Describe “Indirect” method of ascertaining Cash Flow from operating activities.
The Indirect method is widely used in practice for ascertaining cash flow from operating activities. It begins with the amount of Net Profit or Loss. As per AS-3, the specific starting point is Net Profit before Taxation and Extraordinary Items as shown in the Statement of Profit and Loss.
Since the Statement of Profit and Loss is prepared on an accrual basis, it incorporates the effects of all operating activities but also includes non-cash and non-operating items. Therefore, it becomes necessary to adjust the net profit to arrive at actual cash flows. These adjustments are made for items such as depreciation, goodwill written-off, and dividend declared, which are non-cash in nature.
Additionally, adjustments are required for non-operating items like interest paid or profit/loss on the sale of fixed assets. As per AS-3, the net profit is adjusted for the effects of transactions of a non-cash nature, deferrals or accruals of past/future operating cash receipts, and items associated with investing or financing cash flows.
Subsequently, adjustments are made for changes in working capital items. For instance, an increase in current assets like Trade Receivables is deducted, while an increase in current liabilities is added. This calculation results in Cash Generated from Operations, from which Income Tax Paid is deducted.
Finally, this yields the Net Cash Flow from Operating Activities. The result remains the same whether the Direct or Indirect method is used, though the Indirect method is preferred by most companies.
Explanation
The answer is derived from Section 6.6.1 and the AS-3 guidelines provided in the context. It explains the logic behind the Indirect Method: starting with Net Profit (accrual basis) and adjusting for non-cash, non-operating, and working capital items to arrive at cash flow. The structure follows the standard format shown in Illustration 2 of the text.
Solution Steps
Step 1: Start with Net Profit before Taxation and Extraordinary Items.
Step 2: Adjust for non-cash items (e.g., Depreciation) and non-operating items.
Step 3: Adjust for changes in Working Capital (Current Assets and Current Liabilities).
Step 4: Calculate Cash Generated from Operations.
Step 5: Deduct Income Tax Paid to arrive at Net Cash Flow from Operating Activities.