Q.Prepare a format of cash flow from operating activities.

The Cash Flow Statement classifies cash flows into three main categories: Operating, Investing, and Financing activities. Cash flow from operating activities represents the cash generated from the principal revenue-producing activities of the enterprise and other activities that are not investing or financing activities. It reflects the cash-generating ability of the business from its core operations.

For exam purposes, the indirect method is commonly used to prepare cash flow from operating activities. This method starts with net profit before tax and extraordinary items and then adjusts it for non-cash items, non-operating items, and changes in working capital.

Here is the format for preparing cash flow from operating activities using the indirect method:

Cash Flow from Operating Activities (Indirect Method)

I. Net Profit Before Tax and Extraordinary Items

(This is the starting point, calculated by adjusting the net profit as per the Statement of Profit & Loss for items like provision for tax, proposed dividend, interim dividend, and transfers to reserves.)

II. Adjustments for Non-Cash and Non-Operating Items:

Add: Depreciation and Amortisation

Add: Interest Expense (e.g., on debentures, loans)

Add: Loss on Sale of Fixed Assets/Investments

Less: Interest Income

Less: Dividend Income

Less: Rent Income

Less: Gain on Sale of Fixed Assets/Investments

Operating Profit Before Working Capital Changes

III. Adjustments for Working Capital Changes:

Add: Decrease in Current Assets (e.g., Debtors, Stock, Prepaid Expenses)

Add: Increase in Current Liabilities (e.g., Creditors, Bills Payable, Outstanding Expenses) …

Understanding the Cash Flow Statement is crucial because it provides insights into a company's liquidity and solvency by showing how cash is generated and used. Unlike the Income Statement (which uses accrual accounting) or the Balance Sheet (a snapshot), the Cash Flow Statement focuses purely on cash movements. It classifies cash flows into three main categories: Operating, Investing, and Financing activities.

Cash Flow from Operating Activities represents the cash generated from a company's principal revenue-generating activities. These are the day-to-day transactions that determine net profit or loss. The goal is to convert the accrual-based net profit (or loss) into the actual cash generated or used by operations.

There are two methods to prepare the Cash Flow from Operating Activities:

1. Direct Method: This method shows major classes of gross cash receipts and gross cash payments. For example, cash received from customers, cash paid to suppliers, cash paid for operating expenses. It is considered more intuitive but is less commonly used in practice due to data collection challenges.
2. Indirect Method: This method starts with net profit (or loss) before tax and extraordinary items and then adjusts it for the effects of non-cash transactions, deferrals or accruals of past or future operating cash receipts or payments, and items of income or expense associated with investing or financing cash flows. This is the method most commonly taught and used for exam purposes, and the format below will follow it.

The logic behind the indirect method is to reverse the impact of items that affected net profit but did not involve cash, or involved cash but were not related to core operations.

• Non-cash items: Expenses like depreciation and amortisation reduce net profit but do not involve an outflow of cash. Therefore, they are added back to net profit. Similarly, non-cash incomes (rare in operating activities) would be subtracted.
• Non-operating items: Incomes or expenses related to investing or financing activities (e.g., interest received, dividend received, profit/loss on sale of assets, interest paid) are included in the Income Statement but are classified under Investing or Financing activities in the Cash Flow Statement. To isolate operating cash flows, these items are adjusted: non-operating expenses are added back, and non-operating incomes are subtracted.
• Working Capital Changes: Changes in current assets (other than cash and cash equivalents) and current liabilities reflect the timing differences between accrual accounting and cash accounting. For example, an increase in debtors means sales were made but cash was not yet received, so cash from operations is lower than sales revenue.

Let's look at the standard format for preparing Cash Flow from Operating Activities using the indirect method.

Cash Flow from Operating Activities (Indirect Method)

Working Notes

1. Net Profit Before Tax and Extraordinary Items: This is the starting point for the indirect method. It is derived from the Statement of Profit and Loss. To arrive at this figure, you typically take the Net Profit after Tax and make the following adjustments:

   • Add back Provision for Tax (current year's provision).
   • Add back Interim Dividend Paid (if any).
   • Add back Proposed Dividend (for the previous year, if paid in the current year).
   • Add back Transfer to Reserves.
   • Add back Extraordinary Items (if debited to P&L).
   • Less: Tax Refund (if any).
   • Less: Extraordinary Items (if credited to P&L).
   Watch out

   Always start with Net Profit before tax and extraordinary items. If you are given Net Profit after tax, you must reverse the tax provision and any extraordinary items to reach the correct starting point.

2. Depreciation on Fixed Assets: Depreciation is a non-cash expense that reduces the reported net profit but does not involve any actual outflow of cash. To reverse its effect on profit and determine the true cash flow, it is added back.

3. Amortisation of Intangible Assets: Similar to depreciation, amortisation (e.g., of goodwill, patents, trademarks, preliminary expenses, underwriting commission) is a non-cash expense that reduces profit. It is added back to calculate cash flow from operations.

4. Interest Expense: Interest paid on debentures, loans, or other borrowings is a financing activity, not an operating activity. Although it reduces net profit, the cash outflow is classified under financing activities. Therefore, it is added back to net profit to isolate operating cash flows.

5. Loss on Sale of Fixed Assets / Investments: A loss on the sale of an asset (e.g., machinery, land, shares) reduces net profit. However, the actual cash received from the sale is an investing activity. The loss itself is a non-operating, non-cash adjustment to profit. To remove its effect from operating profit, it is added back.

6. Provision for Doubtful Debts (if increased): An increase in the provision for doubtful debts is a non-cash expense that reduces profit. It is added back to reverse its impact on operating profit. If the provision decreases, it would be subtracted.

7. Preliminary Expenses Written Off: These are expenses incurred at the time of company formation, which are written off over a period. The write-off is a non-cash expense and is added back.

8. Interest Income: Interest received on investments or bank deposits is an investing activity, not an operating activity. Although it increases net profit, the cash inflow is classified under investing activities. Therefore, it is subtracted from net profit to isolate operating cash flows.

9. Dividend Income: Dividends received on investments in shares of other companies are an investing activity. Similar to interest income, it is subtracted from net profit. …