Using the Direct Method to Prepare a Cash Flow Statement

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  • 0:04 Direct Method
  • 0:35 Preparation
  • 1:24 Advantages and Disadvantages
  • 2:18 Example
  • 3:19 Lesson Summary
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Lesson Transcript
Instructor: Kevin Newton

Kevin has edited encyclopedias, taught middle and high school history, and has a master's degree in Islamic law.

In this lesson, we learn how to use the direct method to prepare a cash flow statement. While it may seem straightforward, we'll see that this method actually requires additional work.

Direct Method

If you own or manage a business, chances are knowing the bottom line at the end of every month is important to you. You want to know where your money is coming from and, just as importantly, where it is going. That means that you'll have a real interest in cash flow statements, which show how money moves through an organization. However, there are different ways of preparing them. In this lesson, we'll look at how to prepare a cash flow statement using the direct method. Additionally, we'll look at the advantages and disadvantages of doing it this way, as well as an example of it in action.

Preparation

But wait, how do we even make a cash flow statement? First of all, you should know that a cash flow statement has three parts. The first part is the operating section, the second is the investment section, and the third section is the financial section.

The operations section is the only section that is affected by using the direct method. Here you'll list your total income, as well as expenses related to suppliers, production, operations, income taxes, or interest. We'll spend much of the rest of the lesson discussing it.

The investment section talks about any gains or losses that you have from any investing activities. For example, if you sold a chunk of land or bought a new factory, those expenses would be listed in this section.

Finally, the financial section talks about any payments you made for dividends for your investors, as well as the total amount of stock sold or purchased back by the company.

Advantages and Disadvantages

There is one major advantage to the direct method of preparing a cash flow statement: it is easy to follow the money. As a result, you can quickly see where the money for a given term has come from and where it has ended up. The indirect method offers much less detail.

However, there are a number of disadvantages that mean that the direct method is really only used by smaller companies. First of all, it doesn't take into account any non-cash assets. As a result, it can make your company look less profitable than it actually is. For example, if you purchased a lot of fuel for your trucks last month, the fact that you have excess fuel will not show up on a cash flow statement using the direct method.

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