This video provides an overview of the Direct Method for preparing the Statement of Cash Flows.
The Statement of Cash Flows has three sections: the operating section, the investing section, and the financing section. This is true whether the direct or indirect method is used. The investing section lists the cash flows for the period that pertained to the purchase and sell of productive assets (e.g., property, plant, and equipment or long-term investments). The financing section lists the cash flows that pertained to transactions with the company’s owners (issuing stock, repurchasing stock, paying dividends) or creditors (borrowing money, repaying loans). The investing section and financing section are identical regardless of whether the direct method or indirect method is used.
With the direct method, the operating section is prepared by taking the company’s Income Statement and converting it to a cash-basis. The Income Statement was prepared using accrual accounting (e.g., credit sales were included in sales revenue) so to create the operating section you go line-by-line through the Income Statement and convert each line item to cash basis (e.g., sales revenue becomes cash received from customers). Non-cash charges that appear in the Income Statement (e.g., depreciation expense, amortization expense) are not included in the operating section per the Direct Method because they are non-cash charges.
Thus, the operating section prepared according to the direct method presents the company’s cash receipts (e.g., cash received from customers, cash received from interest) minus the company’s cash payments (e.g., cash paid to suppliers, cash paid for interest, cash paid for income taxes) to arrive at the net cash provided (or used) by operating activities (which is what Net Income would have been had the Income Statement been prepared on a cash-basis instead of an accrual-basis).