Indirect Method

The indirect method of calculating cash flow from operating activities starts with the net profit or loss as shown by the Statement of Profit and Loss. This is the logical starting point because the Statement of Profit and Loss summarises all operating activities of the business. However, that statement is prepared on an accrual basis, not a cash basis. It also includes non-cash items (like depreciation) and non-operating items (like profit on sale of a fixed asset or interest paid). To convert this accrual-based profit into the actual cash generated from operations, you must adjust the net profit figure.

The textbook illustrates this with a simple example. Consider the following Statement of Profit and Loss:

Statement of Profit and Loss Account for the year ended March 31, 2017

Note 1: Other income includes profit on sale of land.

This Statement of Profit and Loss shows a net profit of ₹30,000. The adjustments work as follows:

1. Depreciation of ₹5,000 is a non-cash expense. It was deducted to arrive at the profit, but no cash actually left the business. Therefore, you add back ₹5,000 to the net profit.
2. Finance costs of ₹5,000 (interest paid) is a cash outflow, but it belongs to financing activities, not operating activities. It was deducted in the profit statement, so you add back ₹5,000 to the net profit. This amount will later be shown as an outflow under financing activities.
3. Other income includes a profit on sale of land. This is a cash inflow from an investing activity, not an operating activity. It was added to arrive at the net profit, so you deduct this amount from the net profit.

After these three adjustments, the operating profit before working capital changes is calculated.

Beyond these items, the most important adjustments relate to changes in working capital (current assets and current liabilities). Because the profit is on an accrual basis, sales made on credit are included as revenue even though cash hasn't been received, and expenses incurred on credit are included even though cash hasn't been paid. To convert to cash, you apply this rule:

• Increase in current assets (e.g., trade receivables, inventory, prepaid expenses) → Deduct from operating profit.
• Decrease in current assets → Add to operating profit.
• Increase in current liabilities (e.g., trade payables, outstanding expenses) → Add to operating profit.
• Decrease in current liabilities → Deduct from operating profit.

The logic is straightforward: if receivables increase, you have made sales but not collected the cash, so the profit overstates the cash received. If payables increase, you have incurred expenses but not paid the cash, so the profit understates the cash available.

As per AS-3, the indirect method determines net cash flow from operating activities by adjusting net profit or loss for the effect of:

• Non-cash items (depreciation, goodwill written off, provisions, deferred taxes) — these are added back.
• Items whose cash effects are investing or financing cash flows. All investing and financing incomes (e.g., interest received, profit on sale of asset) are deducted from net profit. All such expenses (e.g., finance cost, dividend declared) are added back to net profit and then shown under their respective activity heads.
• Changes in current assets and current liabilities as described above.

The starting point for the indirect method is Net Profit before Tax and Extraordinary Items, not the net profit after tax. Income tax paid is deducted as the very last item to arrive at the net cash from operating activities.

The proforma (Exhibit 6.4) for the indirect method is as follows: