## Cash Flow from Operating Activities – Indirect Method

The indirect method converts Profit Before Tax (PBT) — calculated on an accrual basis — into actual cash generated from operations. It is the most commonly tested method at CA Inter.

### Why Adjust PBT?

PBT includes items that are not operating cash flows:

Non-cash charges (depreciation reduces profit but involves no cash outflow)
Non-operating items (profit/loss on asset sales belongs in Investing)
Accrual timing gaps (a credit sale is profit today but cash later)

---

### The Six-Step Framework

Step 1 – Start with PBT

Always use PBT, not PAT. Income tax is shown separately as actual cash paid in Step 6.

Step 2 – Add Back Non-Cash Expenses

Item	Direction
Depreciation / Amortisation	Add
Provision for doubtful debts	Add
Impairment loss	Add

Step 3 – Reverse Non-Operating Gains and Losses

Item	Reason	Direction
Profit on sale of fixed assets	Cash proceeds go to Investing	Deduct
Loss on sale of fixed assets	Reduces Investing proceeds	Add
Profit on sale of investments	Cash proceeds go to Investing	Deduct

Step 4 – Remove Items Reclassified to Investing / Financing

Item	Move to	In Operating
Interest income received	Investing (or stays in Operating)	Deduct if moved
Dividend income received	Investing (or stays in Operating)	Deduct if moved
Interest expense paid	Financing (or stays in Operating)	Add back if moved
Dividend paid	Financing (or stays in Operating)	Add back if moved

Step 5 – Adjust for Working Capital Changes

Movement	Cash Impact	Adjustment
Current Liability ↑ (Trade Payables, Outstanding Expenses)	Cash retained	Add
Current Liability ↓	Cash paid out	Deduct
Current Asset ↑ (Trade Receivables, Inventory, Prepaid)	Cash tied up	Deduct
Current Asset ↓	Cash released	Add

> Memory rule: Liability up = Cash up; Asset up = Cash down.

Step 6 – Deduct Income Tax Paid (Cash)

Use actual tax paid, not the P&L charge. Compute from the Provision for Tax T-account:

Tax Paid = Opening Provision + P&L Tax Charge − Closing Provision

---

### Standard Template

```

Cash Flow from Operating Activities ₹

Profit Before Tax (PBT) X

Add: Depreciation / Amortisation +X

Add: Loss on sale of assets +X

Less: Profit on sale of assets / investments −X

Less: Interest / Dividend income (→ Investing) −X

Add: Interest expense (→ Financing) +X

——

Sub-total before Working Capital X

Add: Increase in Trade Payables +X

Add: Increase in Outstanding Expenses +X

Less: Decrease in Trade Payables −X

Less: Increase in Trade Receivables −X

Less: Increase in Inventory −X

Add: Decrease in Trade Receivables +X

Add: Decrease in Prepaid Expenses +X

——

Cash Generated from Operations X

Less: Income Tax Paid −X

——

Net Cash from Operating Activities (A) X

```

Worked example

### Example 1

Illustration – USR Pg 315 (Operating Section)

Given information:

PBT: ₹23,000
Depreciation: ₹37,000
Loss on sale of Plant: ₹3,000
Profit on sale of Investments: ₹12,000
Interest income received: ₹6,000 (classified under Investing)
Interest expense paid: ₹23,000 (classified under Financing)
Working capital movements: Inventory ↑₹34,000 | Trade Receivables ↓₹8,000 | Prepaid Expenses ↓₹4,000 | Trade Payables ↑₹7,000 | Outstanding Expenses ↑₹3,000
Income Tax Paid: ₹9,000

	₹
Profit Before Tax	23,000
Add: Loss on sale of Plant	3,000
Less: Profit on sale of Investments	(12,000)
Less: Interest income (→ Investing)	(6,000)
Add: Interest expense (→ Financing)	23,000
Add: Depreciation	37,000
Sub-total before Working Capital	68,000
Less: Increase in Inventory	(34,000)
Add: Decrease in Trade Receivables	8,000
Add: Decrease in Prepaid Expenses	4,000
Add: Increase in Trade Payables	7,000
Add: Increase in Outstanding Expenses	3,000
Cash generated from operations	56,000
Less: Income Tax Paid	(9,000)
Net Cash from Operating Activities (A)	₹47,000

Key insight: Interest income (₹6,000) is removed here and reappears as an Investing inflow. Interest expense (₹23,000) is added back here and reappears as a Financing outflow. Every rupee appears exactly once across the three sections.

### Example 2

Illustration 1 – Operating Section (key steps)

Given: PBT ₹3,78,000 | Depreciation ₹1,40,000 | Profit on Machine Sale ₹21,000 | Income Tax Paid ₹70,000 (derived from T-account: Opening Provision ₹98,000 + P&L Charge ₹1,12,000 − Closing Provision ₹1,40,000 = ₹70,000)

	₹
PBT	3,78,000
Add: Depreciation	1,40,000
Less: Profit on sale of Machine	(21,000)
Sub-total	4,97,000
Net Working Capital Changes	(1,68,000)
Cash generated from operations	3,29,000
Less: Income Tax Paid	(70,000)
Net Cash from Operating Activities (A)	₹2,59,000

Provision for Tax T-account:

```

Provision for Tax

Dr Cr

Tax Paid 70,000 Opening 98,000

Closing 1,40,000 P&L 1,12,000

——————— ———————

2,10,000 2,10,000

```

⚠️ Common exam mistakes

Starting with PAT instead of PBT — income tax paid is shown separately as actual cash, so beginning with PAT double-counts it
Adding profit on sale of assets instead of deducting it (or deducting a loss instead of adding it back) — confusing the direction of the non-operating reversal
Getting working capital signs wrong: an increase in Trade Receivables is a DEDUCTION (cash tied up in debtors), not an addition
Using the P&L income tax expense as 'tax paid' instead of computing actual cash paid from the Provision for Tax T-account — these differ when advance tax or opening/closing provisions exist
Forgetting to both remove interest income/expense from Step 4 AND include them in their correct section — if removed here they must appear under Investing or Financing, not be forgotten entirely
Treating proposed (declared but unpaid) dividend as a cash outflow — only dividends actually paid in the year are included
Adding depreciation as a positive figure and then also including it again as a separate cash outflow — depreciation is only added back; it has no cash entry anywhere in the statement

Bare-Act text Paragraphs 13–14 · AS 3 (Revised) – Cash Flow Statements, ICAI · click to expand

13. An enterprise should report cash flows from operating activities using either: (a) the direct method, whereby major classes of gross cash receipts and gross cash payments are disclosed; or (b) 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. 14. Under the indirect method, net profit or loss is adjusted for the effects of: (a) changes during the period in inventories and operating receivables and payables; (b) non-cash items such as depreciation, provisions, deferred taxes, unrealised foreign currency gains and losses, and undistributed profits of associates; and (c) all other items for which the cash effects are investing or financing cash flows.

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