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

### Core Concept

The indirect method reconciles Profit Before Tax (PBT) to net cash from operations through three layers of adjustments. The end result — Net CFO — must be identical to the direct method answer.

### Step-by-Step Format

```

Profit Before Tax (PBT) ₹ XXX

───── Layer 1: Reverse non-cash charges ─────

Add: Depreciation on tangible assets XXX

Add: Amortisation of intangible assets XXX

───── Layer 2: Remove non-operating items ────

Add: Interest expense (financing cost) XXX

Less: Profit on sale of assets / investments (XXX) ← already in PBT, move to CFI

Add: Loss on sale of assets / investments XXX ← already in PBT, move to CFI

────────

Operating profit before WC changes XXX

───── Layer 3: Working capital adjustments ──

Less: Increase in Inventories (XXX) ← cash tied up in stock

Add: Decrease in Inventories XXX

Less: Increase in Trade Receivables (XXX) ← cash yet to be collected

Add: Decrease in Trade Receivables XXX

Add: Increase in Trade Payables XXX ← suppliers extending more credit

Less: Decrease in Trade Payables (XXX)

────────

Cash generated from operations XXX

Less: Income Tax paid (XXX)

────────

Net Cash Flow from Operating Activities XXX

```

### Memory Device for Working Capital Signs

Movement	Current Asset	Current Liability
Increase	− (cash outflow)	+ (cash inflow)
Decrease	+ (cash inflow)	− (cash outflow)

> Think of it as: A current asset increase means we spent cash to build it up. A current liability increase means someone is financing us.

### Why Remove Profit on Sale?

Profit on sale of an asset was credited to P&L (hence included in PBT), but the full sale proceeds will appear in CFI as an inflow. Leaving it in CFO would double-count the gain. So deduct it from CFO; it belongs entirely in CFI.

### Equivalence Principle

> Direct Method Net CFO = Indirect Method Net CFO

> This is a mandatory self-check — if answers differ, an error exists.

Worked example

### Example 1

LORI Question – Indirect Method (₹)

Step 1: Reconstruct PBT from P&L below GP line

Dr side	₹	Cr side	₹
Office expenses	35,000	Gross Profit b/d	3,75,000
Selling expenses	15,000	Profit on sale of asset	20,000
Depreciation – Furniture	40,000
Depreciation – Intangibles	20,000
Interest expense	5,000
Net Profit Before Tax	2,80,000
Total	3,95,000	Total	3,95,000

Step 2: Indirect Method – CFO

```

PBT 2,80,000

Add: Depreciation (40,000 + 20,000) 60,000

Add: Interest expense 5,000

Less: Profit on sale of asset (20,000)

──────────

Operating profit before WC changes 3,25,000

Working Capital Adjustments:

Less: Increase in Inventory (25,000)

Less: Decrease in Trade Payables (15,000)

──────────

Cash generated from operations 2,85,000

Less: Income Tax paid (55,000)

──────────

Net CFO (Indirect Method) 2,30,000

```

Verification: Net CFO via Direct Method = ₹2,30,000 ✓

⚠️ Common exam mistakes

Adding profit on sale of asset instead of deducting it — it is a non-operating gain already embedded in PBT; deduct it from CFO and show full sale proceeds in CFI
Forgetting amortisation of intangible assets — it is a non-cash charge just like depreciation on tangible assets and must be added back
Treating an increase in trade payables as a cash outflow — it means suppliers are extending more credit, so we paid less cash, making it a positive (inflow) adjustment
Starting with Net Profit After Tax and then also subtracting tax paid as a separate line — this double-counts the tax; always start with PBT and subtract actual tax paid
Omitting interest expense from add-backs — interest is a financing cost and must be removed from CFO (shown separately in CFF)

Bare-Act text Paragraph 20 – Reporting Cash Flows from Operating Activities (Indirect Method) · AS 3 (Revised) – Cash Flow Statements, ICAI · click to expand

Under the indirect method, the net profit or loss is adjusted for the effects of: (a) transactions of a non-cash nature; (b) any deferrals or accruals of past or future operating cash receipts or payments; and (c) items of income or expense associated with investing or financing cash flows.

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AS 3 – Cash Flow Statement: Indirect Method for Operating Activities

Worked example

⚠️ Common exam mistakes