## Indirect Method: Cash Flow from Operating Activities

The indirect method starts with Profit Before Tax (PBT) and adjusts for:

1. Non-cash items (depreciation, loss/profit on disposal, etc.)

2. Non-operating items (interest, dividend classified elsewhere)

3. Working capital changes

4. Income tax paid

### Step 1 – Arrive at PBT

If the P&L shows Retained Earnings (i.e., profit transferred to reserves):

```

PBT = Retained Earnings (net addition to reserves)

+ Provision for Tax (current year — gross, before netting refund)

+ Dividend declared in current year

```

> Note: Provision for tax and dividends are appropriations below PBT — add them back to arrive at PBT.

### Step 2 – Adjustments to PBT

Adjustment	Direction	Reason
Depreciation	Add	Non-cash charge
Loss on sale of machinery	Add	Non-cash, non-operating loss
Premium paid on redemption of pref shares	Add	Financing item
Profit on sale of asset/investment	Deduct	Non-operating income
Interest income	Deduct	Investing item
Non-cash exchange gain on CCE	Deduct	See foreign currency topic

### Step 3 – Working Capital Changes

Change	Direction
Increase in Trade Receivables	Deduct
Decrease in Trade Receivables	Add
Increase in Trade Payables	Add
Decrease in Trade Payables	Deduct
Increase in Prepaid Expenses	Deduct
Decrease in Prepaid Expenses	Add
Increase in Outstanding Expenses	Add
Decrease in Outstanding Expenses	Deduct

Memory rule: An increase in a current asset → cash outflow (deduct). An increase in a current liability → cash inflow (add).

### Step 4 – Income Tax Paid (net of refund)

```

Income Tax Paid (net) = Tax paid during year − Tax refund received

```

This is a separate line item, deducted after working capital adjustments.

### Complete Proforma

```

PBT xx

Add: Provision for tax (CY) xx

Add: Dividend declared in CY xx

----

Adjusted PBT xx

Add: Depreciation xx

Add: Loss on sale of machinery xx

Less: Profit on sale (xx)

Less: Non-operating income (xx)

Working capital changes (net) xx

----

Cash generated from operations xx

Less: Income tax paid (net of refund) (xx)

----

Net CF from Operating Activities xx

```

Worked example

### Example 1

Given:

Retained Earnings increase: ₹17,000
Provision for tax (CY): ₹6,000 (tax paid during year: ₹10,000; refund received: ₹8,000 → net tax paid = ₹2,000)
Dividend declared in CY: ₹18,000
Depreciation: ₹4,000
Loss on sale of machinery: ₹3,000
Premium paid on pref redemption: ₹2,000
Profit on sale: ₹10,000
Increase in TR: ₹12,000 (deduct)
Increase in TP: ₹8,000 (add)
Increase in Prepaid Exp: ₹1,000 (deduct)
Increase in OS Exp: ₹400 (add)

Step 1 – PBT:

17,000 + 6,000 + 18,000 = ₹41,000

Step 2 – Adjustments:

41,000 + 4,000 + 3,000 + 2,000 − 10,000 = ₹40,000

Step 3 – Working capital:

40,000 − 12,000 + 8,000 − 1,000 + 400 = ₹35,400

Wait — recalculate: 40,000 − 12,000 + 8,000 − 1,000 + 400 = 35,400

Step 4 – Tax paid (net): ₹10,000 − ₹8,000 refund = ₹2,000 net outflow

But if tax of ₹3,000 is the net figure given directly: deduct ₹3,000

Net CF from Operations = 35,400 − 3,000 = ₹32,400 (illustrative; actual depends on net tax treatment in the question)

⚠️ Common exam mistakes

Forgetting to add back Provision for Tax and Dividend declared to reach PBT from retained earnings — these are below-the-line appropriations.
Netting the tax refund against provision for tax in Step 1 instead of showing it as a reduction in 'Income Tax Paid' at the end.
Adding back loss on sale but also showing sale proceeds in Operating Activities — sale proceeds belong in Investing Activities.
Treating an increase in prepaid expenses as an 'add' (it is a cash outflow — deduct it).
Confusing 'dividend declared in current year' (add back to PBT) with 'dividend paid in current year' (deduct as financing outflow) — declared goes to PBT reconstruction; paid goes to financing section.

Reference: — AS 3 – Cash Flow Statements

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AS 3 – Indirect Method: Cash Flow from Operating Activities

Worked example

⚠️ Common exam mistakes