In this video, I am going to introduce you direct method of cash flow from operations, preparation. Let's remember indirect method of cash flow from operations. We started our journey with net income. We have done four groups of adjustments. One, we adjusted just at for non-cash expenses like depreciation. We made adjustments for gains and losses like from asset sales. Then we have also done adjustments for operating assets, and operating liabilities, and become a bit cash flow from operations. In direct method of CFO shows the adjustments to net income to calculate CFO, but is not useful to show the exact cash paid or collected for each operating activity. For example, indirect method of CFO doesn't help the answer how much cash collected from customers or how much cash paid to suppliers. Direct method of cash flow from operations shows cash paid collected for each operating activity explicitly. Then of course your question is, why don't we use direct method of cash flow from operations? The purpose of cash flow operations is to show you the correspondence between net income and cash flow from operations. So given the net income how much is cash flow from operations? There is a purpose of CFO statement. The purpose is not to show you how much cash you collected from customers, how much cash you pay to suppliers. However, knowing the direct method of cash flow operations can make cash flow of operations more intuitive for you. So how are we going to calculate CFO under direct methods? I'm going to worry about six cash payments or cash collections under cash flow from operations. These are cash collections from customers, cash collections from interest and dividend income. Just an important point here, although interests are associated with my financing operations, we just said that interests is always operations. This is an exception, similarly dividend income. Dividend income is also coming from my investing activities. However, when you get dividend income it is tagging net income, therefore dividend income is also part of operations. Third we are going to worry about cash paid to suppliers, cash paid for operations, cash paid for tax purposes, and cash paid for interest. So here is our example that we have used to calculate cash flow statement in the previous video, it is exactly the same numbers I have balance sheet numbers for year 2015 and 2016. I also have income statement number for 2016, and then we are given some extra information that the amount of depreciation expense is $800 as is recorded under operating expenses, and there is no purchase or disposal of fixed assets in the year 2016. Now, let's start to calculate cash flow from operations using the direct method. The first thing that we need to calculate is cash collections from customers. To do so, we are going to keep track of how account receivables change over time. There is a beginning amount of account receivables. Account receivables will go up it's sales plus sales. Account receivables will go down by cash collections from customers which is what I am after. At the end you're going to end up with ending amount of account receivables. By using the balance sheet and income statement that you have just seen, I'm going to now feel this numbers. Beginning amount of receivables is 11,000. The amount of sales is 24,000, the amount of ending accounts receivables is 2,000 and therefore cash collections from customers which is equal to sales minus change in account receivable, it's going to be 33,000. One important note here, in the presence of unearned revenue cash collections from customers need an additional adjustment. So let's see what is adjustment looks like. How does unearned revenue account change? There is beginning unearned revenue. Unearned revenue will go up by cash advances from customers, notice that it is cash coming from customers, minus unearned revenue go down service delivered to customers, and we're going to end up with the ending amount of unearned revenue. In other words, cash advances from customers which is another component of cash collections from customers is equal to services delivered plus change in unearned revenue. So cash advances from customers is equal to o service delivered plus change in unearned revenue. If you look carefully at this formula, service delivered has already been including sales. Therefore in the presence of unearned revenue cash collections from customers will need the additional adjustment of plus change in unearned revenue. So cash collections from customers is equal to sales minus change in account receivables plus change in unearned revenue which we have been just introducing this slide. Coming back to our original question, there is no unearned revenue, therefore cash collections from customers is as we have calculated $33,000. The second component here is cash collections from interest and dividend income. So where am I going to find this numbers? Is there any cash collections from interest income or dividend income? I'm going to look at balance sheet to see whether there is any interest receivable or dividends receivable. I don't see them. I'm going to look at my income statement to see whether there is any interests revenues or dividend revenues. I also don't see them. There is a dividend payment of 200 but I don't see a dividend received. We don't have any interest or dividend receivable on the balance sheet. We have given no extra information that Illini Supermarket receives interest or dividend income. Therefore, Illini Supermarket has no interest or dividend income in this year. In real company financial statements, one needs to look at financial statement footnotes for whether a firm has interest or dividend income. So cash collections from interest and dividend income is zero. The third component here is cash paid to suppliers. How are we going to calculate cash paid to suppliers? We are going to go through two accounts. Let me start with the right one. Change in accounts payable. How does accounts payable change? There is beginning amount of accounts payable. Accounts payable will go up with purchases of inventory. Accounts payable will go down with cash paid to suppliers which is what I am after. You are going to come up with the ending amount of accounts payable. So where am I going to find the purchases which I need to come up with cash paid to suppliers? You are going to find the purchases of inventory by using changes in inventory. How does inventory change over time? There is beginning amount of inventory. Inventory will go up with the purchase of inventory. Inventory will go down with cost of goods sold and then you are going to come up with ending inventory. I am going to now put these two frameworks together and I can calculate cash paid to suppliers is equal to cost of goods sold, plus change in inventory minus change in accounts payable. Please stop the video here. Please make sure that if you follow the framework which are introduced you here, you are going to calculate purchase by using changes in inventory. Then you are going to calculate cash paid to suppliers by keeping track of how accounts payable account change makes sure that cash paid to suppliers is equal to cost of goods sold plus change in inventory minus change in accounts payable. By using the numbers of Illini supermarket from year 2016 and 2015, I can calculate cash paid to suppliers as 10,500. Which I am going to record in direct method of cashflow from operations. The next component here is cash paid for operations. So what exactly I mean by cash payable operations. I'm going to look at the balance sheet. I'm going to see whether I have any payable associated with my operations. Is there anything that catches my attention that needs to be payable? Is there anything here I have operating expenses of 9,600. What is cash payable operations? Cash paid for operations includes; cash paid for wages, marketing, sales, and other administrative purposes. So basically you need to look at the balance sheet to see whether there is any wage payable, advertising payable, or other like the secretary salary payable, things like this. We do not have any payable on the balance sheet associated with these expenses. But we have an operating expense of 9,600 of which $800 is depreciation expense. Therefore, cash paid for operations is 9,600 which is my operating expenses minus depreciation which is not an operating expense. It doesn't require any cash. So the amount of cash paid for operations for wages, marketing, sales, and other administrative purposes is 8,800, which I'm going to record on my direct metadata CFO. The next item here is cash paid for tax purposes. I'm going to again look at my balance sheet. Is there any tax payable? Yes at the end of year 2016 there is a tax payable of 1,562. If I look at income statement I see a tax expensive how much 1,736. How am I going to calculate the amount of money paid for tax purposes? I am going to keep track of how tax payable changes. There's beginning amount of tax payable. Tax payable will go up with tax expense. Tax payable will go down by cash paid for tax purposes which is what I am after. Finally you come up with ending amount of tax payable. By using the numbers of Illini Supermarket for year 2015 and 2016. I'm going to feel this framework. Beginning amount of tax payable is zero, ending amount of tax payable is 1,562. The amount of tax expense in income statement is 1,736, and if you do the algebra cash paid for texts is equal to take the expense minus change in tax payable and you are going to find $174 which is paid for tax purposes. The last component of direct method of CFO is cash paid for interest. I am going to look at balance sheet, do I see anything about interest? Yes there is an interest payable of $380 in 2016. If you look at the income statement there is an interest expense of $800. So how can I calculate the amount of money paid for interest purposes? I'm going to keep track of how interest payable account changes. There is a beginning amount of interest payable. Interest payable will go up with interest expense. Interest payable will go down by cash paid for interest which is what I'm after. Finally you come up with ending amount of interest payable. Now let's use the numbers from year 2015 and 2016 for Illini Supermarket. Beginning interest payable zero, interest expenses 800, ending amount of interest payable is 380. Therefore, cash paid for interest is interest expense minus change in interest payable, it's going to be $420. Here I feel all the numbers which are required to calculate direct method cashflow from operations. If you sum them up you're going to find a cashflow from operations using the direct method is 13,106, is this familiar to you? It is exactly the same number that we had calculated using indirect methods. Direct and indirect methods to prepare cash flow from operations result in the same amount of cashflow from operations. There is no difference. These methods do not affect preparation of cash flow from investing and financing activities. So basically for investing and financing activities whatever we have done for the indirect method, will be the same for direct method.