Definition of the Direct Method for Calculating Cash Flows

The direct method is one of the approved methods for preparing the cash flow statement from operating activities, and relies on presenting actual cash inflows and outflows from operating activities in a direct and detailed manner. This method shows cash receipts from customers and cash payments to suppliers, employees, and other parties without going through accounting net income. It is considered more transparent and clear in showing sources and uses of cash, but it requires more detailed information and precise analysis of cash operations, making it less commonly used despite being preferred by financial analysts.

Steps for Implementing the Direct Method for Calculating Cash Flows

The direct method follows a set of systematic steps to identify and classify actual cash flows from operating activities:

1. Identify Cash Receipts from Customers - Collect all cash amounts received from sales of goods and services
2. Calculate Payments to Suppliers - Record all cash amounts paid for purchasing goods and raw materials
3. Record Salary and Wage Payments - Total cash amounts paid to employees and workers
4. Identify Other Operating Payments - Amounts paid for utilities, rent, and operating expenses
5. Record Other Receipts and Payments - Interest received and paid and taxes paid
6. Calculate Net Cash Flow - Subtract total payments from total receipts to arrive at the final result

Advantages and Benefits of the Direct Method for Calculating Cash Flows

The direct method is characterized by its clarity and transparency in showing actual cash flows, helping users understand sources of cash generation and its uses in a direct and tangible way. It provides valuable detailed information for analysts and investors about the company's real ability to generate cash from its core operations, and facilitates the process of forecasting future cash flows. It is also considered more useful in evaluating liquidity and working capital management, and provides a clear view of collection and payment patterns, helping make better management decisions regarding credit policies and supplier management.

Disadvantages and Challenges of the Direct Method for Calculating Cash Flows

The direct method faces significant practical challenges, most notably the need for extensive detailed information about all cash operations, requiring sophisticated accounting systems and additional efforts in tracking and recording. It is considered more costly and time-consuming to prepare compared to the indirect method, and requires more complex review and audit to ensure data accuracy. It may also be difficult to implement in companies that do not have advanced systems for tracking cash flows, and requires additional training for accounting staff. Additionally, it may require continuous adjustments and reclassification of operations to ensure proper classification of cash flows.

Comparison Between the Direct Method and Indirect Method for Calculating Cash Flows

The direct method differs from the indirect method in several important aspects that affect companies' choice of one of them:

Indirect Method	Direct Method	Comparison Aspect
Net income + adjustments	Actual cash flows	Starting point
Simple and relies on existing statements	Complex and needs additional information	Ease of application
Less detailed	More detailed and clear	Level of detail
Lower cost and time	Higher in cost and time	Cost
Most common	Less usage	Practical usage
Shows relationship with net income	Shows actual cash sources	Type of information
Preferred by accountants	Preferred by analysts	User preference

Summary: The direct method is more detailed and transparent but the indirect method is easier and more practically used.

Comprehensive Practical Example of the Direct Method for Calculating Cash Flows

Al-Fajr Trading Company - Financial Data for 2024

Basic Data:

• Annual sales: 2,000,000 SAR
• Accounts receivable at beginning of year: 200,000 SAR
• Accounts receivable at end of year: 250,000 SAR
• Cost of goods sold: 1,200,000 SAR
• Accounts payable at beginning of year: 150,000 SAR
• Accounts payable at end of year: 180,000 SAR
• Operating expenses: 400,000 SAR (including depreciation 60,000)
• Interest paid: 25,000 SAR
• Taxes paid: 45,000 SAR

Calculation of Net Cash Flow from Operating Activities Using Direct Method:

Explanation	Amount (SAR)	Item
Cash inflows:
Sales - increase in receivables	1,950,000	Cash receipts from customers
(2,000,000 - 50,000)		(2,000,000 - 250,000 + 200,000)
Cash outflows:
Cost + increase in payables	(1,170,000)	Payments to suppliers
(1,200,000 - 30,000)		(1,200,000 - 180,000 + 150,000)
Cash operating expenses	(340,000)	Operating payments
(400,000 - 60,000 depreciation)		(salaries, rent, utilities)
Interest paid	(25,000)	Interest payments
Taxes paid	(45,000)	Tax payments
Final result	370,000	Net operating cash flow

Detailed Calculations:

1. Cash receipts from customers: Sales + Beginning receivables - Ending receivables = 2,000,000 + 200,000 - 250,000 = 1,950,000 SAR

2. Payments to suppliers: Cost of goods sold + Beginning payables - Ending payables = 1,200,000 + 150,000 - 180,000 = 1,170,000 SAR

3. Operating payments: Operating expenses - Non-cash expenses (depreciation) = 400,000 - 60,000 = 340,000 SAR

Analysis:

The company achieved positive net operating cash flow of 370,000 SAR, indicating its ability to generate cash from its core operations despite the increase in receivables and investment in working capital.