There are two different ways to calculate the statement of cash flows, the direct format and
the indirect format.
Using the direct format, we calculate the cash flow as:
cash flow = incoming cash flows – outgoing cash flows.
However, when using the indirect format, we calculate the cash flow this way:
cash flow = net income
+ expenses that were not cash outflows
– revenues, that were not cash inflows
+ cash inflows, that were not revenues
– cash outflows that were not expenses
Let us take a look at an example to better understand the two concepts leading to the same result.
Company XY had sales $8,000, but only 30% of them were paid in the same period. The salaries paid amounted to $2,000, the interest paid was $1,000. Loan was granted by banks at $ 3,000, the principal payment on a different loan was $800. Depreciation and amortization was $700, the purchase of equipment amounted to $1,200.
Calculate the cash flow, using the direct format as well as the indirect format.
First, we need to compute net income. This is this done by
net income = revenue – expenses
= 8,000 – (2,000 + 1,000 + 700)
= 8,000 – 3,700
Then, using the indirect format, we shall compute as follows:
net income 4,300
plus expenses that were not cash outflows +700
minus revenues, that were not cash inflows -5,600
plus cash inflows, that were not revenues +3,000
minus cash outflows that were not expenses -2,000
= cash flow. = +400.
Using the direct format, we compute the cash flow as follows:
cash flow = cash inflow – cash outflow
= 0.3*8,000 + 3,000 – (2,000 + 1,000 + 800 + 1,200)
= 5,400 – 5,000
As promised, the two formats lead to the same result.
The most important points of Financial Reporting and Analysis, and Long-Lived Assets in this post can be summarised in this MindMap:
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