Any business looking to attract shareholders knows the importance of cash flow statements.
If investors are going to even consider your company, they'll want to examine the breakdown of your expenses and revenue. While this is straightforward enough, it can be easy to get lost in the complexities of accrual accounting. No matter what stage you're at in your business, it may serve you well to remember the essentials of direct method cash flow.
Why Direct Method?
The direct method isn't the only option, but it has unique merits that separate it from the indirect method.
Researchers like Arizona State University's W. P. Carey School of Accountancy clinical associate professor Steven Orpurt and associate professor of accounting at Singapore Management University Yoonseok Zang have found that the direct method lays the foundation for more accurate predictions of earnings potential and future cash flow. Some cash flow items, like collections from customers, are difficult to translate from net income into cash. Although many companies opt to use the indirect method, the direct is recommended by the Financial Accounting Standards Board (FASB), Generally Accepted Accounting Principles (GAAP) and International Accounting Standards (IAS).
What Does Direct Method Cash Flow Do?
Just as you sort through your personal bank account transactions, the direct method sorts through your company's. In this way, the direct method and indirect are the same. Both assess the health and liquidity of your company.
Unlike an income statement, the statement of cash flows will reveal exclusively the movement of cash through your business. Any assets that require selling aren't included in the assessment.
What Goes Into the Direct Method?
The process of the direct method can be broken down into three elements: operating, investing and financing activities.
Operating calculates the cash flow from the core of the business. It is the sum of all cash transactions, from customer collections to the cost of inventory. This is the section your investors look at closely, as it reveals whether your cash is steady or growing. Few shareholders are likely to be interested in a company that is either losing cash or has its profits tied up in non-liquid assets.
Investing and Financing Activities
The inflows and outlays of your company's operating activities are then added onto its investing and financing activities to calculate cash flow. Its investing activities can be generally sorted into capital expenditures and monetary investments, from the cash spent on major assets to the purchase of money market funds.
Financial activities, which can particularly affect shareholders, include transactions such as loans, debt, dividends paid to investors or the sale of stock. With all these elements summed, you can assess your statement of cash flows personally.
The Freedom of Free Cash Flow
In a best-case scenario, you will have discovered free cash flow. You can confirm this for yourself by subtracting capital expenditures from the operating cash. With your expenses covered, you can play around with the excess cash. This could include anything from exploring new business opportunities and potential expansion to paying off debt.
No matter how large or small your company is, it is important to understand the essentials of direct method cash flow. As one of the more objective ways to determine the health of your business, the direct method can be a vital assessment. Fully comprehending each stage in this process can help you be even more prepared to drive profitability in your business.
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