Operating Cash Flow : Direct & Indirect methods

CFA Level I FRA
#1

Hi, all : I am very much confused by the rules in deciding which items shall be added or substrated to arrive at each coponent of operating cash flows, either using indirect or direct method, particularly when the two methods appear at the same time. Anyone has a clear rule which will not cause any confusion in deciding the directions (plus or minus) ? Thanks in advance !

#2

Anyone can help me ?

#3

Here’s is how i have tried to explain it before, see if it helps you.

If you write:

Assets = Liability + Equity

then you can split out Assets into Cash + other assets

so this equation can be re-written as

Cash + Other Assets = Liability + Equity

then we can also write

Cash = Liability + Equity - Other Assests

therefore,

Changes in Cash = plus ( changes in Liability ) plus ( Changes in Equity ) minus ( Changes in other Assets )

So if for instance, a question says:

Net income = 50

depreciation = 5

account payable increase by 3

interest payable decrease by 3

Inventory increased by 5

account recievables decreased by 6

…

Begin with your Net Income = 50

Add back non cash charges (e,g depreciation, gains, and losses) = **+(**5)

account payables increased by 3 .Account payable is a liability. From the equation above, note that liabilities has a positive sign in front of it, so you can write increase in account payable as + (Increase) = +(3)

Interest payable decreased by 2. Interst payable is a liability. From the equation above, note that Liability has a positive sign in front of it, so you can write decrese in interest payable as +(decrease) = + (-2)

Inventory increased by 5. Inventory is an asset. From the equation above, note that other assets have a negative sign in front of it, so you can write a increase in inventory as -(increase) = -(+5)

Account recievables decreased by 6. Account recievables is an asset. From the equation , note that other asset have a negative sign in front of it, so you can write a decrease in account recievables as -(decrease) = -(-6)

This will help you to figure out the signs.

Note that the equation can also be expanded further to

Cash = Liabilities + Beginning retained earnings + Contributed Capital + Revenue - Expenses -Dividend +Other assets.

#4

bloodline,

Thank you for your help ! I need time to digest it and I will come back if I have further question !

alpha668

#5

Very helpful, this had been giving me a headache and your explaination is a very intuitive. I can now move on THANK YOU :slight_smile:

#6

I wrote a couple of articles on CFO that may be of some help here:

#7

I was always confused with exactly that. And to me it became clear when I realized what non-cash charges were.

And then it just not that difficult.

  • EDIT - of course one should not forget to account for changes in the BS as well as remove non-operating charges.