The previous topic reached operating cash flow by starting from profit and adjusting it. The direct method gets to the same figure from the other end: it adds up the cash received from customers and subtracts the cash paid to suppliers, employees and for other expenses.
This topic also covers the other two headings of the statement, investing and financing, which are found by comparing the opening and closing statements of financial position.
Together with the indirect method, this completes the statement of cash flows. The workings are all the same type: take an opening balance, add what was incurred, subtract the closing balance, and what is left is the cash. The next topic starts ratio analysis.
In 30 seconds
Direct method: cash from customers = opening receivables + sales − closing receivables. Cash to suppliers = opening payables + purchases − closing payables, where purchases = closing inventory + cost of sales − opening inventory. Wages paid = opening accrual + expense − closing accrual. Other expenses exclude depreciation. Investing: purchases of property, plant and equipment = closing cost − opening cost + cost of disposals − revaluation; proceeds = carrying amount ± gain or loss.
Financing: shares issued = movement in share capital plus share premium; loans = movement in total loans; dividends = opening retained earnings + profit after tax − closing retained earnings. Both methods give the same net operating cash flow.
The direct method
The direct method calculates cash receipts and payments from operations: cash received from customers, cash paid to suppliers, cash paid to employees and cash paid for other operating expenses. It gives cash generated from operations, then tax paid and interest paid. International Accounting Standard (IAS) 7 prefers this method, though the indirect method is more common in practice.
| Cash flow | Working |
|---|---|
| Cash from customers | Opening receivables + sales − closing receivables |
| Purchases | Closing inventory + cost of sales − opening inventory |
| Cash paid to suppliers | Opening payables + purchases − closing payables |
| Cash paid to employees | Opening accrued wages + wages expense − closing accrued wages |
| Cash paid for other expenses | Opening payables + other expenses excluding depreciation − closing payables |
A T-account does the same job: put the opening balance on one side, the sales or purchases on the other side, and the cash is the balancing figure. If wages or other costs were paid in advance, the opening prepayment is deducted and the closing prepayment is added. Other expenses usually include depreciation, which is not a cash flow, so it is removed before the working. Payables for other expenses exclude accrued wages, interest and tax.
Example (Abuja Plastics Ltd). Sales ₦1,280,000, cost of sales ₦400,000, wages ₦290,000, other expenses ₦350,000 including depreciation of ₦25,000, interest ₦50,000 and tax ₦40,000. Opening and closing balances: receivables 233,000 and 219,000; inventory 118,000 and 124,000; trade payables 102,000 and 125,000; accrued wages 8,000 and 5,000; accrued interest 30,000 and 45,000; tax payable 52,000 and 43,000.
| Working | ₦ |
|---|---|
| Cash from customers: 233,000 + 1,280,000 − 219,000 | 1,294,000 |
| Purchases: 124,000 + 400,000 − 118,000 | 406,000 |
| Cash paid to suppliers: 102,000 + 406,000 − 125,000 | (383,000) |
| Cash paid to employees: 8,000 + 290,000 − 5,000 | (293,000) |
| Other expenses: 350,000 − 25,000 | (325,000) |
| Cash generated from operations | 293,000 |
| Tax paid: 52,000 + 40,000 − 43,000 | (49,000) |
| Interest paid: 30,000 + 50,000 − 45,000 | (35,000) |
| Net cash from operating activities | 209,000 |
The indirect method gives the same answer. Profit before tax 190,000 plus depreciation 25,000 plus interest 50,000 is 265,000, plus the fall in receivables 14,000, less the rise in inventory 6,000, plus the rise in payables and accruals 20,000, giving 293,000, then tax and interest paid as above.
Investing activities
The investing section holds cash paid for non-current assets and investments, cash received from selling them and, under IAS 7, interest and dividends received (see the International Financial Reporting Standard (IFRS) 18 note below). It is found from the movement in the carrying amount: Opening + additions − disposals − depreciation ± revaluation = closing.
Purchases of property, plant and equipment. Using cost: closing cost − opening cost + cost of assets disposed of − any upward revaluation = purchases. Using carrying amount: closing − opening + carrying amount of disposals + depreciation − revaluation = purchases. Example (disposal). Cost was ₦150,000 at the start and ₦180,000 at the end, accumulated depreciation ₦105,000 and ₦88,000, and an asset costing ₦60,000 with accumulated depreciation of ₦45,000 was sold. Purchases = 180,000 − 150,000 + 60,000 = ₦90,000. Check by carrying amount: 92,000 − 45,000 + 15,000 + 28,000 = 90,000, where depreciation = 88,000 − (105,000 − 45,000) = 28,000.
Example (revaluation). Cost or valuation rose from ₦1,400,000 to ₦1,900,000. Property was revalued up by ₦200,000 and equipment costing ₦260,000 was disposed of.
- Purchases = 1,900,000 − 1,400,000 + 260,000 − 200,000 = ₦560,000.
- The cash is reduced if some assets were bought on credit, and the unpaid balance is deducted.
- If the payables for assets fell from ₦14,000 to ₦4,000 on additions of ₦60,000, the cash paid is 60,000 + 10,000 = ₦70,000.
Proceeds from disposals. Carrying amount at disposal ± the gain or loss = cash. Equipment that cost ₦70,000 with accumulated depreciation of ₦56,000 and sold at a gain of ₦6,000 has a carrying amount of ₦14,000, so proceeds are 14,000 + 6,000 = ₦20,000. If a question gives a note with the selling price, use it directly. Investments work the same way without depreciation: opening 1,000, less disposal at carrying amount 200, plus revaluation 150 gives 950, so additions are 1,500 − 950 = 550.
Financing activities
Share issues. Add share capital and share premium at each date, and the increase is the cash raised. Share capital rising from ₦600,000 to ₦750,000 and share premium from ₦800,000 to ₦1,100,000 give 1,850,000 − 1,400,000 = ₦450,000.
Loans. Add the current and non-current parts of loans and loan notes at each date. An increase is an inflow and a decrease is an outflow. Loans of 760,000 current plus 1,400,000 non-current at the start, and 400,000 plus 1,650,000 at the end, fell from 2,160,000 to 2,050,000, an outflow of 110,000.
Dividends. Dividends paid are found from retained earnings: opening + profit after tax − closing = dividends paid. They normally comprise last year’s final dividend and this year’s interim dividend.
Example (Company X). Share capital 400,000 to 500,000, share premium 275,000 to 615,000, retained earnings 390,000 to 570,000, loans 680,000 (600,000 + 80,000) to 575,000 (520,000 + 55,000), and profit after tax 420,000.
- Shares issued.
1,115,000 − 675,000 = 440,000. - Loans repaid: 105,000.
- Dividends.
390,000 + 420,000 − 570,000 = 240,000. - Net cash from financing.
440,000 − 105,000 − 240,000 = ₦95,000.
A sole proprietor or partnership. The financing flows are capital introduced and drawings: opening capital + profit + capital introduced − drawings = closing capital, with whichever of the two is missing as the balancing figure.
The ideas in more depth
A common error. A common illustration sells a motor vehicle for ₦4,500,000 that has a cost of ₦15,000,000 and accumulated depreciation of ₦9,000,000, a carrying amount of ₦6,000,000. It then says “a gain on disposal of ₦1,500,000” that is deducted from profit. Selling price 4,500 less carrying amount 6,000 is a Loss of ₦1,500,000. In the indirect method a loss is Added back. The investing inflow of ₦4,500,000 is right.
Background (IFRS 18). The older specimen formats show interest paid and income taxes paid in operating activities, and interest and dividends received in investing. Under the IFRS 18 amendments to IAS 7, interest paid and dividends paid are generally financing and interest and dividends received are generally investing. Tax paid stays in operating. The calculations do not change, only the heading under which the line appears.
In the exam, follow the layout the question or the syllabus section expects.
Worked example: Osogbo Retail Ltd
Scenario. Osogbo Retail Ltd had these balances (₦000). Property, plant and equipment at cost: 800 at the start and 950 at the end. Accumulated depreciation: 300 and 330. During the year an item that cost 100 with accumulated depreciation of 70 was sold at a gain of 8. Share capital: 500 to 600. Share premium: 100 to 160. Loans: 200 to 150. Retained earnings: 240 to 290, after profit after tax of 120.
Net cash from operating activities was 230 and cash at the start of the year was 20. Required: the investing and financing sections, and the closing cash.
- Purchases of property, plant and equipment (PPE).
950 − 800 + 100 = 250.
Check: carrying amounts are 620 and 500, so 120 + 30 (disposal) + 100 (depreciation) = 250.
The depreciation is 330 − (300 − 70) = 100. - Proceeds.
Carrying amount 100 − 70 = 30, plus gain 8 = 38.
Investing: (250) + 38 = (212). - Shares issued.
(600 + 160) − (500 + 100) = 160. - Loans.
150 − 200 = (50) repaid. - Dividends.
240 + 120 − 290 = (70).
Financing: 160 − 50 − 70 = 40. - Net cash.
230 − 212 + 40 = 58.
Closing cash = 20 + 58 = ₦78,000.
Common mistakes in the exam
- Using sales instead of cash from customers, or purchases instead of cash paid to suppliers.
- Leaving depreciation in other expenses when working out cash paid.
- Forgetting to add the cost of disposals when finding purchases from the movement in cost.
- Not removing a revaluation from the movement in cost or carrying amount.
- Taking the loans movement from the non-current balance only, and not adding the current portion.
- Using the dividend declared in the statement of profit or loss instead of the dividend paid.
- Showing the carrying amount, instead of the cash proceeds, for a disposal.
- Not agreeing the final figure to opening cash plus the net change.
Quick revision
- Customers: opening receivables + sales − closing receivables.
- Suppliers: opening payables + purchases − closing payables. Purchases = closing inventory + cost of sales − opening inventory.
- PPE purchases = closing cost − opening cost + disposals at cost − revaluation.
- Proceeds = carrying amount ± gain or loss.
- Shares: movement in capital plus premium. Loans: movement in total loans. Dividends: opening RE + profit − closing RE.
Practice questions
These are original questions in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one first.
Section A style: multiple choice
Question 1. Receivables were ₦233,000 at the start and ₦219,000 at the end, and sales were ₦1,280,000. Cash received from customers is:
- ₦1,266,000
- ₦1,294,000
- ₦1,513,000
- ₦1,280,000
Show the answer
B. 233,000 + 1,280,000 − 219,000 = 1,294,000.
Question 2. Closing inventory is ₦124,000, cost of sales ₦400,000 and opening inventory ₦118,000. Purchases are:
- ₦406,000
- ₦394,000
- ₦524,000
- ₦642,000
Show the answer
A. 124,000 + 400,000 − 118,000 = 406,000.
Question 3. Trade payables were ₦102,000 at the start and ₦125,000 at the end, and purchases were ₦406,000. Cash paid to suppliers is:
- ₦406,000
- ₦429,000
- ₦383,000
- ₦508,000
Show the answer
C. 102,000 + 406,000 − 125,000 = 383,000.
Question 4. Compared with the indirect method, the direct method gives a net cash flow from operating activities that is:
- Higher
- Lower
- Unrelated
- The same
Show the answer
D. Both methods reach the same figure by different routes.
Question 5. Cost of property, plant and equipment was ₦150,000 at the start and ₦180,000 at the end. Assets with a cost of ₦60,000 were sold. Purchases are:
- ₦30,000
- ₦90,000
- ₦210,000
- ₦120,000
Show the answer
B. 180,000 − 150,000 + 60,000 = 90,000.
Question 6. Equipment that cost ₦70,000 with accumulated depreciation of ₦56,000 is sold at a gain of ₦6,000. The proceeds are:
- ₦6,000
- ₦14,000
- ₦20,000
- ₦76,000
Show the answer
C. Carrying amount 14,000 + gain 6,000 = 20,000.
Question 7. Share capital plus share premium was ₦675,000 at the start and ₦1,115,000 at the end. The cash from issuing shares is:
- ₦440,000
- ₦1,115,000
- ₦675,000
- ₦1,790,000
Show the answer
A. 1,115,000 − 675,000 = 440,000.
Question 8. Retained earnings were ₦390,000 at the start and ₦570,000 at the end, and profit after tax was ₦420,000. Dividends paid are:
- ₦810,000
- ₦180,000
- ₦420,000
- ₦240,000
Show the answer
D. 390,000 + 420,000 − 570,000 = 240,000.
Question 9. Total loans (current and non-current) were ₦680,000 at the start and ₦575,000 at the end. The financing cash flow is:
- An inflow of ₦105,000
- An outflow of ₦575,000
- An outflow of ₦105,000
- An inflow of ₦680,000
Show the answer
C. A reduction in loans is a repayment, an outflow.
Question 10. A sole trader’s capital was ₦100,000 at the start and ₦120,000 at the end. Profit was ₦40,000 and capital introduced ₦10,000. Drawings are:
- ₦20,000
- ₦30,000
- ₦50,000
- ₦70,000
Show the answer
B. 100,000 + 40,000 + 10,000 − 120,000 = 30,000.
Section B style: written questions
Question 11 (10 marks). (a) Distinguish the direct method from the indirect method of reporting operating cash flows. (4 marks) (b) Show how cash received from customers and cash paid to suppliers are calculated. (6 marks)
Question 12 (20 marks). Kebbi Foods Ltd had sales of ₦960,000, cost of sales ₦600,000, wages ₦120,000, other expenses ₦140,000 including depreciation of ₦30,000, interest ₦20,000 and tax ₦24,000. Opening and closing balances: receivables 90,000 and 100,000; inventory 40,000 and 50,000; trade payables 50,000 and 60,000; accrued wages 5,000 and 8,000; accrued interest 2,000 and 3,000; tax payable 10,000 and 12,000.
(a) Prepare the cash flows from operating activities by the direct method, with workings. (14 marks) (b) Reconcile the cash generated from operations to profit before tax by the indirect method. (6 marks)
A further written question
Question 13 (10 marks). Property, plant and equipment at cost or valuation was ₦600,000 at the start and ₦900,000 at the end. An asset that cost ₦80,000 with accumulated depreciation of ₦60,000 was sold at a loss of ₦5,000. Another property was revalued upwards by ₦120,000. (a) Calculate the purchases of property, plant and equipment. (5 marks) (b) Calculate the proceeds of the sale. (3 marks) (c) State where each appears in the statement of cash flows. (2 marks)
Model answers
Show the model answer to Question 11
(a) The direct method shows the major classes of operating cash receipts and payments, such as cash from customers and cash paid to suppliers and employees. The indirect method starts with profit before tax and adjusts it for non-cash items, accruals and working capital movements. Both give the same net cash from operating activities. (b) Cash from customers = opening receivables + sales − closing receivables.
Purchases = closing inventory + cost of sales − opening inventory. Cash paid to suppliers = opening payables + purchases − closing payables.
Show the model answer to Question 12
(a)
- Cash from customers.
90,000 + 960,000 − 100,000 = 950,000. - Purchases.
50,000 + 600,000 − 40,000 = 610,000, so cash paid to suppliers: 50,000 + 610,000 − 60,000 = (600,000). - Wages.
5,000 + 120,000 − 8,000 = (117,000). - Other expenses.
140,000 − 30,000 = (110,000). - Cash generated from operations.
950,000 − 600,000 − 117,000 − 110,000 = 123,000. - Tax paid.
10,000 + 24,000 − 12,000 = (22,000). - Interest paid.
2,000 + 20,000 − 3,000 = (19,000). - Net cash from operating activities.
123,000 − 22,000 − 19,000 = ₦82,000.
(b)
- Profit before tax.
960,000 − 600,000 − 120,000 − 140,000 − 20,000 = 80,000. - Add depreciation 30,000 and interest 20,000 = 130,000.
- Receivables increase (10,000), inventory increase (10,000), trade payables increase 10,000, accrued wages increase 3,000.
- Cash generated from operations.
130,000 − 7,000 = 123,000, which agrees.
Show the model answer to Question 13
(a) Purchases = 900,000 − 600,000 + 80,000 − 120,000 = ₦260,000.
(b)
- Carrying amount.
80,000 − 60,000 = 20,000. - Loss 5,000, so proceeds = 20,000 − 5,000 = ₦15,000.
(c) Both are in investing activities: the purchases as an outflow of 260,000 and the proceeds as an inflow of 15,000. The loss of 5,000 is added back in operating activities under the indirect method.
Pathfinder on Statement of cash flows: direct method, investing and financing
These are the ICAN Pathfinder questions that test this topic. ICAN owns the questions and the suggested solutions, so we point you to them and do not copy them. Open your Pathfinder, attempt each question under exam conditions, then check your answer against the notes above.
From the previous syllabus. Gives financial data for a company, with revenue, cost of sales, changes in receivables, inventories and payables, a loss on disposal, depreciation, a share issue, loan note repayment, dividend and interest paid. Asks for the statement of cash flows by the direct method, with operating (5 marks), investing (5 marks), financing (5 marks) and closing cash (5 marks).
Revise first: The direct method
From the previous syllabus. Gives cash received from customers, cash paid to suppliers and employees, tax paid, the purchase of property, plant and equipment and the proceeds of a motor vehicle, and asks for the net cash flow from operating and from investing activities.
Revise first: Investing activities
From the previous syllabus. Gives two years of statements of financial position, with land, buildings, equipment, share capital and loans, and asks for the statement of cash flows. The investing and financing sections come from the movements.
Revise first: Financing activities
From the previous syllabus. Each asks for a full statement of cash flows by the indirect method, so you must also find purchases and proceeds of non-current assets, share issues, loan movements and dividends paid for the investing and financing sections.
Revise first: Investing activities
Expect an item on cash from customers or to suppliers, the purchases of property, plant and equipment, or the dividends paid. Check Section A of every diet you practise.
Revise first: The direct method
Source: ICAN Pathfinder, Financial Accounting. Diets covered: May Diet, 2015, November Diet, 2015, November Diet, 2016, November Diet, 2017, May Diet, 2018, May Diet, 2019 and May Diet, 2023. All are on the previous syllabus. Diets before November 2014, and November Diet, 2024 onwards, are not covered here.
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