Model Answer
0 min readIntroduction
The Statement of Cash Flows is a crucial financial statement that summarizes the movement of cash both into and out of a company during a specific period. It categorizes cash flows into three main activities: operating, investing, and financing. There are two accepted methods for preparing this statement: the direct method and the indirect method. While both methods arrive at the same final cash balance, they differ in how they present the cash flows from operating activities. The direct method explicitly lists cash inflows and outflows, while the indirect method starts with net income and adjusts it for non-cash items. Understanding both methods is vital for financial analysis and decision-making.
Direct Method
The direct method reports actual cash inflows and outflows from operating activities. This method provides a clearer picture of where cash is coming from and going to. It requires detailed tracking of cash receipts and disbursements.
Example (Assuming Data):
Let's assume the following data for Ajay Ltd. for the year ended March 31, 2024:
- Cash received from customers: ₹500,000
- Cash paid to suppliers: ₹300,000
- Cash paid to employees: ₹100,000
- Cash paid for interest: ₹20,000
- Cash paid for taxes: ₹30,000
- Proceeds from sale of equipment: ₹50,000
- Purchase of equipment: ₹80,000
- Proceeds from issuing debt: ₹100,000
- Repayment of debt: ₹40,000
The operating activities section of the cash flow statement under the direct method would look like this:
| Operating Activities | Amount (₹) |
|---|---|
| Cash Receipts from Customers | 500,000 |
| Cash Paid to Suppliers | (300,000) |
| Cash Paid to Employees | (100,000) |
| Cash Paid for Interest | (20,000) |
| Cash Paid for Taxes | (30,000) |
| Net Cash from Operating Activities | 50,000 |
Indirect Method
The indirect method starts with net income and adjusts it for non-cash items and changes in working capital accounts. This method is more commonly used because it is easier to prepare, as the information is readily available from the income statement and balance sheet.
Example (Assuming Data):
Using the same data as above, and assuming Net Income is ₹70,000, Depreciation is ₹20,000, and an increase in Accounts Receivable is ₹10,000, and an increase in Accounts Payable is ₹15,000.
The operating activities section of the cash flow statement under the indirect method would look like this:
| Operating Activities | Amount (₹) |
|---|---|
| Net Income | 70,000 |
| Adjustments to reconcile Net Income to Net Cash from Operating Activities: | |
| Depreciation | 20,000 |
| Increase in Accounts Receivable | (10,000) |
| Increase in Accounts Payable | 15,000 |
| Net Cash from Operating Activities | 95,000 |
Investing and Financing Activities (Both Methods)
The investing and financing activities sections are the same under both methods. They are based on actual cash transactions.
- Investing Activities:
- Proceeds from sale of equipment: ₹50,000
- Purchase of equipment: (₹80,000)
- Financing Activities:
- Proceeds from issuing debt: ₹100,000
- Repayment of debt: (₹40,000)
Conclusion
Both the direct and indirect methods are valid approaches to preparing the Statement of Cash Flows. The indirect method is more prevalent due to its ease of preparation, leveraging readily available data from the income statement and balance sheet. However, the direct method offers greater transparency by explicitly showing cash inflows and outflows. Ultimately, the choice of method depends on the company's preference and reporting requirements. A thorough understanding of both methods is crucial for effective financial statement analysis.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.