Operating activities section by direct method

The operating activities section reports the cash flows arising from operating activities of a company during a particular period. It is the first and the most complex of the three sections of statement of cash flows and is prepared by using either direct or indirect method. This article explains the use of direct method; to learn about indirect method, please read “operating activities section by indirect method” article.

Contents:

• The direct method
• Format
• Cash received from customers
• Interest and dividend received
• Cash paid to suppliers and employees
• Interest paid
• Income tax paid

The direct method:

Under direct method, the major classes of operating cash receipts and disbursements are reported separately in the operating activities section. The total of operating cash disbursements are deducted from the total of operating cash receipts to arrive at net cash flows from operating activities. If the total of all operating cash receipts for the period is greater than the total of all operating cash disbursements, the resulting figure is known as the “net cash provided by operating activities”. If the total of operating cash receipts, on the other hand, is less than the total of operating cash disbursements, the resulting figure is known as the “net cash used by operating activities”.

The operating cash receipts (i.e., inflows) usually include the following:

• cash received from customers,
• cash received for interest and
• cash received for dividend income.

The operating cash disbursements (i.e., outflows) usually include the following:

• cash paid to suppliers of merchandise (or raw materials),
• cash paid to employees,
• cash paid for operating expenses,
• cash paid for interest expenses and
• cash paid for income tax.

Format:

Under direct method, the operating cash receipts and disbursements described above are arranged in a certain way. A comprehensive format of operating activities section under direct method is illustrated below:

To calculate cash receipts and payments in the above format we use relevant data from income statement, comparative balance sheet and some additional information. Following is the explanation of how each item can be worked out.

Cash received from customers:

If all the sales are made for cash then the amount of sales revenue and cash received from customers should be equal. In today’s business world, however, we can rarely find a company that sells all the goods for cash. Most of the companies make sales on cash as well as on account. Therefore, the amount of sales revenues generated during a certain period is mostly differs from the amount of cash received from customers during that period. A company that sells goods on account can calculate the cash received from customers during the period by using three figures. These are net sales, beginning balance of accounts receivable, and ending balance of accounts receivable. The procedure is given below:

(i) If accounts receivable increase during the period:

If accounts receivable at the end of the year are more than at the beginning of the year (an increase in accounts receivable), it means the company’s credit sales are more than its collections from customers. The increase in accounts receivable is, therefore, deducted from the net sales figure to calculate cash received from customers.

Cash received from customers = Net sales – Increase in accounts receivable

The net sales figure is available from the income statement and increase or decrease in accounts receivable can be calculated by using beginning and ending balances of the accounts receivable.

(ii) If accounts receivable decrease during the period:

If accounts receivable at the end of the year are less than at the beginning of the year (a decrease in accounts receivable), it means the company’s collections from customers are more than credit sales. The decrease in accounts receivable is, therefore, added to the net sales figure to calculate cash received from customers.

Cash received from customers = Net sales + Decrease in accounts receivable

The above concept can be summarized as below:

Example:

ABC company sells goods on account. The income statement for the year 2013 shows a net sales of $177,000. The accounts receivable at the beginning and at the end of the year 2013 were $25,000 and $35,000 respectively. Calculate total cash that ABC company collected from its customers during the year 2013.

Solution:

Cash received from customers = Net sales – Increase in accounts receivable
= $177,000 – $10,000*
= $167,000

*Increase in accounts receivable: $35,000 – $25,000

Interest and dividend received:

Interest and dividend income is reported in the income statement on accrual basis but we need to covert it to cash basis for the purpose of statement of cash flows. The above concept developed for converting accrual basis sales revenue to the cash basis sales revenue can also be used to convert interest and dividend income from accrual basis to cash basis. The accrual based interest or dividend revenues figure is taken from the income statement and decreased by any increase in interest or dividend receivable during the year and increased by any decrease in interest or dividend receivable during the year.

For the purpose of statement of cash flows, the amounts of interest and dividend received are added together.

Example:

The income statement of ABC company for the year 2013 shows an interest revenue of $5,000 and a dividend revenue of $3,200. The interest receivable at the beginning and at the end of the year 2013 was $1,000 and $1,200 respectively. The dividend income was received in cash and there was no dividend receivable at the beginning and at the end of the year. Calculate the total amount of cash that ABC company received during the year 2013 from interest and dividend.

Solution:

Cash received from interest and dividend = Interest revenue – Increase in interest receivable + Dividend revenue
= $5,000 – $200* + $3,200**
= $8,000

*Increase in interest receivable:
= $1,200 – $1,000
= $200

**There is no dividend receivable at the beginning and the end of the year. The dividend revenue is therefore equal to cash received from dividend.

Cash paid to suppliers and employees:

‘Cash paid to suppliers and employees’ is derived by adding cash ‘paid to suppliers of inventory’ and ‘cash paid for operating expenses’. Cash paid to suppliers of inventory and for operating expenses are calculated separately and then added together. This combined amount is shown in the operating activities section with the caption ‘cash paid to suppliers and employees’. Keep in mind that interest and income tax paid are not included in the operating expenses. They are disclosed as separate items in the operating activities section.

(i) Cash paid to suppliers of inventory

Companies purchase goods for cash as well as on account. The total amount of inventory purchased during the period does not necessarily represent the amount of cash paid to suppliers of inventory. A company that purchases inventory on account may make purchases in one period and pay cash for such purchases in another period. Therefore, we need to calculate cash payments to suppliers for the purchase of inventory. The formula to calculate cash paid to suppliers of inventory is given below:

(ii) Cash paid for operating expenses:

The operating expenses shown in the income statement do not necessarily represent the actual cash payments for these expenses during the period. The reason is that they are reported in the income statement on accrual rather than cash basis. In other words, expenses are reported in the period in which benefit is taken from use of goods or services rather than in the period in which the actual cash payment is made to the providers of such goods or services. In order to convert accrual based expenses to cash based expenses, we need to consider two important points. First, the operating expenses that are reported in the income statement usually include one or more non cash expenses such as depreciation, amortization of intangible assets and amortization of bond discount etc. Second, there is a difference of timing between the recognition of expenses and the payment of cash for those expenses. The following formula or procedure is adopted to convert accrual based operating expenses to cash paid for operating expenses.

Example:

The following information has been extracted from the income statement and balance sheet of ABC company:

Cost of goods sold: $65,000

Operating expenses: $15,000

Accounts payable (for purchase of inventory) on:
December 31, 2013: $15,000
December 31, 2012: $20,000

Accrued expenses payable on:
December 31, 2013: $4,000
December 31, 2012: $3,800

Prepaid expenses on:
December 31, 2013: $5,000
December 31, 2012: $4,500

Inventory on:
December 31, 2013: $8,000
December 31, 2012: $6,500

Required: Calculate cash paid to suppliers of inventory and for expenses during the year 2013. How should the company disclose this payment on a statement of cash flows?

Solution:

(i). Cash paid to suppliers of inventory = Cost of goods sold + Increase in inventory + Decrease in accounts payable
= $65,000 + $1,500* + $5,000**
= $71,500

*Increase in inventory
= (Inventory at Dec. 31, 2013) – (Inventory at Dec. 31, 2012)
= $8,000 – $6,500
= $1,500

**Decrease in accounts payable
= (A/C P.A. at Dec. 31 2012) – (A/C P.A. at Dec. 31 2013)
= $20,000 – $15,000
= $5,000

(ii). Cash paid for operating expenses = Operating expenses + Increase in prepaid expenses – Increase in accrued expenses payable
= 15,000 + $500* – 200**
= $15,300

*Increase in prepaid expenses:
= (Prepaid expenses at Dec. 31, 2013) – (Prepaid expenses at Dec. 31, 2012)
= $5,000 – $4,500
= $500

**Increase in accrued expenses payable:
= (Acc. exp. P/A at Dec. 31, 2013) – (Acc. exp. P/A at Dec. 31, 2012)
= $4,000 – $3,800
= $200

(iii). Disclosure in the statement of cash flows:

ABC company will calculate the cash paid to suppliers and employees by adding ‘cash paid to suppliers of inventory’ and the ‘cash paid for operating expenses’. The cash paid to suppliers and employees will be shown in the operating activities section of the statement of cash flows as follows:

*$71,500 + $15,300

Calculation of cash paid for interest expenses during the period:

The formula used for operating expenses can also be used to convert interest expenses to cash paid for interest. Any decrease in interest payable is added to and any increase in interest payable is deducted from the accrual based interest expenses. Accrual based interest expenses figure is available from the income statement and the increase or decrease in interest payable can be found by making an analysis of comparative balance sheet.

Example:

The ABC company’s total interest expenses for the year 2013 were $7,800. The interest payable at the end of the year 2013 and 2012 was as follows:

• Interest payable at December 31, 2013: $1,200
• Interest payable at December 31, 2012: $1,800

Required: Calculate cash paid for interest during 2013.

Solution:

Cash paid for interest = Interest expenses + Decrease in interest payable
= $7800 + $600*
= $8,400

*Decrease in interest payable:
= Interest payable on Dec. 31, 2012 – Interest payable on Dec. 31, 2013
= $1,800 – $1,200
= $600

Calculation of cash paid for income tax expense during the period:

Like interest and operating expenses, the cash payment for income tax during the year can be calculated by adding a decrease in income tax payable to and deducting an increase in income tax payable from the income tax expenses shown in the income statement. Procedure or formula is given below:

Example:

The income tax expenses of ABC company were $8,700 as per income statement for the year 2013. The income tax payable at the end of the year 2013 and 2012 was as follows:

• December 31, 2013: $1,400
• December 31, 2012: $1,000

Required: Calculate cash paid for income tax during 2013.

Solution:

Cash paid for income tax = income tax expenses – increase in income tax payable
= $8,700 – $400*
= $8,300

*Increase in income tax payable:
= Income tax payable on Dec. 31, 2013 – Income tax payable on Dec. 31, 2012
= $1,400 – $1,000
= $400

The ABC company’s operating cash receipts and disbursements have been calculated above. We can now prepare a complete operating activities section of the company’s statement of cash flows using direct method as follows: