JC Ltd. earned a net profit of ₹ 50,000 after providing depreciation of ₹ 20,000 on fixed assets and a transfer of ₹ 15,000 to general reserve. The position of its Current Assets and Current Liabilities was as follows :
| Particulars | 31.03.2025 (₹) | 31.03.2024 (₹) |
|---|---|---|
| Trade Receivables | 75,000 | 70,000 |
| Trade Payables | 75,000 | 65,000 |
| Inventories | 40,000 | 25,000 |
| Expenses Payable | 7,500 | 5,000 |
| Prepaid Expenses | 5,000 | 10,000 |
| Accrued Incomes | 20,000 | 15,000 |
| Income Received in Advance | 5,000 | 10,000 |
Calculate cash flows from operating activities.
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Start your 14-day free trial to unlock the full solution →Cash flows from operating activities = ₹ 72,500 (net profit before tax and extraordinary items, adjusted for non-cash/non-operating items and changes in working capital).
Concept and Treatment
The cash flow from operating activities is derived using the indirect method, which starts with net profit and adjusts it for:
- Non-cash charges (like depreciation)
- Non-operating items (like transfers to reserves)
- Changes in current assets and current liabilities
Why this approach?
Net profit is calculated on an accrual basis — it includes revenues earned but not yet received and expenses incurred but not yet paid. To convert this accrual profit into actual cash generated from operations, we must:
- Add back non-cash expenses (depreciation, amortisation, etc.) because they reduce profit but do not involve cash outflow.
- Add back transfers to reserves (like general reserve) because they are appropriations of profit, not operating expenses.
- Adjust for changes in working capital items:
- An increase in a current asset (e.g., trade receivables, inventories) means cash was used to build that asset — subtract the increase.
- A decrease in a current asset means cash was released — add the decrease.
- An increase in a current liability (e.g., trade payables, expenses payable) means cash was conserved — add the increase.
- A decrease in a current liability means cash was paid out — subtract the decrease.
Common Pitfall
Students often forget that transfer to general reserve is an appropriation of profit, not an operating expense. It must be added back to net profit when calculating cash from operations. Similarly, depreciation is a non-cash charge — always add it back.
Solution
Step 1: Calculate Net Profit Before Tax and Extraordinary Items
Given: Net profit after depreciation and transfer to general reserve = ₹ 50,000
We need to work backwards to find the profit before these adjustments:
| Particulars | Amount (₹) |
|---|---|
| Net profit as given | 50,000 |
| Add: Transfer to general reserve (appropriation) | 15,000 |
| Add: Depreciation (non-cash charge) | 20,000 |
| Net profit before tax and extraordinary items | 85,000 |
The net profit of ₹ 50,000 is after deducting depreciation (₹ 20,000) and after transferring ₹ 15,000 to general reserve. So to get back to the operating profit figure, we add both back.
Step 2: Adjust for Changes in Working Capital
We compare the balances of current assets and current liabilities between 31.03.2024 and 31.03.2025.
| Particulars | 31.03.2025 (₹) | 31.03.2024 (₹) | Change (₹) | Effect on Cash |
|---|---|---|---|---|
| Current Assets | ||||
| Trade Receivables | 75,000 | 70,000 | +5,000 | Decrease (subtract) |
| Inventories | 40,000 | 25,000 | +15,000 | Decrease (subtract) |
| Prepaid Expenses | 5,000 | 10,000 | -5,000 | Increase (add) |
| Accrued Incomes | 20,000 | 15,000 | +5,000 | Decrease (subtract) |
| Current Liabilities | ||||
| Trade Payables | 75,000 | 65,000 | +10,000 | Increase (add) |
| Expenses Payable | 7,500 | 5,000 | +2,500 | Increase (add) |
| Income Received in Advance | 5,000 | 10,000 | -5,000 | Decrease (subtract) |
Working Notes:
- Trade Receivables increase by ₹ 5,000 — more credit sales not yet collected → cash outflow → subtract.
- Inventories increase by ₹ 15,000 — more stock purchased → cash used → subtract.
- Prepaid Expenses decrease by ₹ 5,000 — less cash tied up in prepayments → cash inflow → add.
- Accrued Incomes increase by ₹ 5,000 — more income earned but not received → cash not yet in → subtract. …
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