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101 Concepts for the Level I Exam

Concept 49: Steps in the Preparation of Direct and Indirect Cash Flow Statements


Operating Cash Flow

Direct method: In the direct method, we take each item from the income statement and convert it to its cash equivalent by removing the impact of accrual accounting. The rules to adjust are:

  • Increase in asset is use of cash (-ve adjustment) and decrease in asset is source of cash (+ve adjustment)
  • Increase in liability is source of cash (+ve adjustment) and decrease in liability is use of cash (-ve adjustment)

Cash collected from customers: Adjust sales for changes in accounts receivables and unearned revenue.

Cash for inputs: Adjust COGS for changes in inventory and accounts payable.

Cash operating expenses: Adjust SG&A for changes in related accrued liabilities or prepaid expenses.

Cash interest paid: Adjust interest expense for change in interest payable.

Cash taxes paid: Adjust tax expense for changes in tax payable and changes in deferred tax assets and liabilities.

 

Consider a company which reported sales of $10 million.  Accounts receivable for the year went up from $2 million to $4 million. Unearned revenue went up from $1 million to $2 million. Calculate cash collected from customers.

Solution:

Δ Accounts receivable = $2 million. This is an asset and increase in asset is use of cash so –ve adjustment.

Δ Unearned revenue = $1million. This is a liability and increase in liability is source of cash so +ve adjustment.

Cash collected from customers = + $10 million – $2million + $1million = $9 million

 

Consider a company with COGS of $20 million for a particular period. During this period, inventory increased by $4 million and accounts payable went up by $2 million. Calculate the cash paid to suppliers.

Solution:

Δ Inventory = $4 million. This is an asset and increase in asset is use of cash so –ve adjustment.

Δ Accounts payable = $2 million. This is a liability and increase in liability is source of cash so +ve adjustment.

Cash paid to suppliers = – $20 million – $4 million + $2 million = – $22 million

Indirect method shows how cash flow from operations can be obtained from reported net income as a result of a series of adjustments. The steps are:

  • Begin with net income.
  • Add back all non-cash charges to income and subtract all non-cash components of revenue (For example: add depreciation and amortization).
  • Subtract any gains that resulted from financing or investing cash flows (For example: Gain on the sale of an equipment).
  • Add or subtract changes to related balance sheet operating accounts.

Decrease in operating assets (source of cash) should be added and increase in operating assets (use of cash) should be subtracted.

Similarly, increase in current liabilities (source of cash) should be added and decrease in current liabilities (use of cash) should be subtracted.

Consider a company with net income of $100 million in 2001. Depreciation expense is $10 million. Gain on sale of equipment is $4 million.  Increase in A/R is $8 million. Increase in A/P is $4 million. Increase in inventory is $10 million. Calculate CFO using the indirect method.

Solution:

Net Income 100
Add non-cash charges (depreciation) + 10
Less gain on sale of equipment – 4
Less increase in A/R -8
Add increase in A/P +4
Less increase in inventory -10
Total 92
CFO = $92 million  

Investing cash flows: CFI is calculated by determining changes in the gross asset account that result from the purchase or sale of equipment. It can be calculated by using the following formulae:

  • Cash paid for new equipment = ending gross equipment balance + gross cost of equipment sold – beginning gross equipment balance
  • Cash from sale of old equipment = book value of equipment sold + gain (or – loss) on sale of equipment

Financing cash flows: CFF is the sum of net cash flows from creditors and net cash flows from shareholders. It can be calculated using the following formulae:

(1) CFF = net cash flow from creditors + net cash flow from shareholders

(2) Net cash flow from creditors = new borrowings – principal repaid

(3) Net cash flow from shareholders = new equity issued – shares repurchased – cash dividends

 

The following information is available about company ABC for 2001.

New borrowings                               $10 million

Principal repaid                                 $5 million

New equity issued                             $5 million

Shares repurchased                          –

Dividends paid                                   $2 million

Calculate CFF.

Solution:

Net cash flow from creditors = new borrowings – principal repaid = 10 – 5 = $5 million

Net cash flow from shareholders = new equity issued – shares repurchased – cash dividends = 5 – 0 – 2 = $3 million.

CFF = net cash flow from creditors + net cash flow from shareholders = 5 + 3 = $8 million