Direct Method Cash Flow Statement Guide (With Example)

The direct method, shows operating cash flows as the actual cash received from customers and the cash paid to suppliers, employees, and others:

This contrasts with the indirect method, which reconciles accounting profit to cash flow through a series of adjustments.

Operating cash flows, under the direct method are typically presented in the following categories:

Whilst the use of the direct method is encouraged by both IAS 7 and ASC 230, the indirect method remains more prevalent in practice due to its simpler preparation process.

You can download our comprehensive direct method example spreadsheet which demonstrates all calculations discussed in this article.

Cash Receipts from Customers

Cash receipts from customers represent the primary cash inflow for most operating entities.

This figure is calculated by adjusting revenue for movements in trade receivables, as revenue is recognised on an accrual basis whilst cash flows represent actual receipts.

Formula for Cash Receipts from Customers

The basic formula for calculating cash receipts from customers is:

This adjustment recognises that:

• An increase in trade receivables (closing > opening) indicates that revenue exceeded cash collected, requiring a deduction from revenue
• A decrease in trade receivables (closing < opening) indicates that more cash was collected than revenue recognised, requiring an addition to revenue

Practical Considerations

When calculating cash receipts, consider the following:

1. Revenue recognition timing: If revenue includes significant non-cash elements (such as barter transactions or contra arrangements), these must be excluded from the calculation

2. Bad debt write-offs: trade receivables movements should be adjusted for any write-offs during the period, as these represent accounting adjustments rather than cash movements

3. Advances from customers: Opening and closing balances of customer advances should be included in the trade receivables adjustment, as these represent cash received before revenue recognition

In our example spreadsheet, revenue of £2,800,000 is adjusted for a trade receivables increase of £52,300 (from £250,000 to £302,300) and bad debts written off of £12,700, resulting in cash receipts from customers of £2,735,000.

Cash Paid to Suppliers and Employees

Cash paid to suppliers and employees represents the cash outflows for operating expenses.

This calculation is more complex than cash receipts as it requires multiple adjustments to derive the cash paid to suppliers and employees from profit before tax.

How to Calculate Cash Paid to Suppliers and Employees

The calculation starts with profit before tax and systematically adjusts for non-cash items and working capital movements:

Step 1: Start with profit before tax

Begin with the profit before tax figure from the income statement.

Step 2: Exclude revenue

Deduct revenue, as this is separately presented in cash receipts from customers.

Step 3: Add back non-cash expenses

Add back depreciation of property, plant and equipment, depreciation of right-of-use assets, amortisation of intangible assets and unrealised foreign exchange gains or losses.

These are accounting charges that do not involve cash outflows.

Step 4: Exclude items diclosed elsewhere

Add back the total interest expense, as well as any other finance costs. Under the direct method, these are not classified within cash paid to suppliers and employees but is instead presented separately.

Interest income (and other finance income) should be deducted as it forms part of profit but is also presented separately.

Realised foreign exchange gains and losses that relate to operating activities should remain in the calculation, whilst those relating to investing activities or financing activities, should be excluded to accurately reflect the actual cash flows in those activities. Examples of these, per activity, include realised foreign exchange gains or losses on:

• Operating activities: operating expenses
• Investing activities: acquisition of property, plant and equipment
• Financing activities: settlement of a loan after revaluation

Step 5: Adjust for working capital movements

Apply the following working capital adjustments:

• Inventory: Opening inventory - Closing inventory (an increase in inventory represents cash used to acquire stock)
• Trade Payables: Closing payables - Opening payables (an increase in payables means less cash was paid than expenses incurred)

This formula converts accrual-based expenses into actual cash payments by removing non-cash items and adjusting for timing differences in working capital accounts.

Other Operating Activities

Beyond cash receipts and payments for core operations, several other cash flows must be classified within operating activities, depending on the entity's accounting policy choice and the applicable accounting standard.

Interest Payments

Under current IAS 7, interest paid is one of the limited items for which entities are permitted an accounting policy choice. Interest paid may be classified as either an operating activity or a financing activity, provided the classification is applied consistently from period to period.

However, with the introduction of IFRS 18 (effective 1 January 2027), the majority of entities need to classify interest paid as a financing activity, to match the new income statement categories. A limited exception applies to entities whose main business activity is financing (such as banks and certain financial institutions), for which interest paid is instead classified as an operating cash flow.

By contrast, under the US GAAP standard, ASC 842, interest paid must be classified as an operating cash flow.

From a practical perspective, determining interest paid for the direct method typically requires a reconciliation of the related balance sheet liability. This reconciliation considers the opening balance, the closing balance, and any non-cash movements that affected the account during the period, such as capitalised interest or foreign exchange differences.

The total cash payment made to settle a liability on which interest accrued usually comprises both a principal component and an interest component. For cash flow presentation purposes, the interest paid component is usually calculated as the lower of the total cash payment or the interest expense recognised for the period which related to the specific balance sheet account. In other words, we deem the interest to be paid first.

The principal portion of the payment represents the residual amount after deducting interest paid from the total cash outflow. This amount reflects the repayment of the underlying liability and is therefore usually classified within financing activities, consistent with its nature as a return of capital rather than a cost of operations.

In our example, interest paid comprises:

• Interest on long-term loans: £1,720
• Interest on lease liabilities: £180,000
• Total interest paid: £181,720

Interest Received

Under current IAS 7, interest received on cash balances and investments may be classified as either operating activities or investing activities, provided the classification is applied consistently. In practice, classification as operating activities is common where interest income arises from an entity's routine cash management activities and forms part of its operating return.

IFRS 18 also brings changes for interest received. For most entities, interest received is classified as an investing activity, consistent with its nature as a return on invested funds. A limited exception applies to entities whose main business activity is financing, such as banks and certain financial institutions, for which interest received is classified as an operating cash flow, as it arises from their primary revenue-generating activities.

With ASC 230, however, interest received must be classified as an operating cash flow, reflecting its inclusion in net income and the absence of any classification alternatives under US GAAP.

In applying the direct method, it is generally assumed that the interest component is received first, with any remaining cash inflow treated as a repayment of principal.

In our example, interest received of £18,000 represents 4% return on the opening cash balance.

Tax Payments

Income tax paid is always classified as operating activities under both IAS 7 and ASC 230, unless the tax can be specifically identified with financing or investing activities (which is rare in practice).

While some prefer to consider current and deferred tax separately, we prefer the simplicity of grouping the two together in the calculation for tax paid. With all other things being equal, both methods will yield the same answer.

Tax paid is calculated through a reconciliation of tax payable and deferred tax e.g.:

Dividends Paid

Dividends paid to shareholders are typically classified as financing activities under both IAS 7 and ASC 230, as they represent distributions to providers of equity capital rather than costs incurred in generating revenue.

However, IAS 7 permits an accounting policy choice, allowing dividends paid to be classified as either operating activities or financing activities, provided the classification is applied consistently. Many IFRS reporters currently present dividends paid within operating activities to assist users in assessing the entity's ability to generate sufficient operating cash flows to fund dividend distributions.

With the introduction of IFRS 18, this flexibility is removed. Under IFRS 18, dividends paid are required to be classified as financing activities, reflecting their nature as distributions to equity holders and aligning the statement of cash flows more closely with the new defined financing category in the statement of profit or loss. As a result, entities that currently present dividends paid within operating activities under IAS 7 will need to revise their classification on adoption of IFRS 18.

Under ASC 230, dividends paid must be classified as financing cash flows, with no alternative classification permitted.

Calculation of dividends paid

Dividends paid are typically calculated through a reconciliation of the dividends payable balance, considering opening and closing balances and dividends declared during the period.

In our example:

Investing Activities

Note: The presentation of investing activities is identical under both the direct and indirect methods. The only difference between the two methods relates to the presentation of operating activities.

Investing activities represent cash flows from the acquisition and disposal of long-term assets and investments that are not included in cash and cash equivalents. Both the direct and indirect methods present these as gross cash outflows and inflows for each major class of asset.

In our example spreadsheet, we demonstrate the acquisition of property, plant and equipment through a balance sheet reconciliation. This reconciliation removes all non-cash movements such as:

• Depreciation charges
• Revaluation adjustments through other comprehensive income
• Unrealised foreign exchange movements
• Disposal carrying amounts

In our article on common adjustments, we also cover how to account for disposals of PPE and other fixed assets.

This section is not covered in full detail in this article as it does not differ between the direct and indirect methods. For comprehensive guidance on investing activities, please refer to our other resources.

Financing Activities

Note: The presentation of financing activities is identical under both the direct and indirect methods. The only difference between the two methods relates to the presentation of operating activities.

Financing activities comprise cash flows that result in changes in the size and composition of the contributed equity and borrowings of the entity. Both methods present each major class of financing cash flow separately.

In our example spreadsheet, we demonstrate two key financing activities:

Lease Liability Payments:

Cash payments on lease liabilities are split between principal and interest components through a balance sheet reconciliation. The principal repayment of £120,000 is presented in financing activities, whilst the interest component of £180,000 is presented in operating activities (based on our accounting policy choice under IAS 7).

The reconciliation adjusts for new leases recognised during the period (£1,250,000), which represents a non-cash transaction excluded from the cash flow statement.

Loan Repayments:

In our example, total cash paid on the loan was £1,720, which related entirely to interest payments. No principal repayment was made during the period. The loan balance increased due to capitalised interest and unrealised foreign exchange movements, which are non-cash adjustments.

Other financing cash flows that may be presented include proceeds from issuing shares or other equity instruments, payments to acquire or redeem the entity's shares, proceeds from issuing debentures or other borrowings, and repayments of amounts borrowed.

This section is not covered in full detail in this article as it does not differ between the direct and indirect methods. For comprehensive guidance on financing activities, please refer to our other resources.

Non-Cash transactions

Non-cash investing and financing transactions are excluded from the cash flow statement but must be disclosed separately elsewhere in the financial statements under both IAS 7 and ASC 230.

These transactions represent significant investing or financing activities that do not directly affect cash flows but are important for understanding the entity's financial position and activities.

Conclusion

The direct method of preparing a cash flow statement provides superior transparency about an entity's cash generation and utilisation patterns by presenting major classes of gross cash receipts and payments. Whilst more complex to compile than the indirect method for operating activities, the direct method offers significant analytical benefits to users seeking to understand cash flow dynamics.

Both IAS 7 and ASC 230 encourage the use of the direct method, recognising its value in providing more useful information to financial statement users. The key difference between the standards lies primarily in classification requirements, with ASC 230 requiring operating classification for interest and dividends received, whilst IAS 7 permits more flexibility.

For clarification, guidance, or feedback on our article, please reach out to us at insight@leash.co.za.