Question

Because the statement of cash flows is often a challenge for students to learn, what steps are you going to take to either memorize or learn the direct AND indirect method. Please share these with your peers. Why is this statement so important for a company?

Answer 1

The cash flow statement shows the inflow and outflow of cash and cash equivalents. There are two methods to prepare the cash flow statement namely Direct & Indirect.

Steps to prepare the Indirect method of Cash flow statement:

Some information would be required before proceeding with the steps

• Balance sheets for the end of last year and end of the current year are needed to calculate the amount of change in each balance sheet account. These changes in balance sheet accounts are needed to prepare certain parts of the statement of cash flows.
• Income statement information for the current year is needed as the starting point for converting net income from an accrual basis to a cash basis, which is shown in the operating activities section of the statement of cash flows.
• Other information is needed to complete the statement of cash flows, such as cash dividends paid and the original cost of long-term investments sold.

With the above information in hand, there are four key steps to prepare the cash flow statement using the Indirect method:

Step 1. Prepare the operating activities section by converting net income from an accrual basis to a cash basis

The indirect method begins with net income from the income statement and makes several adjustments related to changes in current assets, current liabilities, and other items to arrive at cash provided by operating activities. Cash provided by operating activities represents net income on a cash basis

Step 2. Prepare the investing activities section by showing cash activity for noncurrent assets

This step tells the effect of changes in the non-current assets has on cash.

Step 3. Prepare the financing activities section by showing cash activity for noncurrent liabilities and owners’ equity

This step tells the effect of changes in noncurrent liabilities and owners’ equity have on cash.

Step 4. Reconcile the change in cash

This step confirms that the net of these changes (Cash increase or decrease in above 3 steps) equates to the change in cash on the balance sheet.

Steps to prepare the direct method of Cash flow statement:

Step 1. Cash flow from operating activities - This represents the key source of an organization's income i.e. how much is cash generated from the core activities.

Step 2. Cash from Investing Activities - This section records changes in equipment, assets or investments. Cash changes from investing are generally considered “cash outflows” because cash is used to purchase equipment, buildings, or short-term assets. When a company divests an asset, the transaction is considered a “cash inflow”. A healthy company generally invests continually in plant, equipment, land and other fixed assets.

Step 3. Cash from Financing Activities - Changes in debt, loans or stock options, long-term borrowings, etc. are accounted for under Financing Activities. When capital is raised, it is considered “cash in”; when dividends are paid or debt is reduced, “cash-out”. The Financing Activities section shows how borrowing affects the company’s cash flow.

The bottom line on the Cash Flow Statement is the Net Increase (Decrease) in Cash and Cash Equivalents. It's determined by calculating the total cash inflows and outflows for each of the three sections in the Cash Flow Statement.

Importance of Cash flow statement:-

The cash flow report is important because it tells the business cash position and need of cash to pay its expenses, bank loans, taxes and to purchase new assets. A cash flow report determines whether a business has enough cash to do exactly this. The importance of cash flow statement can be measured because of the following reasons:

1. A cash flow statement tells you where the money went
2. A cash flow statement can help you focus on creating excess cash
3. Cash flow statements often provide better KPI’s (Key Performance Indicators) than profit and loss statements.
4. Cash flow statements help with financing decisions