Cash flow statement: the direct method

The direct method shows operating cash flows as major classes of gross receipts and payments — cash received from customers, cash paid to suppliers, cash paid to employees — instead of starting from profit. IAS 7.19 encourages it because users can see where cash actually came from and went. US GAAP (ASC 230) also encourages it, but an entity that uses it must still disclose a reconciliation of net income to operating cash flow. In practice most companies use the indirect method; the direct method is the one lenders and small-business owners find easier to read.

The technique is the same for every line: start with the income statement figure, then adjust for the movement in the related working-capital balance.

• Receipts from customers = revenue + opening receivables − closing receivables. If receivables grew, some of the year's sales are still unpaid.
• Payments to suppliers takes two steps. First find purchases = cost of sales + closing inventory − opening inventory. Then payments = purchases + opening payables − closing payables.
• Payments for expenses = expense + opening accrual − closing accrual (an accrued expense not yet paid), or expense + closing prepayment − opening prepayment (paid in advance).
• Non-cash items such as depreciation, impairment and unrealised fair value changes never appear. They are not receipts or payments.

Because both methods describe the same cash, they must give the same operating total. Working the reconciliation is the best check on a direct-method statement.