Cash Flow from Operating Activities (Direct and Indirect Method) under AS 3

Understand Cash Flow from Operating Activities (Direct and Indirect)

Key rules to remember

Starting point (indirect method)

Net profit before tax and extraordinary items

AS 3 starts here. If the question gives profit after tax, add back the tax provision first.

Operating profit before working capital changes

Net profit before tax + Depreciation and amortisation + Interest expense + Loss on sale of fixed assets + Other non-cash expenses − Interest income − Dividend income − Profit on sale of fixed assets − Other non-cash gains

Interest and dividend items are removed because they are shown under financing or investing for a non-financial enterprise.

Working capital adjustments

Increase in current assets → deduct; Decrease in current assets → add; Increase in current liabilities → add; Decrease in current liabilities → deduct

Use only operating items. Exclude cash, bank and current investments, and exclude items such as proposed dividend or tax payable if you are handling them separately.

Cash generated from operations

Operating profit before working capital changes ± Working capital adjustments

This is the figure before tax.

Net cash from operating activities

Cash generated from operations − Income tax paid

Tax paid = Opening tax payable + Tax expense for the year − Closing tax payable (adjust for advance tax as per the data).

Cash received from customers (direct method)

Sales (credit) + Opening debtors − Closing debtors

Add cash sales. Adjust for bad debts written off and discount allowed if given.

Cash paid to suppliers (direct method)

Purchases + Opening creditors − Closing creditors

Purchases = Cost of goods sold + Closing inventory − Opening inventory.

Cash paid for expenses (direct method)

Expense for the year + Closing prepaid − Opening prepaid + Opening outstanding − Closing outstanding

Exclude depreciation and other non-cash charges.

How to solve Cash Flow from Operating Activities (Direct and Indirect) questions

1. 1Read the requirement. Note the method asked, and whether the entity is a financial or non-financial enterprise.
2. 2Find the starting profit. For the indirect method, work out net profit before tax and extraordinary items. If net profit is given, use it as it is, adding back only the tax if the figure is after tax. When only the change in the Profit and Loss balance is given, add back tax provision, proposed dividend, interim dividend and transfers to reserves to derive net profit before tax.
3. 3List non-cash and non-operating items: depreciation, amortisation, write-offs, provisions, interest paid, interest and dividend received, profit or loss on sale of assets. Add back losses and expenses; deduct gains and income.
4. 4Prepare the working capital changes. Compare opening and closing balances of inventory, debtors, creditors, prepaid and outstanding expenses, and other operating items. Apply the rule: current assets up means cash down; current liabilities up means cash up.
5. 5Compute cash generated from operations. If the question mentions extraordinary items, show their cash effect separately as AS 3 requires.
6. 6Compute income tax paid from the provision and tax payable accounts, and deduct it to reach net cash from operating activities.
7. 7For the direct method, build each receipt and payment separately: cash from customers, cash to suppliers, cash for expenses, then deduct tax. Cross-check your total with the indirect method if time allows.
8. 8Show all workings as notes. Examiners award step marks for tax paid, purchases and other working notes.

Quickest way: Table-and-tick approach for the indirect method and MCQs

Common mistakes in Cash Flow from Operating Activities (Direct and Indirect)

• Starting with profit after tax instead of profit before tax and extraordinary items.

  The Profit and Loss account balance or the net profit figure is easiest to see, so students take it directly.

  Fix: If net profit after tax is given, add back the tax provision to reach profit before tax. When only the change in the Profit and Loss balance is given, add back tax provision, proposed dividend, interim dividend and transfers to reserves to derive net profit before tax. Then deduct tax paid separately at the end.

• Applying the working capital signs the wrong way round.

  Students confuse an increase in debtors with an inflow because it looks like higher sales.

  Fix: Ask one question: did cash go up or down? Higher debtors mean cash is stuck, so deduct. Higher creditors mean you kept cash, so add.

• Leaving interest expense or interest income inside operating activities.

  Students forget that for a non-financial enterprise these belong to financing and investing flows.

  Fix: Add back interest paid and deduct interest and dividend received while moving from profit to operating cash flow, then show them in the proper section.

• Including depreciation in direct method payments.

  Students take the expense line from the Profit and Loss account without checking whether it is cash.

  Fix: Exclude depreciation, amortisation and provisions from cash paid for expenses. Only cash items appear in the direct method.

• Taking the tax provision for the year as the tax paid.

  The provision is shown in the Profit and Loss account and looks like the cash amount.

  Fix: Compute tax paid as opening tax payable plus tax charged for the year minus closing tax payable, and show it as a working note.

• Treating profit or loss on sale of fixed assets as operating.

  It appears in the Profit and Loss account, so students leave it in profit.

  Fix: Add back the loss or deduct the profit. The sale proceeds go under investing activities.

Worked examples