Cash flow refers to the movement of cash and cash equivalents into and out of a business. Transactions that increase cash and cash equivalents are known as cash inflows, while those that decrease them are called cash outflows. A statement that records these inflows and outflows over a specific period is known as a Cash Flow Statement. It can be prepared using the comparative balance sheets of a company and provides information about the sources and uses of cash during an accounting period. Cash flow transactions are classified into three categories: operating activities, investing activities, and financing activities. Operating activities relate to the principal revenue-generating functions of the business, investing activities involve the purchase and sale of long-term assets and investments, and financing activities include transactions that affect the company's capital and borrowings. In India, the preparation of a Cash Flow Statement is governed by Accounting Standard (AS) 3 (Revised), issued by the Institute of Chartered Accountants of India. Furthermore, under the Companies Act, 2013, the preparation of a Cash Flow Statement is mandatory for all companies except One Person Companies (OPCs) as specified under Section 2(40)].
Cash Flow from Operating Activities:
The principal revenue-producing activities of a company are categorised under Operating Activities. Simply put, it includes those activities which help an organisation in ascertaining the net profit or net loss of an enterprise. Some of the cash flows arising from operating activities are as follows:
- Cash receipts from the sale of goods and rendering services.
- Cash receipts from fees, royalties, commissions, and other revenue.
- Cash payments to and on behalf of employees.
- Cash payments to suppliers for goods and services.
- Cash payments or refunds on income taxes unless they can be identified, specifically with financing and investing activities.
- Cash receipts and cash payments of an insurance enterprise for premiums and claims, annuities, and other policy benefits.
- Cash receipt and payments that relates to future contracts, option contracts, forward contracts, and swap contracts when the contracts are held for dealing or trading purposes.
Calculation of Cash Flow from Operating Activities:
The basic information required for the calculation of cash flow from operating activities is taken from the comparative balance sheets, and profit & loss account of the current accounting period. There are some non-cash transactions in the profit & and loss account that do not result in either inflow or outflow of cash, these items are eliminated from the net profit as per the profit & loss account. According to AS-3, there are two methods that can be used to determine cash flow from operating activities; viz., direct method and indirect method.
(*As per CBSE Syllabus, we will be discussing the Indirect Method only)
Indirect Method: Under the Indirect Method of calculating Cash Flow from Operating Activities, the calculation begins with Net Profit before Tax and Extraordinary Items. However, the net profit shown in the Profit and Loss Statement cannot be taken directly as cash generated from operations because it includes several non-cash and non-operating items. Therefore, non-cash expenses such as depreciation, amortisation, and goodwill written off are added back to the net profit, while non-operating incomes such as profit on the sale of fixed assets are deducted. Further, adjustments are made for changes in current assets and current liabilities, as these items affect cash flow but may not appear in the Profit and Loss Statement. After making all these adjustments and deducting income tax paid, the resulting figure represents the Net Cash Flow from Operating Activities.
I. Adjustment for Non-Cash Items:
A. Items to be added back to the Net Profit:
The profit & loss account of a company consists of some expenses which do not result in the outflow of cash and are known as non-cash items. These items are added back to the net profit for the calculation of cash profit. These items are:
- Depreciation: Depreciation is shown as an expense in the profit & loss account reducing the profits of the year without reducing the cash as it is a non-cash item. Therefore, depreciation is added back to the profit for calculating operating profit.
- Amortisation of Intangible or Fictitious Assets: When a company writes off these assets, it shows them as expenses or losses in the profit & loss statement; however, such write-off does not involve any cash payment. Therefore, such items are added back to the profit for determining the operating profit. The intangible and fictitious assets of a company include Goodwill Written Off, Trade Marks and Patent Rights, Discount on the Issue of Shares and Debentures, and Preliminary Expenses.
- Loss on Sale of Fixed Assets: Generally, the loss on sale of fixed assets is taken to the profit & loss statement of a company. It should be added back to the profits of the company to ascertain the operating profits. Besides, while preparing the cash flow statement of the company, Net Proceeds from the sale of fixed assets is shown as cash inflow.
- Transfer to Reserves: Reserves that are carried out of profits of a company are added back as these reserves do not result in any outflow of cash. Examples of such reserves are General Reserve, Sinking Fund, etc.
- Creation of Provisions: If a company has created any provision out of profits, these are added back to the profits earned during the year for the calculation of operating profits. It is because such provisions reduce the profits made during the year without reducing the cash. Some examples of such provisions are Provisions for Doubtful Debts, Provisions for Taxation, Provisions for Discounts on Trade Receivables, and Proposed Dividends,
B. Items to be deducted from Net Profits:
The profit & loss account of a company consists of some incomes which do not result in the inflow of cash and are known as non-operating incomes. These items are deducted from the net profit for the calculation of operating profits. These items are:
- Profit on Sale of Fixed Assets: The total amount of cash received by a company from the sale of fixed assets is shown separately in its cash flow statement as cash inflow. Therefore, the amount of profits on the sale of fixed assets shown in the profit & loss statement must be deducted from the profits.
- Re-transfer of Excess Provisions: When a company makes provisions of doubtful debts, depreciation, etc. in excess of its needs, they are transferred as income to the profit & loss statement. These excess provisions are deducted from profits because they do not change the current year's cash flow in any way.
- Other Non-trading Incomes: If some non-trading incomes, such as interest received, dividend received, etc., appear in the profit & loss statement of a company, they are deducted from the profits as they are separately shown in the cash flow statement of the company as cash inflows.
II. Adjustment in Respect of Changes in Current Assets and Current Liabilities
Current assets and current liabilities change frequently during business operations. Although these changes do not affect net profit, they influence the actual cash available from operating activities. Therefore, adjustments are made while calculating cash flow from operating activities.
1. Decrease in Current Assets: A decrease in current assets (such as Trade Receivables, Prepaid Expenses, and Accrued Income) indicates that cash has been received or realised. Hence, it increases cash generated from operations.
Treatment: Add the decrease in current assets to operating profit.
2. Increase in Current Assets: An increase in current assets indicates that more cash has been invested in these assets, reducing the cash available from operations.
Treatment: Deduct the increase in current assets from operating profit.
3. Decrease in Current Liabilities: A decrease in current liabilities (such as Trade Payables, Outstanding Expenses, and Income Received in Advance) shows that more cash has been paid to settle liabilities.
Treatment: Deduct the decrease in current liabilities from operating profit.
4. Increase in Current Liabilities: An increase in current liabilities indicates that payments have been postponed, resulting in cash being retained in the business.
Treatment: Add the increase in current liabilities to operating profit.
In simple terms, the adjustment in current assets and current liabilities can be made with the help of the following formula:
(+) Decrease in Current Assets
(+) Increase in Current Liabilities
(-) Increase in Current Assets
(-) Decrease in Current Liabilities
Note: No adjustment is made for cash & cash equivalents like overdraft, etc. while calculating the net cash generated from operating activities.
Format of Cash Flow from Operating Activities (under Indirect Method):
* Net profit before taxation and extraordinary items is calculated as:
