Q.Explain the method of calculating 'Cash flows from Operating Activities' under direct method.
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Operating Activities Classification — A First Look
Think of a business as a living organism. Just as your body needs to breathe, eat, and circulate blood to stay alive, a business needs to sell goods, pay suppliers, collect cash from customers, and pay salaries to keep running. These day-to-day transactions that keep the business alive are called Operating Activities.
What Exactly Are Operating Activities?
Operating activities are the principal revenue-producing activities of a business. They are the core, routine transactions that happen again and again — not one-time events like selling a building or taking a loan.
For a typical trading or manufacturing company, operating activities include:
- Cash received from customers (sales)
- Cash paid to suppliers (purchases)
- Cash paid for salaries, rent, electricity, taxes
- Cash received as interest or dividends (if the company is in the business of lending/investing)
The NCERT Class 12 Accountancy textbook (Part II, Chapter 6 — Cash Flow Statement) defines operating activities as: "The principal revenue-producing activities of the enterprise and other activities that are not investing or financing activities."
Why Does This Classification Matter?
You might wonder: Why can't we just lump all cash flows together?
The answer is simple: A business can survive a bad investment decision, but it cannot survive a failure in its core operations. If a company stops generating cash from selling its products, it will eventually shut down — no matter how many buildings it owns or loans it takes.
The Cash Flow Statement separates activities into three buckets:
- Operating Activities — the heartbeat
- Investing Activities — buying/selling long-term assets
- Financing Activities — borrowing/repaying loans, issuing shares
This separation helps investors and managers see whether the company's core business is generating enough cash to sustain itself.
Accounting Treatment — Which Account Is Debited/Credited?
Operating activities are not a separate ledger account. They are a classification used in the Cash Flow Statement. However, the underlying journal entries for each operating transaction follow standard double-entry rules.
Here are the most common operating transactions and their journal entries:
| Transaction | Debit | Credit |
|---|---|---|
| Cash sale | Cash A/c | Sales A/c |
| Credit sale (later collected) | Cash A/c | Debtors A/c |
| Cash purchase | Purchases A/c | Cash A/c |
| Payment to supplier (credit purchase) | Creditors A/c | Cash A/c |
| Salary paid | Salary A/c | Cash A/c |
| Rent paid | Rent A/c | Cash A/c |
| Interest received (if operating) | Cash A/c | Interest Income A/c |
| Tax paid | Tax A/c | Cash A/c |
Do not confuse the classification with a separate ledger. Operating activities are not a T-account. They are a section in the Cash Flow Statement.
The Cash Flow Statement Format (Operating Activities Section)
The NCERT textbook gives a proforma for the Cash Flow Statement under the Indirect Method (which starts with Net Profit and adjusts for non-cash items). Here is the operating activities section:
| Cash Flow from Operating Activities | Amount (₹) |
|---|---|
| Net Profit before Tax and Extraordinary Items | XXX |
| Adjustments for non-cash/non-operating items: | |
| Add: Depreciation | XXX |
| Add: Goodwill amortised | XXX |
| Add: Loss on sale of asset | XXX |
| Less: Profit on sale of asset | (XXX) |
| Less: Interest income (if investing) | (XXX) |
| Operating Profit before Working Capital Changes | XXX |
| Changes in Working Capital: | |
| Add: Decrease in Current Assets (e.g., Debtors) | XXX |
| Less: Increase in Current Assets | (XXX) |
| Add: Increase in Current Liabilities (e.g., Creditors) | XXX |
| Less: Decrease in Current Liabilities | (XXX) |
| Cash Generated from Operations | XXX |
| Less: Tax Paid | (XXX) |
| Net Cash Flow from Operating Activities | XXX |
The Indirect Method is the one prescribed by NCERT for Class 12. You start with Net Profit (from the Statement of Profit & Loss) and then add back non-cash expenses (like depreciation) and adjust for changes in working capital.
A Simple Example to Tie It Together
Suppose a company has:
- Net Profit for the year: ₹1,00,000
- Depreciation charged: ₹10,000
- Debtors increased by: ₹5,000
- Creditors increased by: ₹3,000 …
Under the direct method, cash flow from operating activities is found by taking actual cash receipts from customers and other operating revenue and deducting actual cash payments to suppliers, employees and for other operating expenses (and income tax). …
Direct method shows actual operating cash receipts minus actual operating cash payments.
Under the direct method, the major classes of gross cash receipts and gross cash payments arising from operating activities are shown directly, as follows:
A. Operating cash receipts:
- Cash received from customers (cash sales + collection from debtors/bills receivable).
- Cash received from other operating incomes (commission, fees, royalty received, etc.).
B. Operating cash payments:
- Cash paid to suppliers of goods and services (cash purchases + payment to creditors/bills payable).
- Cash paid to and on behalf of employees (wages, salaries).
- Cash paid for other operating expenses (rent, insurance, etc.).
Cash generated from operations = Total operating receipts (A) − Total operating payments (B).
Less: Income tax paid.
= Net cash from operating activities.
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Showing the 12 most recent of 16 on this concept.
- CBSE 2026Set ANNUAL1 markMCQQ.Or. For a Banking Company, the cash flow from deposits by customers are classified under(a) operating activities(b) investing activities(c) financing activities(d) None of the above
›Reveal solutionSolution
For a bank, taking deposits and lending money IS the principal business — so AS-3 makes a special exception classifying these cash flows as operating, not financing, activities.
Under AS-3, the general rule is that cash received from borrowings (like bank loans or debentures) is a Financing Activity for a typical manufacturing/trading company, because borrowing is incidental to its main line of business (manufacturing or trading goods/services).
However, AS-3 carves out a specific exception for financial enterprises such as banks, financial institutions, and similar entities: for them, activities like accepting deposits from customers, lending and borrowing money, and dealing in securities are their very own principal revenue-generating (operating) activities — this IS their core business, not merely a source of financing for some other operation.
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- CBSE 2025Set ANNUAL1 markMCQQ.Net Profit during the year Rs. 2,45,000; Decrease in inventories Rs. 20,000 and Increase in Trade Receivables Rs. 35,000. Net cash from operating activities will be ________. (A) Rs. 2,30,000 (B) Rs. 2,60,000 (C) Rs. 2,80,000 (D) Rs. 3,00,000
›Reveal solutionSolution
Net Cash from Operating Activities = Net Profit + Decrease in Current Assets − Increase in Current Assets = 2,45,000 + 20,000 − 35,000 = Rs. 2,30,000.
Under the Indirect Method of preparing a Cash Flow Statement, Net Profit is adjusted for changes in working capital items to arrive at Net Cash from Operating Activities:
- A decrease in inventories (a current asset) is a source of cash — it is added to net profit, since less cash is tied up in stock. …
- CBSE 2025Set ANNUAL1 markMCQQ.Which of the following "Non cash & non operating item" will be added to the Net Profit before Tax of the current year, under Operating Activity of Cash Flow Statement?(a) Purchase of Machinery(b) Goodwill written off(c) Sale of Furniture
›Reveal solutionSolution
Any non-cash expense that reduced the reported Net Profit — like goodwill, depreciation, or other intangibles written off — must be added back when computing cash flow from operating activities, since no actual cash went out for it.
Why the other two options are wrong
Item Why it is NOT added to Net Profit under Operating Activities Purchase of Machinery A cash outflow under Investing Activities, not a non-cash item added to operating profit Sale of Furniture A cash inflow under Investing Activities; any profit/loss on sale is adjusted separately, the sale itself isn't an "add-back" Goodwill written off A non-cash, non-operating expense already deducted in arriving at Net Profit — must be added back … - CBSE 2024Set MARCH1 markMCQQ.Which of the following transactions is always transaction of operating activity?(a) Interest paid on loan(b) Dividend received(c) Dividend paid(d) Salary expense
›Reveal solutionSolution
Salary expense is always an operating activity, so option (d) is correct.
In this GSEB Class-12 Commerce cash-flow topic, operating activities are the principal revenue-producing activities and other activities that are not investing or financing.
- Interest paid on loan - financing activity. …
- CBSE 2024Set ANNUAL1 markMCQQ.Which of the following is not included in Operating Activities while preparing Cash Flow Statement?(a) Increase in Current Liabilities.(b) Increase in Current Assets.(c) Sale of Fixed Assets.(d) Payment of Tax.
›Reveal solutionSolution
Sale of Fixed Assets is NOT an operating activity — it is an investing activity (option c).
Operating activities are the principal revenue-producing activities and the effects of changes in working capital. So an increase in current liabilities, an increase in current assets and payment of tax (on operating profit) all affect operating cash flow.
…
- CBSE 2023Set MARCH1 markQ.What are operating activities?
›Reveal solutionSolution
Operating activities are the principal revenue-producing activities of the business and other activities that are neither investing nor financing.
As per AS-3 in the Karnataka 2nd PUC syllabus, operating activities are the day-to-day trading activities that generate the main revenue of the enterprise. Examples of operating cash flows include cash received from the sale of goods and services, cash received from customers (debtors), cash paid to suppliers (creditors), cash paid to and on behalf of employees, and payment of operating expenses. The net cash from operating activities is a key indicator of whether …
- CBSE 2023Set ANNUAL1 markMCQQ.The revenue producing activities of an enterprise are called(a) Operating activities.(b) Investing activities.(c) Financing activities.(d) Cash equivalent.
›Reveal solutionSolution
The principal revenue-producing activities of a business are its operating activities — answer (a).
This WBCHSE HS Accountancy MCQ (cash flow statement, aligned with the NCERT/CBSE curriculum) tests the definition of operating activities.
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- CBSE 2023Set ANNUAL1 markQ.When is dividend received considered as operating activities?
›Reveal solutionSolution
For a financial enterprise (e.g. an investment/finance company), dividend received is part of its main business and is classified as an operating activity.
This short-answer WBCHSE HS Accountancy item tests the classification of dividend received in a cash flow statement.
The treatment depends on the nature of the business:
- For a non-financial (ordinary trading/manufacturing) enterprise, dividend received is income from investments and is classified under investing activities. …
- CBSE 2023Set ANNUAL1 markMCQQ.While calculating cash flow from operating activities which will be added? (A) Increase in Inventory (B) Decrease in Bills Payable (C) Increase in Creditors (D) Increase in Trade Receivables
›Reveal solutionSolution
Under the indirect method, an increase in current liabilities is a source of cash (added), while an increase in current assets is a use of cash (deducted).
While calculating cash flow from operating activities (indirect method), adjustments are made to net profit for changes in working capital:
- An increase in a current asset (like Inventory or Trade Receivables) means more cash is tied up — it is deducted.
- A decrease in a current liability (like Bills Payable) means cash was paid out to reduce it — it is deducted. …
- CBSE 2022Set MARCH1 markMCQQ.Which of the following is not a cash outflow from operating activities?(a) Cash payment to suppliers of goods(b) Cash payment to employees(c) Cash payment to acquire fixed assets(d) Cash payment to insurance premium
›Reveal solutionSolution
Payment to acquire fixed assets is an investing outflow, not an operating one — option (c).
…
- CBSE 2022Set ANNUAL1 markMCQQ.Which one is not included in Operating Activities?(a) Cash received from debtor.(b) Salary paid to employees in cash.(c) Cash paid for income tax.(d) Interest received from investment.
›Reveal solutionSolution
Cash from debtors, salary paid, and income tax paid are operating cash flows; interest received on investments is an investing inflow. The item NOT in operating activities is option (d).
…
- CBSE 2022Set ANNUAL1 markMCQQ.Cash receipts from the sale of goods and services in which a business deals will be shown in cash flow statement under(a) operating activities(b) investing activities(c) financing activities(d) None of the above
›Reveal solutionSolution
Core trading receipts belong under Operating Activities in the Cash Flow Statement.
Operating activities are the principal revenue-generating activities of an enterprise. Cash receipts from the sale of goods and rendering of services — i.e. the business's core trading activity — are therefore classified under Operating Activities, distinct from Investing Activities (acquisition/disposal of long-term assets and i …
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