Cash Flow from Operating Activities

The movement of cash & cash equivalents or inflow and outflow of cash is known as Cash Flow. Cash inflows are the transactions that result in an increase in cash & cash equivalents; whereas cash outflows are the transactions that result in a reduction in cash & cash equivalents. Hence, a statement showing flows of cash & cash equivalent during a specified time period is known as a Cash Flow Statement. One can prepare a cash flow statement if the two comparative balance sheets of a company are given. The transactions of a cash flow statement are categorised into three activities; namely, Cash flow from Operating Activities, Cash flow from Investing Activities, and Cash flow from Financing Activities. The Institute of Chartered Accountants in India has issued Accounting Standard AS - 3 revised for the preparation of cash flow statements. Besides, with the introduction of the Companies Act 2013, the preparation of a Cash Flow Statement is now mandatory for every type of company except OPC (One Person Company) [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, Net Profit before Tax and extraordinary items is taken into consideration first. As there are various items of expenses and incomes in the profit & loss statement of a company that does not result in any outflow and inflow of cash, we cannot take the value of net profit as per the profit & loss statement for determining cash flow from operating activities. Such items are added back and subtracted from the net profit respectively and can be studied under the heading: Adjustment for Non-Cash Items. Similarly, there are some items that are not shown in the profit & loss statement of a company but lead to an increase or decrease in cash. Such items are also adjusted while calculating cash flow from operating activities and can be studied under the heading: Adjustment in respect of Changes in Current Assets and Current Liabilities. 

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:

1. 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. 
2. 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. 
3. 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. 
4. 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.
5. 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:

1. 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. 
2. 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.
3. 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:

The current assets and current liabilities of a company keep on changing frequently. Even though such transactions do not have any effect on the amount of net profits of the company, they have an impact on the cash generated from operating activities. Therefore, in order to determine the cash flow from operating activities, it is essential to make the necessary adjustments for these changes. The adjustments for current assets and current liabilities (except cash & cash equivalents) will be made as follows:

1. Effect of decrease in current assets such as Prepaid Expenses, Accrued Incomes, Trade Receivables, etc.:

For example, the Trade Receivables of a company at the beginning of the year were ₹2,00,000, and trade receivables at the end of the year were ₹1,10,000. A decrease in trade receivables indicates that the collection made by the company from the trade receivables is more than the amount of its credit sales during the year. Therefore, ₹90,000 will be added to the operating profits to determine the net cash generated from operating activities. The same treatment will be done for the decrease in other current assets. It means that a decrease in the current assets should be added to the operating profit. 

2. Effect of increase in current assets such as Prepaid Expenses, Accrued Incomes, Trade Receivables, etc.:

For example, the Trade Receivables of a company at the beginning of the year were ₹2,00,000, and trade receivables at the end of the year were ₹2,10,000. An increase in trade receivables indicates that the collection made by the company from the trade receivables is less than the amount of its credit sales during the year. Therefore, ₹10,000 will be deducted from the operating profits to determine the net cash generated from operating activities. The same treatment will be done for the increase in other current assets. It means that an increase in the current assets should be deducted from the operating profits. 

3. Effect of decrease in current liabilities such as Outstanding Expenses, Incomes received in Advance, Trade Payables, etc.:

For example, the Trade Payables of a company at the beginning of the year were ₹50,000, and trade payables at the end of the year were ₹30,000. A decrease in the trade payables indicates that the payments made by the company to the trade payables were more than the amount of credit purchases during the year. It means that the trade payables are being paid more amount resulting in a decrease in cash generated from operations. Therefore, ₹20,000 will be deducted from operating profits for arriving at the amount of net cash generated from operating activities. The same treatment will be done for the decrease in other current liabilities. It means that a decrease in the current liabilities should be deducted from the operating profits.

4. Effect of increase in current liabilities such as Outstanding Expenses, Incomes received in Advance, Trade Payables, etc.:

For example, the Trade Payables of a company at the beginning of the year were ₹50,000, and trade payables at the end of the year were ₹90,000. An increase in the trade payables indicates that the payments made by the company to the trade payables were less than the amount of credit purchases during the year. It means that the trade payables are being paid less amount resulting in an increase in cash generated from operations. Therefore, ₹40,000 will be added to operating profits for arriving at the amount of net cash generated from operating activities. The same treatment will be done for an increase in other current liabilities. It means that an increase in the current liabilities should be added to the operating profits.

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: