Restate an indirect-method cash flow statement in direct form
The idea
Each direct-method line can be reconstructed from the income statement and the change in the corresponding balance sheet account. Cash collected from customers is revenue less the increase in receivables. Cash paid to suppliers is cost of goods sold plus the increase in inventory less the increase in payables. Cash paid for operating expenses is the expense less the increase in accrued liabilities and plus the increase in prepaid expenses. Doing the conversion is worthwhile because it shows which specific relationship — collection, payment or stocking — is driving a divergence between earnings and cash.
A practice question
How is cash collected from customers calculated from the indirect statement?
- Revenue plus the increase in receivablesWhy not: The wrong sign. A growing receivable balance means part of the revenue was billed and not collected, so it comes off rather than on.
- Revenue less the increase in receivables — correct
- Revenue less the increase in payablesWhy not: Payables are what the company owes its suppliers. They belong in the conversion of cost of goods sold, not of revenue.
A growing receivable balance means part of the revenue was not collected. Subtracting the increase converts the accrual figure to cash.
A harder one
Cost of goods sold is 500, inventory rose 40 and payables rose 25. What was cash paid to suppliers?
- 515 — correct
- 565Why not: 500 + 40 + 25 — both movements added. Owing suppliers more means paying out less, so the payables rise is a deduction.
- 485Why not: 500 − 40 + 25, with both signs reversed. Buying more than was sold raises the cash requirement; owing more lowers it.
500 + 40 - 25 = 515. More was bought than sold, which raises the cash requirement, and some of it has not yet been paid for, which reduces it.
The hardest tier
Why is the conversion worth performing even though the operating cash flow total is unchanged?
- Because it changes the classification of interest paidWhy not: Classification is a policy choice made by the company and is unaffected by how an analyst re-presents the section.
- Because it is required by accounting standardsWhy not: Nothing requires an analyst to do it. It is worth doing for what it reveals, not because anyone insists.
- Because it identifies which relationship drives it — correct
Collection, payment or inventory build: the direct format names which one is producing the gap between earnings and cash. The indirect statement lists the adjustments but not their operational meaning, while the direct format shows whether the problem is that customers are not paying or that the company is stocking up.
In the app: 9 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
Take the free diagnostic →