How to Calculate Cash Flow from Operating Activities

Understand Cash Flow from Operating Activities

Key rules to remember

Operating profit before working capital changes

Profit before tax + Depreciation + Interest expense + Foreign exchange loss + Loss on sale of assets − Interest income − Dividend income − Profit on sale of assets

Add back non-cash items and items whose cash effect is investing or financing. Remove investing income. Reverse the signs for a gain or loss opposite to the one shown.

Cash generated from operations (indirect)

Operating profit before working capital changes − Increase in debtors + Decrease in debtors − Increase in inventories + Decrease in inventories + Increase in creditors − Decrease in creditors

An increase in an operating asset reduces cash. An increase in an operating liability raises cash.

Net cash from operating activities

Cash generated from operations − Income taxes paid ± Cash flow of an extraordinary item (AS 3 only)

In the AS 3 illustration, the proceeds of 180 from the earthquake settlement are added after the cash flow before the extraordinary item (1,690) to reach 1,870. Ind AS does not allow extraordinary items, so under Ind AS you will not present this line.

Cash receipts from customers (direct)

Sales − Increase in debtors (or + Decrease in debtors)

Use credit sales. Adjust for bills receivable too if the question gives them.

Cash paid to suppliers (direct)

Purchases − Increase in creditors (or + Decrease in creditors)

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

Direct method result

Cash receipts from customers − Cash paid to suppliers and employees = Cash generated from operations

AS 3 illustration: 30,150 − 27,600 = 2,550. It equals the indirect method figure of 2,550.

How to solve Cash Flow from Operating Activities questions

1. 1Read which method the question asks for. If it is silent, use the indirect method.
2. 2Start with net profit before tax (and before any extraordinary item). Do not start with profit after tax, because tax paid is deducted later.
3. 3Add back non-cash items: depreciation, provisions, unrealised foreign exchange loss, and loss on sale of fixed assets.
4. 4Remove items whose cash effect is investing or financing: interest income, dividend income and profit on sale of assets (deduct), and interest expense (add back). Show these in the investing or financing section instead.
5. 5This gives operating profit before working capital changes. Now take the change in each current asset and current liability from the two balance sheets and adjust with the correct sign.
6. 6This gives cash generated from operations. Deduct income tax actually paid, using a tax working note if needed. Under AS 3, add or deduct the cash flow of any extraordinary item after that, as the illustration does with the earthquake settlement. Ind AS does not allow extraordinary items.
7. 7For the direct method, compute cash receipts from customers and cash paid to suppliers and employees, then deduct tax paid.
8. 8Cross-check: the direct and indirect figures for cash generated from operations must match.

Quickest way: Sign rule for working capital changes

Common mistakes in Cash Flow from Operating Activities

• Starting from profit after tax and then deducting tax paid again

  Students take the first profit figure on the statement without checking whether it is before or after tax.

  Fix: Begin with profit before tax. Tax is deducted only once, as tax paid, after cash generated from operations.

• Leaving interest and dividend income inside operating profit

  These items sit in the profit and loss statement, so students assume they are operating.

  Fix: In the AS 3 illustration, interest income (300) and dividend income (200) are deducted and interest expense (400) is added back. The cash is shown under investing or financing activities.

• Reversing the sign of working capital changes

  Students memorise 'increase means add' without separating assets from liabilities.

  Fix: Use the rule: more debtors or inventories means less cash; more creditors means more cash. In the illustration, an increase in debtors of 500 is shown as (500).

• Deducting the tax expense instead of tax paid

  The profit and loss statement shows the provision, not the cash paid.

  Fix: Tax paid = opening tax payable + tax expense for the year − closing tax payable, unless the question gives the tax paid directly. In the AS 3 illustration the income-tax charge is 300 while income taxes paid are 860, which shows that tax paid can differ from the tax expense.

• Treating non-cash transactions as cash flows

  Students include share issues for assets or conversion of debentures in the statement.

  Fix: AS 3 (para 41) and Ind AS 7 (para 44) exclude non-cash transactions such as acquiring assets by assuming liabilities, acquiring an enterprise by issuing shares, and converting debt to equity. Disclose them separately if material.

• Using total sales or cost of sales directly in the direct method

  Students forget that sales are credit sales and purchases are not the same as cost of goods sold.

  Fix: Adjust sales for the change in debtors. Compute purchases from cost of goods sold and the inventory change, then adjust for the change in creditors.

Worked examples