Question

Chapter – Cash Flows

1. Explain the difference between the Direct Method and the Indirect Method.
2. What is the concept of Free Cash Flow?
3. How would an entry showing a loss on the sale of a piece of equipment be shown on the Cash Flow Statement? Show the entry below any explanation.

Answer 1

The statement of cash flows contains activities under 3 heads

1. operating,

2. investing and

3. financing

.Only the operations activity deals with the question of direct versus indirect cash flows.

Direct Method	Indirect Method
When using the direct method, you list cash flows in the operations section of the cash flow statement. Cash flows due to operations arise from customer collections and cash paid to suppliers, employees and others. The section also reports cash paid for income tax and interest.	In the indirect method, firstly you need to add back non-cash expenses such as depreciation, amortization, loss provision for accounts receivable and any losses on the sale of a fixed asset. You also adjust net income for changes between the opening and closing account balances in current assets except cash and current liabilities for the period. These accounts include debtors, stock , creditors prepaid assets, payable liabilities and unearned revenues.
The disadvantage in using direct method is that a company might not keep the information in the required form	In simple you adjust net profit from accrual to cash basis

Free cash flow:

free cash flow (FCF) is the cash left over after a company pays for its operating expenses and capital expenditures, also known as CAPEX.

It can be put in as formula as follows;

Free cash flow= Net Income+ Non cash Expenses -increase in working capital- capital expenditures(CAPEX)

Sale of piece of an equipment is shown under investment activity , as it is not a operating activity since equipment is not meant for trading , and not a financing activity because we neither get any return like dividends or interest nor pay.

And investment activity is same under direct or indirect method under cash flow statement