Q.Discuss the indirect method of ascertaining cash flow from operating activities.
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Start your 14-day free trial to unlock the full solution →The indirect method starts from net profit and adjusts for non-cash items, non-operating items, and working capital changes to arrive at cash flow from operating activities; the alternative part defines a Cash Flow Statement and lists its limitations.
Indirect Method of ascertaining Cash Flow from Operating Activities (as per AS-3, Revised):
Under the indirect method, Cash Flow from Operating Activities is derived by starting with the Net Profit before Tax and Extraordinary Items and adjusting it for items that affected profit but did not involve an actual movement of cash, and for non-operating items, in the following sequence:
Step 1 — Start with Net Profit before Tax and Extraordinary Items.
Step 2 — Add back non-cash and non-operating expenses/losses already debited to the P&L (since they reduced profit but did not use cash, or relate to investing/financing activities, not operations):
- Depreciation and amortisation (of fixed/intangible assets)
- Goodwill, patents, preliminary expenses written off
- Loss on sale of fixed assets/investments
- Interest on borrowings and debentures paid (a financing outflow, added back here since it's deducted again, correctly, as part of financing activities)
- Provision for doubtful debts and other provisions
Step 3 — Deduct non-operating incomes/gains already credited to the P&L (since they relate to investing/financing activities, not operations):
- Profit on sale of fixed assets/investments
- Interest and dividend received on investments
- Rental income
This gives Operating Profit before Working Capital Changes.
Step 4 — Adjust for changes in Current Assets and Current Liabilities (Working Capital changes) relating to operating items:
- Increase in a current asset (other than cash) → deduct (cash tied up)
- Decrease in a current asset → add (cash released)
- Increase in a current liability → add (cash retained longer)
- Decrease in a current liability → deduct (cash paid out)
This gives Cash Generated from Operations.
Step 5 — Deduct Income Tax Paid (net of any tax refund), and adjust for any extraordinary items (added/deducted as appropriate), to arrive at the final figure:
Net Cash Flow from Operating Activities.
OR — Define a Cash Flow Statement; its limitations:
A Cash Flow Statement is a statement that shows the inflows and outflows of cash and cash equivalents of an enterprise during a given period, classified under Operating, Investing and Financing Activities, as prescribed by Accounting Standard-3 (Revised).
Limitations of a Cash Flow Statement:
- It cannot be equated with the Income Statement — a cash flow statement only shows cash movements, not the true economic profitability of the business, since profit is based on the accrual concept while cash flow is not.
- Not a substitute for the Statement of Profit & Loss — net cash flow for a period need not indicate net income, since several non-cash items affect profit. …
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