Measuring
Cash Flow
No one can manage cash
flow without understanding how cash flows through your business. Understanding
cash flow involves learning about the various components of cash receipts
and disbursements, how to measure cash flow, and what factors affect
the amount and timing of these items.
There are two generally
accepted methods of measuring cash flow:
Direct Method
Indirect Method
Direct Method
The direct method uses
the cash activity recorded in your business's checkbook to measure
its cash flow. Because the cash activity is obtained directly from
information recorded in your business' checkbook, this method is known
as the "direct" method.
Using the direct method,
you determine the total amount of cash your business receives by totaling
the cash receipts in its checkbook. The next step is to classify these
receipts by type of activity: operating, investing, or financing.
The direct method can be
used with either the cash or accrual basis of accounting.
Using the same information
from the Best Company (page ?), let's measure the cash flow using
the direct method. For this example, assume the Best Company took
out a $300 loan from its bank.
Cash receipts total $1500:
$1100 received from operating activities ($400 from cash sales, $600
from collection on customer accounts, and $100 from interest income),
$100 received from the sale of equipment and $300 received from a
bank loan.
Under the direct method,
the receipts of Best Company would be recorded in the statement of
cash flows as follows:
|
Operating Activities:
|
|
|
Cash received from
customers
|
$1000
|
|
Interest income
received
|
$100
|
|
|
|
|
Investing Activities:
|
|
|
Proceeds from sale
of equipment
|
$100
|
|
|
|
|
Financing Activities:
|
|
|
Proceeds from bank
loan
|
$300
|
Similarly, you can determine
the total amount of cash spent by your business by totaling the cash
disbursements in the checkbook and classifying the total disbursements
by type of activity: operating, investing or financing.
Based on the Best Company
figures (page ?), cash disbursements total $1400. After further investigation,
you determine that $900 was cash spent on operating activities. Of
this amount, $700 was spent on expenses for operating the business
such as acquiring inventory for resale and paying operating expenses
($200 on cash expenses; and $500 was charged on account for operating
expenses previously charged on account. An additional $100 was paid
for interest expense and $100 for income taxes.
Assume that $200 was used
to buy equipment and the remaining $300 was cash paid to repay the
principal on loans.
Using the direct method,
these disbursements would be recorded in the statement of cash flows
as follows:
|
Operating Activities:
|
|
|
Cash paid for operations
|
$700
|
|
Interest expenses
paid
|
$100
|
|
Income taxes paid
|
$100
|
|
|
|
|
Investing Activities:
|
|
|
Purchase of equipment
|
$200
|
|
|
|
|
Financing Activities:
|
|
|
Principal payments
on loans
|
$300
|
Click
here to view an example of a complete cash flow statement using the
direct method.
Indirect Method
The indirect method derives
the cash activity from your business's balance sheets and income statement
to measure its cash flow. Because the cash activity is derived indirectly
from information on your business's balance sheets and income statement,
this method is known as the "indirect" method.
The indirect method is
commonly used by businesses using the accrual basis of accounting.
The indirect method is
more complicated then the direct method of accounting. In spite of
its complication, the indirect method is often easier to calculate
than the direct method because the information needed is already in
the business's balance sheets and income statement. You do not have
to dig through your checkbook, adding and classifying numbers, to
use this method. The key difference between the two methods is in
the way cash receipts and disbursements for operating activities are
calculated and reported. Cash from investing and financing activities
are calculated and reported the same way under both methods.
Indirect Method: Cash
Basis
If your business uses the
cash basis of accounting, measuring the cash flow of your business
is relatively easy. The income statement reflects the income and expenses
from the operation of your business on a cash basis of accounting.
To measure the cash flow from operations of your business, you need
to adjust the income statement for certain non-cash items or items
for which you did not receive or spend cash. An example of a non-cash
item is depreciation on equipment.
Depreciation
Depreciation is an accounting
procedure which allocates the cost of acquiring the equipment over
the useful life of the equipment. For example, if you purchased equipment
for $500 at the end of year one, you would record the purchase of
the equipment in year one as an equipment purchase. If the estimated
useful life of the equipment was five years, you would record depreciation
expense of $100 ($500 divided by five years) in years two through
six. In this example, no expense was recorded on the income statement
in year 1 even though the cash was expended during the year. For years
two through six, depreciation expense of $100 was recorded in each
of the years even though no cash was spent during the year. Although
depreciation is an expense on the income statement, it does not represent
a cash outlay as the cash was spent at the time the equipment was
purchased.
Indirect Method: Accrual
Basis
If your business uses the
accrual basis of accounting, measuring the cash flow from operations
of your business is more complicated. On an accrual basis, the income
statement reflects the income and expenses from the operations of
your businesses. In addition to adjusting the income statement for
any non-cash items, you need to adjust the income and expenses for
changes in your business' current assets and current liabilities,
such as accounts receivables and accounts payable.
Using the information from
the Best Company example, the cash from operating activities of the
statement of cash flows would be:
|
|
Cash basis
|
|
|
Operating
Activities:
|
|
|
Net income
|
$200
|
|
Add: non-cash
items Depreciation
|
100
______
|
|
Cash received
from operations
|
$300
|
|
|
Accrual
basis
|
|
|
Operating
Activities:
|
|
|
Net income
|
$300
|
|
Add: non-cash
items Depreciation
|
100
____
|
|
|
|
|
Changes in
current assets and liabilities
|
|
|
Accounts
receivable
|
(200)
|
|
Accounts
payable
|
100
|
|
Cash received
from operations
|
$300
|
|
Click
here to view an example of a completed cash flow statement using the
indirect method.
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