Cash Flow from Operating Activities: Direct and Indirect Method

Understand Cash Flow from Operating Activities

Key rules to remember

Operating profit before working capital changes

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

Interest and dividend income are removed only when the question classifies them under investing activities. Interest expense is added back when it is classified under financing.

Cash generated from operations (indirect)

Operating profit before working capital changes − Increase in inventories − Increase in trade receivables + Increase in trade payables (reverse the signs for decreases)

Use only operating current assets and liabilities. Cash, bank and loans are not part of this adjustment.

Net cash from operating activities

Cash generated from operations − Income tax paid

Tax paid is normally shown as an operating outflow unless it can be specifically identified with investing or financing.

Cash received from customers (direct)

Sales − Increase in trade receivables (or + Decrease in trade receivables)

Start from credit sales if cash sales are given separately, and add cash sales.

Cash paid to suppliers (direct)

Purchases + Decrease in trade payables (or − Increase in trade payables)

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

Cash paid for expenses (direct)

Expense (excluding depreciation and other non-cash items) + Decrease in outstanding expenses + Increase in prepaid expenses

Reverse the signs for an increase in outstanding expenses or a decrease in prepaid expenses.

How to solve Cash Flow from Operating Activities questions

1. 1Read the question for the method asked (direct or indirect) and for any instruction on classifying interest and dividends. If none is given, treat interest and dividends received as investing and interest and dividends paid as financing, as in the AS 3 illustration.
2. 2For the indirect method, start with net profit before tax and extraordinary items. Check whether the given profit is before or after tax, and add back the provision for tax if needed.
3. 3List non-cash items: depreciation, amortisation, provisions, unrealised foreign exchange loss or gain. Add the expenses and deduct the gains.
4. 4List investing and financing items inside profit: interest expense, interest income, dividend income, profit or loss on sale of fixed assets or investments. Reverse each one so that it leaves operating profit.
5. 5Total the above to get operating profit before working capital changes.
6. 6Compare opening and closing balances of inventories, trade receivables, trade payables and other operating items. Apply the signs: increase in assets is deducted, increase in liabilities is added.
7. 7Arrive at cash generated from operations, deduct income tax actually paid (work it out from the tax provision account if needed), and show any exceptional or extraordinary cash item separately.
8. 8For the direct method, compute cash received from customers, cash paid to suppliers and cash paid for expenses using the formulas above, and show cash generated from operations as the difference.

Quickest way: Four-line indirect method sprint

Common mistakes in Cash Flow from Operating Activities

• Starting from profit after tax and then also deducting tax paid.

  Students see tax in the question and deduct it without checking which profit figure they began with.

  Fix: Start from profit before tax. Add back the provision for tax if only profit after tax is given. Deduct only the tax actually paid at the end.

• Adding back depreciation but not removing interest income or dividend income.

  Students remember non-cash items but forget non-operating income that sits inside profit.

  Fix: Go through the profit and loss statement line by line. Anything that belongs to investing or financing is removed from operating profit.

• Wrong sign on working capital changes.

  Students memorise the sign instead of reasoning about cash.

  Fix: Ask whether cash was tied up or released. A higher inventory or debtors balance means cash was tied up, so deduct it. Higher creditors means cash was held back, so add it.

• Including cash, bank balances or short-term loans in working capital changes.

  Students treat every current item on the balance sheet as working capital.

  Fix: Use only operating items such as inventories, trade receivables, trade payables and operating provisions. Cash and cash equivalents form the end result of the statement, and borrowings are financing.

• Treating the provision for tax as tax paid.

  The provision appears in the profit and loss account and is easy to pick up.

  Fix: Tax paid = Opening tax liability + Provision for the year − Closing tax liability. Prepare a quick tax account when balances are given.

• Showing a loss on sale of a machine as an operating outflow without adding it back, or showing the sale proceeds as operating.

  Students confuse the accounting loss with the cash received.

  Fix: Add the loss back (or deduct the profit) in operating profit. Show the sale proceeds under investing activities.

Worked examples