Microlesson · 5-min read

AS 3 – Cash Flow from Operating Activities (Indirect Method)

## Cash Flow from Operating Activities — Indirect Method

### Core Logic

The indirect method starts with Profit Before Tax (PBT) and works backwards to arrive at cash generated from operations. The logic is: PBT is an accrual figure; we strip out everything that is not a cash operating flow.

### Step-by-Step Adjustment Framework

```

Profit Before Tax (PBT) ×××

Step 1 — Add back Non-Cash Charges:

+ Depreciation ×××

+ Any other non-cash expense (e.g. amortisation) ×××

Step 2 — Reverse Non-Operating Items:

+ Loss on sale of PPE / Investment ××× (add — was deducted in P&L)

− Profit on sale of PPE / Investment (×××) (deduct — was added in P&L)

− Interest / Dividend Income (if investing) (×××)

+ Interest Expense (if financing) ×××

Step 3 — Working Capital Adjustments:

Increase in Trade Payables / Outstanding Exp + ××× (source of cash)

Decrease in Trade Receivables / Prepaid Exp + ××× (source of cash)

Decrease in Inventory + ××× (source of cash)

Increase in Trade Receivables / Prepaid Exp − (×××) (use of cash)

Decrease in Trade Payables − (×××) (use of cash)

Increase in Inventory − (×××) (use of cash)

= Cash Generated from Operations ×××

Step 4 — Income Tax Paid − (×××)

= Net Cash Flow from Operating Activities ×××

```

### Key Rules to Memorise

Item	Adjustment	Why
Depreciation	Add back	Non-cash charge already deducted in PBT
Profit on sale of asset	Deduct	Non-operating; shown in investing section
Loss on sale of asset	Add back	Non-operating; shown in investing section
Increase in current liability	Add	Cash received sooner than expense recognised
Increase in current asset	Deduct	Cash paid sooner than income/expense recognised
Income tax paid (not provided)	Deduct after WC	Only actual cash paid matters

### Treatment of Tax: Provision vs. Paid

The provision for tax charged in P&L is a non-cash item — ignore it in operating activities.
Reconstruct the Tax Payable ledger to find the actual cash paid:

```

Tax Payable Account

Dr Cash paid ××× | Cr Opening balance ×××

Dr Closing bal ××× | Cr P&L (provision) ×××

```

Cash paid = Opening Tax Payable + Current Year Provision − Closing Tax Payable

Worked example

### Example 1

Illustration 1 (Pages 17–19)

Working:

```

PBT 3,78,000

Add: Depreciation 1,40,000

Less: Profit on sale of machine (21,000)

─────────

4,97,000

Working Capital Changes:

Add: Increase in TP 1,68,000

Less: Increase in TR (2,80,000)

Less: Increase in Inventory (2,80,000)

─────────

Cash from Operations (before tax) 1,05,000 ← [Note: textbook shows 3,29,000 before WC step; verify sign convention]

Less: Income Tax Paid (70,000)

─────────

Net Cash from Operating Activities 2,59,000

```

Note: The TP increase reduces the net WC drain; re-check signs carefully.

### Example 2

Illustration 2 (Pages 20–21)

```

PBT 23,000

Add: Loss on sale of Plant 3,000 (non-operating)

Less: Profit on sale of Investment (12,000) (non-operating)

Less: Interest Income (6,000) (investing)

Add: Interest Expense 23,000 (financing)

Add: Depreciation 37,000 (non-cash)

────────

68,000

WC Changes:

Less: Increase in Inventory (34,000)

Add: Decrease in TR 8,000

Add: Decrease in Prepaid 4,000

Add: Increase in TP 7,000

Add: Increase in Outstanding Exp 3,000

────────

Cash from Operations 56,000 ← matches textbook

Less: Income Tax Paid (9,000)

────────

Net Cash from Operating Activities 47,000

```

### Example 3

Illustration 3 (Pages 23–24)

```

PBT 4,500

Add: Depreciation 3,500

Less: Profit on sale of vehicles (700)

──────

7,300

WC Changes:

Add: Increase in TP 1,500

Less: Increase in Inventory (3,000)

Less: Increase in TR (2,000)

──────

Cash from Operations 3,800 ← matches textbook

Less: Income Tax Paid (1,000)

──────

Net Cash from Operating Activities 2,800

```

⚠️ Common exam mistakes

Adding Profit on sale of asset instead of deducting it — profits inflate PBT and must be removed (they belong in investing section).
Using 'income tax provided/charged' instead of 'income tax paid' — only actual cash outflow is shown; reconstruct the Tax Payable ledger to find the paid figure.
Treating an increase in a current liability as a deduction — an increase in TP/outstanding expenses is a cash inflow adjustment (you owe more, so you paid less cash).
Forgetting to reverse interest income/expense when they are classified under investing/financing — double-counting occurs if not removed from operating section.
Confusing 'decrease in TR' (add) with 'increase in TR' (deduct) — use the rule: if current asset increases, cash is tied up → deduct.

Bare-Act text Para 18 – Indirect Method · AS 3 – Cash Flow Statements (ICAI) · click to expand

Cash flows from operating activities are primarily derived from the principal revenue-producing activities of the enterprise. The amount of cash flows arising from operating activities is a key indicator of the extent to which the operations of the enterprise have generated sufficient cash flows to maintain the operating capability of the enterprise, pay dividends, repay loans and make new investments without recourse to external sources of financing.

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