## Indirect Method — Cash Flow from Operating Activities

The indirect method starts from Profit Before Tax (PBT) and reverses all accrual adjustments to arrive at actual cash generated from operations. It applies only to Section A (Operating Activities); Sections B and C are identical under both methods.

### Three Layers of Adjustment

#### Layer 1 — Add Back Non-Cash Charges

These were deducted in computing PBT but involve no cash outflow:

Depreciation on tangible fixed assets
Amortisation of intangible assets
Provisions (to the extent no cash was paid yet)

#### Layer 2 — Remove Non-Operating Items

These belong in Investing or Financing sections, not Operating:

Item in PBT	Adjustment	Reason
Profit on sale of asset	Deduct	Cash from sale goes to Investing; profit inflated PBT
Loss on sale of asset	Add back	Cash from sale goes to Investing; loss reduced PBT
Interest expense	Add back	Will appear as Financing outflow separately

#### Layer 3 — Working Capital (WC) Changes

Cash lags the accrual figures; WC adjustments bridge the gap:

WC Change	Cash Impact	Direction
Increase in Current Assets (Debtors ↑, Inventory ↑)	Cash used / not yet received	Deduct
Decrease in Current Assets	Cash released / received earlier	Add
Increase in Current Liabilities (Creditors ↑)	Cash not yet paid out	Add
Decrease in Current Liabilities	Cash paid out	Deduct

### Full Indirect Method Format

```

Profit Before Tax (PBT) X

Add: Depreciation (tangible assets) X

Add: Amortisation (intangible assets) X

Add: Interest Expense X

Less: Profit on Sale of Assets (X)

Add: Loss on Sale of Assets X

───

Operating Profit before WC Changes X

Working Capital Adjustments:

Add: Decrease in Inventory / Trade Receivables X

Add: Increase in Trade Payables X

Less: Increase in Inventory / Trade Receivables (X)

Less: Decrease in Trade Payables (X)

───

Cash Generated from Operations X

Less: Income Tax Paid (X)

───

Net Cash from Operating Activities X

```

### Critical Principle

> Net Cash from Operating Activities must be identical under both the direct and indirect methods.

This equality is not coincidental — it is a mathematical certainty. Use it as a verification check when solving problems that ask for both methods.

Worked example

### Example 1

LORI Question — Indirect Method (₹)

Step 1: Derive PBT from the P&L Account

Note: Only P&L items are relevant here; the Trading Account GP (₹3,75,000) is the starting point.

P&L Item	₹
Gross Profit (given)	3,75,000
Less: Office Expenses	(35,000)
Less: Selling Expenses	(15,000)
Less: Depreciation — Furniture	(40,000)
Less: Depreciation — Intangibles	(20,000)
Less: Interest Expense	(5,000)
Add: Profit on Sale of Asset	20,000
Profit Before Tax (PBT)	2,80,000

Step 2: Indirect Method Reconciliation

Item	₹
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)
Sub-total before WC changes	3,25,000
Working Capital Adjustments (net)	(40,000)
Cash Generated from Operations	2,85,000
Less: Income Tax Paid	(55,000)
Net CF from Operating Activities	2,30,000

Verification: Direct method (LORI question) also gives ₹2,30,000 — both methods agree. ✓

Note: Trading Account items (purchases, wages included in COGS) are embedded in the GP figure and are NOT separately adjusted in the indirect method P&L reconciliation.

⚠️ Common exam mistakes

Forgetting to add back depreciation — it is a non-cash deduction from PBT and must always be reversed
Adding profit on sale of assets instead of deducting it — profit inflated PBT; deduct it here since the actual cash proceeds belong in Investing Activities
Getting working capital signs reversed — an INCREASE in debtors/inventory is a DEDUCTION (cash not yet received), not an addition
Double-adjusting interest: if interest expense was already added back as a non-operating item, do not also deduct interest paid separately within operating activities
Using net profit after tax instead of PBT as the starting point — always start from PBT, then separately deduct actual tax paid (which may differ from tax expense due to advance tax, timing, etc.)
Adjusting Trading Account items (purchases, direct wages) separately when GP is already given — GP already nets these out; adjust only P&L items

Bare-Act text Paragraph 12(b) (Indirect Method for Operating Activities) · AS 3 (Revised) — Cash Flow Statements, ICAI · click to expand

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

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

Worked example

⚠️ Common exam mistakes