our Accounts Receivable. We would be making a journal entry, a sales journal entry, that would look something like this: Debit Accounts Receivable, Credit Sales. This would increase our Accounts Receivable with our revenue. What would decrease our Accounts Receivable? It's when we collect cash from our customers. They owe us money, and when they pay us, they don't owe us anymore. When we collect cash, that decreases our Accounts Receivable. So in the direct method, we're concerned about this cash. We would debit Cash and credit Accounts Receivable to remove the account from our books. So, what's important to us in this case is the cash amount, the cash collected as reflected in our Accounts Receivable journal or T account. What's left after all of that is our ending balance in the account. We have our beginning balance, plus the additions which are sales, minus the subtractions which are the cash we collect, giving us our ending balance.

Let's pause here, and then we'll talk about the cash paid to suppliers.

Direct Method: Cash Paid to Suppliers

So when we talk about cash paid to suppliers, it can be a little trickier. There's going to be 2 relevant T accounts. We're going to have to think about inventory, as well as accounts payable, AP, okay? So let's make T accounts for both inventory and accounts payable. Oh, give it more space. Okay. Inventory and accounts payable. So, we're going to have some beginning balance in inventory and then we're going to be making purchases, right? We're going to purchase more inventory and then that would increase our inventory balance when we purchase some. What would decrease our inventory balance? When we sell the inventory, right? And it goes to cost of goods sold. So that would get rid of some of our inventory, and we would be left with our ending balance in inventory. Now what about the accounts payable side? We would have some beginning balance, and it's a credit, right? Because this is a liability, and what would increase our accounts payable? When we purchase stuff, right? So, we can assume in this lesson that we're going to purchase everything on credit and pay them later. So we'll have our purchases here and that's going to increase our accounts payable, right? We're going to purchase more inventory. We're making a couple of assumptions. First, that we're just purchasing inventory in AP. And we're also assuming that we're putting all our purchases, none of our purchases are in cash. Now, you can make that assumption anyway. Even if we pay in cash immediately, well, maybe for a millisecond, right? We owe them an account payable and then we pay them in cash, right? So it can all flow here through accounts payable. All our purchases can be increases to our accounts payable. And how do we decrease our accounts payable? With that cash paid, right? When we pay them in cash, that's going to decrease our accounts payable, and then we'll be left with our ending balance. So notice, the cash paid to our suppliers is the important part of this journal entry right here. Now why would we need to use both of these balances? Well, they could make the question really tricky by talking about inventory. They could give you the beginning balance of inventory, the ending balance of inventory, they could tell you cogs, and you'd have to figure out purchases. And then with that purchases number, you would have to bring that purchases number over into your AP because those are going to be the same number. And then you'd have to use your beginning and ending balances from AP, as well as the purchases to figure out the cash paid. Okay? So it can be a little trickier here, but they would have to give you all that information. If they're talking about the direct method and they're giving you inventory numbers, accounts payable numbers, chances are you're going to have to figure out these purchases to back into the cash paid to suppliers. Alright? Let's go ahead and in the next video, we'll talk about cash paid for operating expense.

Direct Method: Cash Paid for Operating Expenses

So the last big category in our direct method is the cash paid for operating expenses. Now, we don't have the synergy of T accounts as we did with the cash paid to suppliers. We're just going to talk about two main ones, which are our interest payable, as well as our income tax payable. These are the main ones that you see when you talk about operating expenses, and you have to figure them out with a T account. So, interest payable, let's start there. Because these don't go hand in hand. They're two different topics. So interest payable, well, it's going to have some beginning balance as a credit, right? This is interest that we already owe. And how are we going to increase our interest payable? By having interest expense, right? If we incur some interest expense, we're going to pay it later. So, notice in all of these examples, we're just assuming that things are going to be paid later. So we have interest expense increasing our interest payable. And what's going to decrease our interest payable? When we pay the cash, right? The cash paid for the interest is going to decrease our interest payable and we'll be left with an ending balance. So, notice in all these cases, they're going to have to give you some of these numbers, and you solve for the cash paid. Sometimes they'll just tell you what the cash paid is and you don't have to go through this trouble. Okay? But a lot of times it takes familiarity with the T accounts cash paid amount was. They could easily tell you, beginning balance in interest payable was 5,000, the ending balance was 10,000. Interest expense was 40,000. What was the cash paid? Well, you would just use this formula, right? You would use your T account and you would figure out what the cash paid is based on the information they gave you. So, the same thing with Income Taxes Payable, they would have to give you the information. So, income tax payable, right? We have to pay income taxes, and we would have some beginning balance in our income tax payable, and that would be a credit there. And what would increase our income tax payable? Having income tax expense, right? If we have an expense, well, we're due to pay it at some point. So we have the income tax expense increasing the payable. What would decrease the payable would be the cash we paid for the income taxes, right? Just like with interest, and that would leave us with our ending balance in the income tax payable. So, notice those lessons on the base formula and learning how to use T accounts, they're going to come back to haunt you if you need to use the direct method. Right? You need to be very familiar with the T accounts and being able to find the missing pieces of the puzzle when we use the direct method. Okay? Let's go ahead and use an example on the next page to explain these. Alright? Let's do that.

Direct Method

ABC Company is preparing its statement of cash flows using the direct method. So, we're focusing on the direct method in this example. The accountant gathered the following information: Purchases totaled $200,000; Accounts payable increased by $6,000 during the year; Cash received from customers was $440,000; Depreciation expense was $25,000; Cash paid for operating expenses, excluding interest, totaled $140,000; Interest expense was $35,000; Interest payable increased by $5,000; and a loss on the disposal of plant assets equaled $6,000.

What is the cash flow provided by operating activities? There's a lot of information here, but we need to focus on the direct method, particularly on operating cash flows. Depreciation expense and the loss on the disposal of plant assets are not relevant for the direct method as they are adjustments made in the indirect method.

The cash received from customers and cash paid for operating expenses are given directly: $440,000 received from customers and $140,000 paid for operating expenses excluding interest. This leaves us with other calculations like determining the cash paid to suppliers and cash paid for interest based on increases in related payables.

For the increase in accounts payable by $6,000, we assume zero beginning balance for simplicity, leading to an ending balance of $6,000 with total purchases of $200,000. Thus, cash paid to suppliers is calculated as $194,000 (200,000 - 6,000 = 194,000).

For interest, given the $5,000 increase in interest payable and $35,000 interest expense, and assuming zero beginning balance, the cash paid for interest is calculated as $30,000 (35,000 - 5,000 = 30,000).

Adding these calculations for the direct method: The cash inflow from customers was $440,000, and the cash outflow includes $140,000 for operating expenses, $194,000 paid to suppliers, and $30,000 for interest, totaling $364,000 in outflows. Thus, the operating cash flow is calculated as $76,000 ($440,000 - $364,000 = $76,000).

This example shows how to utilize not only given direct cash information but also apply derived calculations using increases in liabilities (payables) to figure out actual cash payments. Practice figuring out this flow in a similar problem to understand how the direct method operates extensively.

ABC Company is preparing its Statement of Cash Flows using the direct method. The accountant gathered the following information:cash paid to suppliers was $140,000; sales revenue was $350,000; Accounts Receivable increased by $10,000 during the year; depreciation expense was $15,000; operating expenses totaled $80,000; Prepaid Expenses decreased by $8,000 during the year; and a loss on the disposal of plant assets equaled $6,000. What is the cash flow provided by operating activities?

• A. $128,000
• B. $138,000
• C. $144,000
• D. $149,000

Answer: (A)

During the year, cash paid to suppliers was $340,000. Cash received from customers was $580,000. Cash paid for operating expenses totaled $64,000. Depreciation expense totaled $16,000. The company also purchased equipment for $35,000. Using the direct method, what is the cash provided by operating activities?

• A. $125,000
• B. $141,000
• C. $160,000
• D. $176,000

Answer: (D)

Here’s what students ask on this topic:

What is the Direct Method for calculating Operating Cash Flows?

The Direct Method for calculating Operating Cash Flows involves directly summing all cash inflows and outflows related to operating activities. This method focuses on cash transactions such as cash received from customers, cash paid to suppliers, and cash paid for operating expenses. Unlike the Indirect Method, which starts with net income and adjusts for non-cash items, the Direct Method provides a clearer view of actual cash movements. Key components include analyzing T accounts for accounts receivable and accounts payable to determine cash flows accurately.

How do you calculate cash received from customers using the Direct Method?

To calculate cash received from customers using the Direct Method, you need to analyze the accounts receivable T account. Start with the beginning balance of accounts receivable, add credit sales (which increase accounts receivable), and subtract the ending balance of accounts receivable. The difference represents the cash collected from customers. The formula is:

$\mathrm{Cash} \mathrm{Received} \mathrm{from} \mathrm{Customers}=\mathrm{Beginning} \mathrm{Accounts} \mathrm{Receivable}+\mathrm{Credit} \mathrm{Sales}-\mathrm{Ending} \mathrm{Accounts} \mathrm{Receivable}$

What T accounts are used to determine cash paid to suppliers in the Direct Method?

To determine cash paid to suppliers using the Direct Method, you need to analyze two T accounts: Inventory and Accounts Payable. Start with the beginning balance of inventory, add purchases (which increase inventory), and subtract the ending balance of inventory to find the cost of goods sold (COGS). Then, use the Accounts Payable T account, starting with the beginning balance, adding purchases (from the inventory calculation), and subtracting the ending balance to find the cash paid to suppliers. The formula is:

$\mathrm{Cash} \mathrm{Paid} \mathrm{to} \mathrm{Suppliers}=\mathrm{Beginning} \mathrm{Accounts} \mathrm{Payable}+\mathrm{Purchases}-\mathrm{Ending} \mathrm{Accounts} \mathrm{Payable}$

How do you calculate cash paid for operating expenses using the Direct Method?

To calculate cash paid for operating expenses using the Direct Method, you need to analyze T accounts for Interest Payable and Income Tax Payable. For Interest Payable, start with the beginning balance, add interest expense, and subtract the ending balance to find the cash paid for interest. Similarly, for Income Tax Payable, start with the beginning balance, add income tax expense, and subtract the ending balance to find the cash paid for income taxes. The formulas are:

$\mathrm{Cash} \mathrm{Paid} \mathrm{for} \mathrm{Interest}=\mathrm{Beginning} \mathrm{Interest} \mathrm{Payable}+\mathrm{Interest} \mathrm{Expense}-\mathrm{Ending} \mathrm{Interest} \mathrm{Payable}$

$\mathrm{Cash} \mathrm{Paid} \mathrm{for} \mathrm{Income} \mathrm{Taxes}=\mathrm{Beginning} \mathrm{Income} \mathrm{Tax} \mathrm{Payable}+\mathrm{Income} \mathrm{Tax} \mathrm{Expense}-\mathrm{Ending} \mathrm{Income} \mathrm{Tax} \mathrm{Payable}$

What are the advantages of using the Direct Method for Operating Cash Flows?

The Direct Method for Operating Cash Flows offers several advantages. Firstly, it provides a clearer and more straightforward view of actual cash transactions, making it easier to understand the company's cash flow situation. This method directly shows cash inflows and outflows, which can be more informative for stakeholders. Additionally, it helps in better cash management by highlighting specific areas where cash is being generated or spent. Lastly, it can improve financial transparency and decision-making by providing detailed insights into the company's operating activities.