Cash Flow from Operating Activities: Direct and Indirect Method

Understand Cash Flow from Operating Activities: Direct and Indirect Method

Key rules to remember

Indirect method format

Net profit before tax + non-cash expenses + non-operating losses + finance costs − non-operating gains − investment income = Operating profit before working capital changes

Non-cash: depreciation, amortisation, goodwill or preliminary expenses written off, provisions made. Non-operating: loss or profit on sale of fixed assets or investments. Finance cost is added back because interest paid is shown under financing. Interest and dividend income are deducted because they are shown under investing.

Cash generated from operations

Operating profit before working capital changes − increase in current assets (or + decrease) + increase in current liabilities (or − decrease)

Use only operating current assets and liabilities: debtors, bills receivable, inventory, prepaid expenses, creditors, bills payable, outstanding expenses. Leave out cash and bank balances.

Net cash from operating activities

Cash generated from operations − income tax paid (+ refund received)

Income tax paid is normally an operating cash outflow. Show it as one separate line below cash generated from operations.

Direct method format

Cash receipts from customers − cash paid to suppliers − cash paid to employees − other operating cash expenses = Cash generated from operations

Then deduct income tax paid to get net cash from operating activities.

Cash received from customers

Credit sales + opening debtors − closing debtors (adjust for bad debts and discounts allowed, if any) + cash sales

Bad debts written off and discount allowed reduce the cash collected from debtors.

Cash paid to suppliers

Purchases + opening creditors − closing creditors, where Purchases = Cost of goods sold + closing stock − opening stock

Add cash purchases if given separately.

How to solve Cash Flow from Operating Activities: Direct and Indirect Method questions

1. 1Identify the method asked for and the starting figure. For the indirect method, begin with net profit before tax. If only net profit after tax is given, add back the tax provision to reach profit before tax.
2. 2List every non-cash expense in the profit and loss account (depreciation, amortisation, goodwill or preliminary expenses written off, provisions) and add it back.
3. 3Pull out items that belong to investing or financing. Add back losses on sale of assets and interest expense. Deduct profits on sale of assets, interest income and dividend income.
4. 4Total the lines to get operating profit before working capital changes. Show this subtotal clearly.
5. 5Compute the change in each operating current asset and liability from the two balance sheets. An increase in an asset or a decrease in a liability reduces cash. A decrease in an asset or an increase in a liability adds cash.
6. 6Add the net working capital change to get cash generated from operations. Then deduct income tax paid. If only the provision and the opening and closing tax balances are given, work out tax paid from the tax account.
7. 7For the direct method, build each cash line separately (receipts from customers, payments to suppliers, wages, expenses) using the opening and closing balances, then subtract the total payments from receipts.
8. 8Label the final figure net cash from operating activities and state whether it is an inflow or an outflow.

Quickest way: Profit-and-balance-sheet shortcut

Common mistakes in Cash Flow from Operating Activities: Direct and Indirect Method

• Reversing the sign on working capital changes, for example adding an increase in debtors.

  Students think an increase is always positive. For assets it means cash is tied up.

  Fix: Remember: assets go opposite to cash, liabilities go with cash. Debtors up means minus. Creditors up means plus.

• Adding interest income and dividend income to operating profit instead of deducting them.

  These credits are in profit, so students assume they are operating cash.

  Fix: Deduct them from profit before tax because they are shown under investing activities. Likewise add back interest expense, which is shown under financing.

• Including the change in cash and bank balance in working capital changes.

  Cash is a current asset in the balance sheet, so it gets pulled into the list.

  Fix: Exclude cash and bank. The statement exists to explain the change in cash, so it cannot be an input.

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

  Students mix up the starting figure and the tax line.

  Fix: Start from profit before tax, then deduct tax paid once, after cash generated from operations. If you begin with profit after tax, add back the tax charge first.

• Adding back depreciation but forgetting a loss or profit on sale of a fixed asset.

  Depreciation is memorised as the only adjustment, and the sale entry is buried in the notes.

  Fix: Scan the profit and loss account and the notes for every gain or loss on asset sale. Add back losses and deduct gains. Show the sale proceeds under investing activities.

• In the direct method, using sales or purchases directly as cash figures.

  Credit transactions are ignored.

  Fix: Adjust sales for opening and closing debtors. Convert cost of goods sold to purchases using stock, then adjust for creditors.

Worked examples