How does the direct method work?

Definition

The direct method builds cash from operations by listing actual cash receipts and actual cash payments. On the books, this is another way to assemble the operating section of the Statement of Cash Flows, not a second set of books.

A neighborhood grocer reads it as cash from customers minus cash to vendors, payroll, and rent. Those totals are cash that moved, not the revenue and expense lines on the Income Statement.

It is a presentation of operating cash. The same month's groceries, wages, and rent sit underneath; only the path is listed as receipts and payments.

Accrual sales can differ from cash from customers. This method shows the cash that actually came in and went out.

Where it shows up

Cash flow: Related to how the operating section is built from actual receipts and payments.

P&L: Related to revenue and expenses, which are not the cash totals.

Balance Sheet: Related to the bank balance those receipts and payments move.

See also: Cash Flow From Operations · Statement Of Cash Flows · Cash Application

When you look at your Statement of Cash Flows, a direct operating section lists cash collected and cash paid. It does not start at leftover profit.

When cash from customers is high, the register and collections were strong. When cash to vendors is high, the grocer paid a lot of bills this period.

The Balance Sheet still holds accounts receivable and accounts payable. This method just does not use those changes as the face of the operating section.

The Income Statement still shows sales and costs when they were earned and incurred. Those lines are not the cash totals listed here.

A busy week on account can raise sales while cash from customers stays flat. This method makes that gap obvious because it only lists cash.

Investing and financing sections sit below, same as under the other layout. This method is only about how the operating block is listed.

How it works

List cash received from customers. That total is collections, not the sales line.

List cash paid to vendors. That total is bill payments, not the cost of goods that sold.

List cash paid for wages. Payroll expense on the P&L can differ if pay was accrued.

List cash paid for rent and similar running costs. Rent expense matches the cash only when rent was paid in the same period it was used.

Subtract the payments from the receipts. What remains is operating cash for the period.

Stay with receipts and payments when you read this layout. Do not start at leftover profit and add depreciation back.

Do not treat a sale on account as cash from customers. The cash line waits until the customer pays.

After the month closes, this list is the period's operating cash story. Next month starts the count again from that month's receipts and payments.

Matching incoming checks to open invoices feeds the customer-receipt total. This page stays with the listed receipts and payments, not that matching desk.

Operating expenses on the P&L can include costs not yet paid. This method only lists the cash that left.

Example

Corner Basket Grocers collected $90,000 from customers this month. It paid $55,000 to vendors, $22,000 for payroll, and $6,000 for rent.

Subtract those payments from the collections. Operating cash is $7,000.

The $7,000 is cash from running the store this month. Sales on the Income Statement can be a different number if some tickets are still unpaid.

If the same month had $5,000 more still sitting in receivables, cash from customers would be $85,000. Operating cash would then be $2,000.

A Saturday rush paid in cash raises the customer-receipt line the same day. A catering invoice paid next month waits until next month's list.

Last June the store collected $88,000 and posted $6,500 of operating cash. This month's $7,000 is a bit higher because vendor payments were lighter.

Common mix-ups

The direct method is not the same as the Income Statement. Sales and expenses are earned and incurred; this method lists cash receipts and cash payments.

The direct method is not the same as the indirect method. The indirect method starts at leftover profit and adjusts; this method lists the cash that moved.

The direct method is not the same as the bank's period record of every transaction. That record includes investing and financing activity; this method is only the operating receipts and payments on the Statement of Cash Flows.

Related terms

• Cash Flow From Operations: Cash generated or used by the day-to-day running of the business.
• Statement Of Cash Flows: A statement that explains how cash moved through operating, investing, and financing activities during a period.
• Indirect Method: Building operating cash flow by starting at net income and adjusting for non-cash and working-capital items.
• Cash Application: Matching incoming customer payments to the right open invoices.
• Check Run: The scheduled batch in which approved vendor bills are paid.
• Cash Flow Forecast: A forward projection of cash receipts and payments.
• Bank Statement: The bank's period record of every transaction and the ending balance.
• Net Change In Cash: The total increase or decrease in cash across all three cash-flow sections.