Indirect Method vs. Direct Method
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School. Per: Hunkar Ozyasar, eHow Contributor, last updated September 17, 2011 Direct Method
If the accountant prepares the cash flow statement by using the information in the income statement, she is using the direct method. Under such a scenario, she identifies and adds up all cash sales and collections of receivables from credit sales during previous periods. She subtracts all cash payments to arrive at the net cash flow from operating activates. The accountant disregards all cash movement from non-operating activities, such as bank loans or distribution of cash to shareholders in the form of dividends. A positive result indicates a net cash gain from ongoing activities, while a negative result reveals that the firm's regular activities used up more cash than they generated
When using the indirect method, also known as the reconciliation method, the accountant starts with net income and makes adjustments for all activities that would impact the cash flow without resulting in a change in net income or vice versa. The three steps in this adjustment involve the change in accounts receivable, change in accounts payable and investing and financing activities. The accountant deducts any increase in accounts receivable from net income; if there is a reduction, he subtracts the net reduction. Next, he adds the increase in accounts payable to the result from the prior step; if there is a decline, he must subtract the net decline. The final step is a little more complicated and involves a thorough...
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