Cash Flow from operating activities-direct method

                The cash flow from investing activities and financing activities are both found out by finding the actual cash flows from the various ledgers directly. This is the same under both direct and indirect methods

Cash flow from operating activities

        Cash flow in this section under direct method is found out by collating the actual cash flow form various journals and deriving at, directly from the balance sheets, income statements and T accounts(ledgers). This is unlike the indirect method, in which, various non cash expenses, incomes, gains losses, are reversed from the net income, and various cash out flows and inflows  which do not comprise in the net income figure ( like cash received and payed for receivables and payable ), are added back to the net income, to arrive at the cash flow from operating activities.

              Cash receipts from operations include cash received from customers for goods and services, cash interest and dividends, and other operating receipts if any. Cash payments include cash paid to employees and suppliers of goods and services, cash interest and income tax payments, and other operating payments if any. We must search through the accounts to find these cash receipts and payments.

Sales and purchase

1. Cash inflows from direct cash sale and purchases are found out directly from the various cash journals.

 2. Cash payments received after the sales is found out  as given below

  Change in accounts receivable for sales = sales on account in that period-cash received after sales

3. Cash payments payed after purchase is found out as given below

 Change in accounts payable for purchase=purchase on account in that period - cash payed after purchase

4. Change in accounts payable/receivable for purchase/ sales, sales on account are found out from the various ledgers. Purchase on account can be derived directly from change in merchandise inventory and COGS if we assume that all purchases are on account.

5. If we assume all the purchase/sales are on account and the accounts receivable/purchases are only for sales and purchases, then we can find out the cash received/ payed after sale/purchases directly from the consecutive balance sheets and the income statement.

Accrued Liabilities( Wages, Salary, tax, interest)

Consider the following common transactions

Interest expense             5000
Interest  payable                                    5000

Cash                                                     2000
Interest payable              2000

Here the cash out flow can be calculated as follows

Change in accrued liability = expense-cash

Prepaid expenses ( Rent, supplies, insurance)

Rent                               10000
Cash                                                 10000

Rent expense                  2000
Rent                                                  2000

All the pre paid expense are paid totally with cash ( no point in being pre paid if there is any payable)

The cash out flow for pre paid expenses can be calculated as follows.

Change in prepaid expense = cash- expirations

SUMMING UP

Cash flow from operating activities can be calculated from the various methods as described above. The idea
is to find the cash flow directly, than deducing from the net income figure, as in the indirect method.

                      

Cash flow from operating activities –Indirect Method (different transactions).

Cash Flow from operating activities

     Cash flow from operating activities includes cash inflows from sales of goods and services, interest income and dividend income. Cash outflows includes outflow for merchandise inventory, employee wages, taxes, interest expense and various other expenses. The formula for cash flow from operating activities is as given below.

                        Net Income

            +          Depreciation expense

            +          Amortization Expense of Intangibles

            +          Amortization of Bond Discount

            +          Loss on sale of Plant assets or Investments

            +          Decrease in Accounts receivable

            +          Decrease in Merchandise Inventory

            +          Decrease in prepaid expenses (Rent, Supplies, Insurance)

            +          Increase in Accounts payable (except dividends payable)

            +          Increase in Accrued Liabilities (Taxes payable, Wages Payable,

                        Interest Payable, Expenses payable)

            +          Decrease in Investment in Subsidiary (Equity method)

            +          Increase in Deferred Tax liability

            =          Net Cash Flow from Operations

Depreciation/ Amortisation

            Depreciation and amortization expenses are all non cash expenses, which needs to be added back to the net income. The amortization of bond discount is also a non cash expense, and bond premium is a non cash revenue which has to be added back and subtracted from the net income respectively. The discount account is contra to the bonds payable account, the total cash flow when the bond is issued at a discount can be found out by merging the contra account to the bonds payable account, similarly, the premium account. This will be recorded in the cash flow from financing activities, for the period in which the bond is issued.

Loss on sale of Plant assets or Investments

            Consider the following transaction

       Cash       100000

       Plant                                             120000

       Loss        20000

            We know that the $100000 cash in flow will not be reflected in the net income figure, but non cash loss of $20000 will be. The whole $100000 cash inflow will be recorded in the cash flow from investing activity section as

 

      Cash from sale of Plant asset         100000

Therefore, the amount $20000, which is contained in the net income figure as a reduction, has to be reversed. Therefore all the losses in the sale of Plant assets or investments have to be added back to the net income figure to arrive at the net cash flow figure.

            Consider the following transaction

      

       Cash       120000

       Plant                                            100000

       Gain                                             20000

      

           Here the $120000 cash inflow which will not be reflected in the net income figure will be recorded in the cash flow from investing section as follows

      

       Cash from sale of Plant asset        120000

The non cash gain of $20000 which is contained in the net income figure as an increase has to be subtracted to avoid double counting.

           Consider the following transactions

Cash                      70000

Notes receivable    50000

Plant                                                   100000

Gain                                                    20000

Cash                      70000

Notes Receivable   30000

Plant                                                   120000

Loss                      20000

In both cases the cash received is recorded in cash flow from investing activities, Gain/ losses treated subtracted/added to net income as previous examples, note receivable treated in the loans made section in cash flow from financing activities.

Since there is no actual cash from the loans made (notes receivable) the figure will not be recorded in that section, unlike accounts receivable figures in the balance sheet.

(Refer Loans made section in the cash inflow from investing activities for further details)

              Consider the following transactions

Cash                                                   70000

Notes Payable                                    50000

Machine               100000

Loss                     20000

Here when the machine is purchased, we record it by its Fair Market Value, which, in this case is less than the valuation of its price. Therefore the loss. Here also the loss is treated the same as in the above cases. And the notes payable, which is a short term loan taken by the company from the seller, is treated in the notes payable section in the cash flow from financing activities. (Since there is no cash outflow in the notes payable account, it is not recorded)

       If the fair market value of an asset is greater than the valuation price, while purchasing, the valuation price is taken into account and no gain is recorded.

Decrease in Accounts Receivables

                 Consider the different transactions given below

     (I)           Accounts receivable                     2000

                    Sales                                                                   2000

   

    (II)           Notes receivable (note/loan)        2000

                    Cash                                                                    2000

  

    (III)         Cash                                            2000

                    Accounts receivable                                             2000

    (IV)         Sales Return                                 2000

                    Accounts Receivable                                            2000

Case (I)        Here the sales is actually a non cash income, a part of net income. The accounts receivable has to be subtracted from the net income to find the net cash flow.

Case (II)       Refer loan made section in the cash flow from investing activities.

Case (III)      Here the cash is finally received for the accounts receivables. The accounts receivable has to be added to the net income to derive the net cash flow.

Case (IV)      Here the sales return is a contra to sales and this is a part of the net income figure. To arrive at the net cash flow, the accounts receivable has to be added back to the net income figure to arrive at the net cash flow.

So any increase in the total accounts receivable figure which denotes that the accounts receivable figure from case (I) is greater than case (II) and (III), and vice versa. So the increase in the total accounts receivable figure has to be reduced from  the net income and vice versa to arrive at the net cash flow figure.

Decrease in Accounts Payable

                 Consider the different transactions given below

     (I)           Purchase                                        2000

                    Accounts Payable                                                2000

   

    (II)           Cash                                              2000

                    Notes Payable                                                     2000

  

   

    (III)          Accounts Payable                           2000

                     Cash                                                                  2000

Case (I)       This accounts payable increase will be a part of total accounts payable figure. Any increase in accounts payable has to be added to the net income to arrive at the cash flow.  Purchase is a special expense which is dealt in the next section

Case (II)       Refer notes payable in cashflow from financing activities

Case (III)   Here the cash is finally paid for the accounts payable. The accounts Payable has to be subtracted from the net income to derive the net cash flow.

So the decrease in the total accounts payable figure has to be subtracted to the net income and vice versa to arrive at the net cash flow figure.

Cash flow in sales and purchases

        Consider the common transactions given below.

(I)               Sales                                                    1000

                   Cash                      300

                   Acc receivable       700

(II)              Purchase                800

                   Cash                                                     200

                   Acc Payable                                         600

Case (I)   The sales figure is a part of net income figure. In order to arrive at the cash flow, we just need to reverse the non cash income of acc receivable to arrive at the net cash flow.

Case (II)   The purchase account is just an intermediate account, in the periodic inventory system. In the met income calculation, only the COGS is subtracted. Purchase account does not figure in the net income calculation, but it comes in the balance sheet as a part of change in the inventory over a year. So our target here is to
1. Record the cash outflow during the purchase which does not come in the net income figure.

2. Eliminate the increase in accounts payable for purchases, if there is any, from the increase on the total accounts payable figure,  which is added to the net income to find the cash flow. This is because of the following reasons.

   a. Any increase in accounts payable is added to the net income figure, because the accounts payable accounts has a non cash exp in the other side if the coin.

   b. The accounts payable for purchases is an exemption, though purchase exp is a non cash exp. This is because, purchase exp does not get subtracted from the gross income to arrive at the net income.

   c.  So increase in accounts payable for purchases should not be added to the net income figure to find the cash flow.

3. Eliminate the non cash expense of COGS from the net income figure

This is done in the following operation of inventory.

Decrease in merchandise Inventory

Case (I)

Decrease in inventory (DI) = COGS – Purchase (COGS>purchase)

When we add this figure to the net income figure, the non cash expense of COGS in the net income is eliminated and the purchase figure is subtracted

-purchase=-cash –account payable

The accounts payable figure for purchases in always present in the total accounts payable in the balance sheet. So when total accounts payable increase is added to the net income to derive the net cash flow, the accounts payable for purchases which is ingrained in the total accounts payable, also gets added.

But, the accounts payable for purchase SHOULD NOT be added to the net income to arrive at the cash flow figure. Any other accounts payable increase happens because of a non cash expense.

This is because, unlike sales figure which is added and COGS which is subtracted, purchase figure is not subtracted from the gross revenues to arrive at the net income, while preparing the income statement. Therefore the accounts payable for the purchase ( as a part of purchase) is not expensed to arrive at the net income figure, which is unlike any other accounts payable.

Now when we add DI to the net income figure, the COGS which is subtracted to arrive at the net income figure when the Income statement is prepared and the accounts payable for purchase which is added( as a part of total accounts payable) to net income while preparing the net cash flow from net income, are both eliminated.

This gives us the actual cash flow.

Case (II)

Increase in inventory = purchase-COGS (purchase>COGS)

So it has to be subtracted to arrive at the same result.

Decrease in Pre paid expenses (Rent, Supplies, Insurance)

      Prepaid expenses are capitalised expenses, which are paid upfront, and expensed in a fixed rate annually.

      Consider the following case

          Supplies exp            5000
          Supplies                                                    5000

Here the idea is that any decrease in the prepaid expenses is caused by a non cash expense. So that decrease has to be reversed to arrive at the net cash flow.

      Consider the following case

          Supplies                  10000

          Cash                                                          4000

          Accounts payable                                       6000

Here cash flow is -4000. Suppose this is the only operation in a year, then net income will be 0

When the supplies increase 10000 is subtracted from the net income as per the equation and the accounts payable 6000 is added to the net income, the total cash flow becomes -4000.

      

      Consider the following transaction.

           Supplies                                                   10000

           Cash                     4000

          Acc receivable       6000

Here cash flow is 4000. Suppose this is the only operation in a year, then net income will be 0.

When the supplies decrease 10000 is added and the accounts receivable increase 6000 is subtracted, the total cash flow becomes 4000

From the above examples, we find that any decrease in the prepaid expenses has to be added and vice versa to arrive at the net cash flow. The accounts payable addition and the accounts receivable subtraction required to arrive at the net cash flow, is already done with the total accounts receivable/payable.

Increase in Accrued Liabilities (Taxes payable, Wages Payable, Interest payable,  Expenses payable)

Consider the following transactions

(I)                      Interest expense    2000

Interest payable                                  2000

 

(II)                   Interest income                                   2000

Interest payable    2000

       (III)        Cash                                                  2000

                     Interest Payable     2000

      

In case (I) and (II) the decrease and increase in accrued liability is caused by a non cash income and expense respectively. So they have to be added and subtracted from net income respectively to arrive at the cash flow.

In case (III) here the cash outflow is recorded by subtracting the increased accrued liability.

There fore any decrease in accrued liability has to be added and vice versa to the net income figure to arrive at the net cash flow figure.

Contingency liabilities comes in accrued liabilities

Decrease in Investment in Subsidiary (Equity method)

This has significance when the investment in the subsidiary falls between 20% -50% and the parent company has significant influence over the subsidiary.

Consider the following transactions

  Investment in long term securities    100000

  Cash                                                                                   100000

 Investment in long term securities     15000

 Investment income                                                                 15000

 Investment in long term securities                                            7500

 Cash                                               7500

In the above situation where we assume that the investment is 30% in the subsidiary with significant influence. The second entry is the portion (30%) of subsidiary’s income ($50000) under equity method, and the third entry is the entry for the cash inflow for dividends. Dividend received is considered as a reduction in the investments.

            

             Increase in the investment=Investment income –cash (inv.income>cash).

So when this is subtracted from net income, it takes care of the reversal of non cash income and addition of cash inflow to arrive at the net cash flow

            And, decrease in the investment=Cash-Investment income (cash>inv.income)

So when this is added to the net income, it takes care of the reversal of the non cash income and addition of cash inflow to arrive at the net cash flow.

Increase in differed tax liability

Consider the following transactions

     (I)    Income Tax expense            2000

             Deferred Tax Liability           750

             Income tax Payable                                                 2750

     (II)   Income Tax expense            2750

              Deferred tax Liability                                               750

              Income tax payable                                                 2000

In order to derive the net income, the non cash income tax expense, has to be added back to the net income.  

In case (I) the income tax payable exceeds the income tax expense by the amount of deferred tax liability. So the deferred tax liability has to be subtracted from the net income to arrive at the cash flow.

In case (II) the income tax payable trails the income tax expense by the amount of deferred tax liability. So the deferred tax liability has to be added to the net income to arrive at the total cash flow.

There for a decrease in deferred tax liability has to be subtracted from the net income to arrive at the net cash flow and vice versa.

CAPEX AND AMORTIZATION

           CAPEX the expenses which needs to be capitalized in the balance sheet. These include the expenses which augments the productive capacity or the asset quality.

These are debited to an asset account and are depreciated.      

 Expenses which increases the life of an asset are debited to the accumulated depreciation account, and all the maintenance expenses are expensed. 

Expenses like Plant re arrangement costs, Computer software costs etc are capitalised as intangible assets. They are amortized.

AMORTIZATION

All the intangible assets are amortized. Some of the intangible assets includes Computer software costs, plant rearrangement costs, deferred charges such as prepaid insurance, rent etc, goodwill, patents, trade marks and names, copy rights, rented property modifications, franchise fees (not for perpetual or permanent) , discount account for hidden interest costs in zero coupon liabilities etc.