Direct Method Investing: Strategies For Success

The direct method in investing is one of two accounting treatments used to generate a cash flow statement. It shows all the cash transactions a business completes, including total operating, financing, and investing cash flow over a set period. This method provides a clear picture of a company's cash flow and performance. It is calculated by listing actual cash inflows and outflows during the reporting period, including cash collected from customers, interest income or dividends received, and cash paid to employees and suppliers. While it offers a more detailed view of a company's financials, it is more complex and time-consuming to prepare and is therefore less commonly used than the indirect method.

Cash receipts from customers

The direct method of accounting for cash flow is one of two treatments used to generate a cash flow statement. It uses actual cash inflows and outflows from the company's operations, instead of modifying the operating section from accrual accounting to a cash basis.

The direct method is also known as the income statement method. It determines changes in cash receipts and payments, which are reported in the cash flow from the operations section. The cash flow statement is then divided into three categories: cash flow from operating activities, cash flow from financing activities, and cash flow from investing activities.

The direct method is considered more complex and time-consuming than the indirect method. It requires listing all the cash disbursements and receipts, which can be challenging to assemble. However, it is preferred by the Financial Accounting Standards Board (FASB) because it offers a clearer picture of cash flows in and out of a business.

• List cash receipts from customers. Do not include any sales made on credit.
• List any interest income or dividends that your company received.
• Include a list of all cash paid to employees.
• Include a list of cash paid to your suppliers. Include any interest or income taxes that your company pays.

These steps will allow you to show how your business performs on a cash flow basis, providing a detailed view of your financials.

Cash paid to vendors and suppliers

The direct method of accounting for cash flow involves listing all cash receipts and payments during the reporting period. This includes cash paid to vendors and suppliers.

The second step is to determine how much of the merchandise purchased was paid for in cash. This is done by adding the decrease in accounts payable to the cost of goods purchased. A decrease in accounts payable means more cash was paid out than merchandise was purchased on credit.

For example, if a company's inventory account increased by $107 and its cost of goods sold was $70,950, then the cost of goods purchased would be $71,057. If the accounts payable decreased by $919, then the cash paid to vendors and suppliers would be $71,976.

The direct method provides a more detailed view of a company's financials, but it is more time-consuming and difficult to prepare. Fewer companies use this method, as it is not compatible with the accrual accounting methods that are more commonly used.

Income before income taxes

The direct method is one of two accounting treatments used to generate a cash flow statement. It uses actual cash inflows and outflows from a company's operations, instead of modifying the operating section from accrual accounting to a cash basis. The cash flow statement is divided into three categories: cash flow from operating activities, cash flow from financing activities, and cash flow from investing activities.

The direct method provides a clear picture of a company's cash flow and performance. However, it can be more difficult to prepare than the indirect method. The Financial Accounting Standards Board (FASB) recommends the direct method for its transparency, but the indirect method is more commonly used, especially by larger firms, due to its ease of use and direct connection to the balance sheet.

The direct method is helpful as it can provide a more detailed view of a company's cash inflows and outflows, which can be beneficial to investors and creditors. It includes the following:

• Salaries paid to employees
• Cash paid to vendors and suppliers
• Cash collected from customers
• Interest income and dividends received
• Income before income taxes
• Net cash from operating activities

The direct method's detailed presentation of cash flow from operations, including income before income taxes, offers a transparent view of a company's financial health and can aid in making informed investment decisions.

Net cash from operating activities

There are two methods for calculating net cash from operating activities: the direct method and the indirect method. The direct method, also known as the income statement method, involves listing actual cash inflows and outflows during the reporting period. It measures only the cash that has been received, typically from customers, and the cash payments or outflows, such as to suppliers. The inflows and outflows are then netted to arrive at the net cash flow from operating activities.

The direct method provides a clear picture of a company's cash flow and is preferred by the Financial Accounting Standards Board (FASB). However, it is more complex and time-consuming than the indirect method, as it requires listing all cash disbursements and receipts.

• List cash collected from customers (do not include any sales made on credit)
• List any interest income or dividends received
• List all cash paid to employees
• List all cash paid to suppliers or vendors
• Subtract cash outflows from cash inflows to calculate the net cash flow from operating activities

While the direct method provides more transparency, the indirect method is more commonly used, especially by larger firms, due to its ease of use and direct connection to the balance sheet.

Cash flow from investing activities

The direct method of accounting is one of two treatments used to generate a cash flow statement. It uses actual cash inflows and outflows from a company's operations, instead of modifying the operating section from accrual accounting to a cash basis. The cash flow statement is divided into three categories: cash flow from operating activities, cash flow from financing activities, and cash flow from investing activities.

• Purchase of property, plant, and equipment (PP&E)
• Proceeds from the sale of PP&E
• Acquisitions of other businesses or companies
• Proceeds from the sale of other businesses (divestitures)
• Purchases of marketable securities (i.e. stocks, bonds, etc.)
• Proceeds from the sale of marketable securities

The direct method for the statement of cash flows provides more detail about the operating cash flow accounts. However, it is more time-consuming and complex than the indirect method, which is more commonly used.

Frequently asked questions