Cash flow information: Direct and indirect methods
The comparative year-end balance sheets of Sign Graphics, Inc., revealed the following activity in the company's current accounts:
To understand cash flow information, there are two methods commonly used: the direct method and the indirect method. These methods help in presenting the flow of cash in and out of a company during a specific period.
1. Direct Method: The direct method focuses on the actual inflows and outflows of cash. It provides a more detailed picture of the company's cash activities. This method requires analyzing specific cash receipts and cash payments related to operating activities.
To determine cash flows for operating activities using the direct method, you need to consider the following:
- Cash Receipts: Identify the cash received from customers, interest income, and other sources.
- Cash Payments: Identify the cash paid to suppliers/vendors, employees, interest expenses, taxes, and other significant outflows.
2. Indirect Method: The indirect method starts with the net income from the company's income statement and adjusts for non-cash items, changes in working capital, and other relevant activities.
To determine cash flows for operating activities using the indirect method, follow these steps:
- Start with Net Income: Begin with the net income reported on the income statement.
- Adjust for Non-cash Items: Add back any non-cash expenses such as depreciation, amortization, and loss on disposal of assets.
- Adjust for Changes in Working Capital: Analyze changes in current assets (e.g., accounts receivable, inventory) and current liabilities (e.g., accounts payable, accrued expenses) to identify their effect on cash flow.
- Account for Other Activities: Consider other relevant activities, such as gains/losses on the sale of assets or investments.
Both methods provide valuable insights into a company's cash flow activities. The direct method offers greater detail, while the indirect method starts with net income and makes adjustments to determine cash flow. Companies can choose the method that suits their needs, and the information can be found in the company's financial statements, especially the cash flow statement.