Question

Define and describe the difference between the direct and indirect methods for calculating the cash flow from operating activities.

What are the other major sections of the cash flow statement? Describe the main functions of these components.

Answer 1

Direct Method basically  is a straight and simple way of calculating all Cash inflows and cash outflows during the year

Direct method takes into account  opening balance of cash and ends in tallying with or arriving at closing balance of cash

Direct method identifies stages as  how cash is spent and how cash is earned which is simple to derive and classifies the outflow /inflow as cash flow from operating activities and cash flow from Investing activities and financing activities .It completely eliminates Non cash expenditure.It is arrived from extracts of cash book/ledger

whereas

Indirect method on the other hand starts with Net profit or loss before tax and extraordinary items and items like other increase or decrease in current assets and current liabilities is adjusted accordingly and also non cash expenditure like depreciation and other non operating expenses are added back to net profit  to classify the cash outflow and cash inflows accordingly into operating activities and investing activities financing activities etc

Based on the information available either of the methods are used

Indirect method is bit complex and decrease in current assets and increase in current liabilities are added to net profit and increase in current assets and decrease in current liabilities are subtracted from net profit to arrive at cash flow from operating activities

Differences are

Direct method is simple while Indirect method is quite complex to calculate

Direct method is taking all actual inflows and outflows into account For arriving at cash from Operating activities Cash received from Customers and all operational expenses are taken into account and the difference between the two is shown as cash flow from Operating activities

Whereas Indirect method adds back to Net profit all Increase in Current Liabilities and decrease in Current assets and Subtracts all Increase in Current assets and decrease in Current Liabilities to arrive at cash flow from Operating activities

Direct method ignores NOn cash Expenditures whereas All non cash expenditures and Non operational expenditures are added back to net profit and from where adjustments for increase/decrease in assets and liabilities begin

Other Major Segments are Cash flow from Investing activities and cash flow from Financing activities

Main functions of these components especially cash flow from financing activities are to identify the amount of cash and cash equivalents spent to fund the company using debt equity and dividends.It is basically cost of using the funds of the company and also includes huge inflow of loans/debts and heavy settlements and redemption of debts if any

Main functions of Investing is to identify how excess cash inflows are secured and routed to and how Non current assets are purchased to yield returns in future and how excess funds are used.Increase in capital expenditure is increase in Investment activities which though is a reduction in cash flow at present  but in future would fetch high returns/Cash inflows .