Direct Method
As discussed in Chapter 7, we know that the cash flow statement is designed for the purpose of tracing a company’s cash flows and their sources/uses. Accordingly, under the direct method of preparing the cash flow from operating activities section, each income statement line item—revenues, cost of goods sold (COGS), selling, general and administrative (SG&A), interest expense, income taxes, etc.—is converted from accrual to cash accounting (Exhibit A.3).
| CONSOLIDATED STATEMENTS OF CASH FLOWS | |||||
| In millions | fiscal year ended Dec. 31, 2005 (52 weeks) | fiscal year ended Jan. 1, 2005 (52 weeks) | fiscal year ended Jan. 3, 2004 (53 weeks) | ||
| Cash flows from operating activities: | |||||
| Cash receipts from sales | $ 36,923.1 | $ 30,545.8 | $ 26,276.9 | ||
| Cash paid for inventory | (26,403.9) | (22,469.2) | (19,262.9) | ||
| Cash paid to other suppliers and employees | (8,186.7) | (6,528.5) | (5,475.5) | ||
| Interest and dividends received | 6.5 | 5.7 | 5.7 | ||
| Interest paid | (135.9) | (70.4) | (64.9) | ||
| Income taxes paid | (591.0) | (569.2) | (510.4) | ||
| Net cash provided by operating activities | 1,612.1 | 914.2 | 968.9 | ||
| Cash flows from investing activities: | |||||
| Additions to property and equipment | (1,495.4) | (1,347.7) | (1,121.7) | ||
| Proceeds from sale-leaseback transactions | 539.9 | 496.6 | 487.8 | ||
| Acquisitions, net of cash and investments | 12.1 | (2,293.7) | (133.1) | ||
| Cash outflow from hedging activities | — | (32.8) | — | ||
| Proceeds from sale or disposal of assets | 31.8 | 14.3 | 13.4 | ||
| Net cash used in investing activities | (911.6) | (3,163.3) | (753.6) | ||
| Cash flows from financing activities: | |||||
| Reductions in long-term debt | (10.5) | (301.5) | (0.8) | ||
| Additions to long-term debt | 16.5 | 1,204.1 | — | ||
| Proceeds from exercise of stock options | 178.4 | 129.8 | 38.3 | ||
| Dividends paid | (131.6) | (119.8) | (105.2) | ||
| Additions to/(reductions in) short-term debt | (632.2) | 885.6 | (4.8) | ||
| Net cash (used in) provided by financing activities | (579.4) | 1,798.2 | (72.5) | ||
| Net increase (decrease) in cash and cash equivalents | 121.1 | (450.9) | 142.8 | ||
| Cash and cash equivalents at beginning of year | 392.3 | 843.2 | 700.4 | ||
| Cash and cash equivalents at end of year | $ 513.4 | $ 392.3 | $ 843.2 | ||
| Reconciliation of net earnings to net cash provided by operating activities: | |||||
| Net earnings | $ 1,224.7 | $ 918.8 | $ 847.3 | ||
| Adjustments required to reconcile net earnings to net cash provided by operating activities: | |||||
| Depreciation and amortization | 589.1 | 496.8 | 341.7 | ||
| Deferred income taxes and other non-cash items | 13.5 | (23.6) | 41.1 | ||
| Change in operating assets and liabilities providing/(requiring) cash, net of effects from acquisitions: | |||||
| Accounts receivable, net | (83.1) | (48.4) | (311.1) | ||
| Inventories | (265.2) | (509.8) | 2.1 | ||
| Other current assets | (13.2) | 35.7 | (3.0) | ||
| Other assets | (0.1) | 8.5 | (0.4) | ||
| Accounts payable | 192.2 | 109.4 | (41.5) | ||
| Accrued expenses | (43.8) | (144.2) | 116.5 | ||
| Other long-term liabilities | (2.0) | 71.0 | (23.8) | ||
| Net cash provided by operating activities | $ 1,612.1 | $ 914.2 | $ 968.9 | ||
Source: Used with permission of CVS Corporation. 2005 Annual Report, 2005 10-K, (c) CVS Corporation, 2005.
Note the difference between direct and indirect methods:
The direct method essentially provides a cash income statement.
Under the indirect method, the first line of the cash flow statement is net income from the income statement, while the subsequent lines are the necessary adjustments to net income, in order to arrive at the amount of cash generated from operations during the same period.
If companies choose to report the operating activities section using the direct method, they must additionally also report the operating activities section under the indirect method.
This method is used by a minority of companies:
It reveals cash movement of every income statement line item. Companies may not want to reveal such detailed information for a variety of reasons.
Companies using the direct method are required to also disclose the indirect method, so it makes sense to use the indirect method in the first place.