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Cash Flow from Operating Activities

CASH FLOW FROM OPERATING ACTIVITIES

 

TABLE OF CONTENTS

  • What is cash flow from operating activities?
  • What are the operating activities?
  • What are the operating cash flows?
  • How to calculate cash flow from operating activities?
    • What are the methods of calculating cash flow from operating activities?
    • Direct Method
    • Indirect Method
  • Example of calculation of cash flow from operating activities Indirect Method.
What is cash flow from operating activities? 

 

Operating activities are the principal revenue-producing activities of the enterprise and other activities that are not investing and financing activities. In other words, operating activities are the activities that constitute the primary or main activities of an enterprise. For example, operating activities for a company manufacturing garments are procurement of raw material, the incurrence of manufacturing expenses, sale of garments, etc. We can simply say that the operating activities include the cash effects of those transactions and events that enter into the determination of net profit or loss.

 

What are the operating activities?

 

It is often assumed that the operating activities category includes only those cash flows that arise from an entity’s principal revenue-producing activities. However, because cash flows arising from operating activities represent a residual category, which includes any cash flows that do not qualify to be recorded within either investing or financing activities, these can include cash flows that may initially not appear to be ‘operating’ in nature.

 

For example, the acquisition of land would typically be viewed as an investing activity, as land is a long-term asset. However, this classification is dependent on the nature of the entity’s operations and business practices. An entity that acquires land regularly to develop residential housing to be sold would classify land acquisitions as an operating activity. This is because such cash flows relate to its principal revenue-producing activities and therefore meet the definition of an operating cash flow.

 

What are the operating cash flows?

The following are some of the examples of both operating cash inflows and outflows.

  • cash receipts from the sale of goods and the rendering of services;
  • cash receipts from royalties, fees, commissions, and other revenues;
  • Payments to suppliers for goods and services;
  • cash payments to and on behalf of employees;
  • cash payments for the cost of goods sold (COGS) and selling, general and administrative expenses (SG&A);
  • cash receipts and payments of an insurance enterprise for premiums and claims, annuities and other policy benefits;
  • cash payments or refunds of income taxes unless they can be specifically identified with financing and investing activities;
  • cash receipts and payments relating to future contracts, forward contracts, option contracts, and swap contracts when the contracts are held for dealing or trading purposes.
  • Interest received and interest paid;
  • Dividend received;
  • Acquisition and disposal of trading securities; and
  • All other receipts and payments that do not form part of the transactions are defined as investing or financing activities.
How to calculate the cash flow from operating activities?

There are two methods for calculating the cash flow from operating activities. Operating activities are the main source of revenue and expenditure in an enterprise. Net profit/loss as reported in the Statement of Profit & Loss is different from the net cash flow from operating activities as the financial statements are generally prepared on the accrual basis of accounting under which the net income will not indicate the net cash provided by or net loss will not indicate the net cash used in operating activities.

In order to calculate the net cash flows in operating activities, it is necessary to replace revenues and expenses with actual receipts and payments in cash. This is done by eliminating the non-cash revenues and/or non-cash expenses from given earned revenues and incurred expenses.

What are the methods of ascertaining cash flow from operating activities?

There are two methods of converting net profit into net cash flows from operating activities:

(i) Direct method, and

(ii) Indirect method.

cash flow from operating activities
(i) Direct method

Under the direct method, cash receipts from operating revenues and cash payments for operating expenses are arranged and presented in the cash flow statement. The net cash flow from operating activities is the difference between cash receipts and cash payments. It is in effect a cash basis Statement of Profit & Loss. In this case, each cash transaction is analysed separately and the total cash receipts and payments for the period are determined. We may convert the accrual basis of revenue and expenses to equivalent cash receipts and payments. Make sure that a uniform procedure is adopted for converting accrual base items to cash base items.

The following are some examples of usual cash receipts and cash payments resulting from operating activities:

  • Cash sales of goods and services;
  • Cash collected from debtors (customers);
  • Receipts of interest or dividends;
  • Cash receipts of royalties, fees, commission and other revenues;
  • Cash payments to suppliers (creditors);
  • Payments for various operating expenses i.e., rent, rates, power etc.
  • Cash payments for wages and salaries to employees;
  • Cash payments for income tax etc.

Format of Cash Flow Statement Direct Method- Operating Activities

A. Cash flows from operating activities

(+) Cash receipts from customers

(-) Cash paid to suppliers and employees

Cash generated from operations

(-) Income taxes paid

Cash flow before extraordinary item

(+/-) Extraordinary items

Net Cash from Operating Activities

 

(ii) Indirect method

Under the Indirect Method, the net profit or loss is duly adjusted for the effects of (1) transactions of a non-cash nature, (2) any deferrals or accruals of past/future operating cash receipts, and (3) items of income or expenses associated with investing or financing cash flows. It is important to mention here that under the indirect method, the starting point is net profit/loss before taxation and extraordinary items as per the Statement of Profit and Loss of the enterprise. Then this amount is for non-cash items, etc., adjusted for ascertaining cash flows from operating activities.

A summary of adjustments required to convert the net profit to net cash flow from operating activities through the indirect method is as follows:

Cash Flow from Operating Activities

A. Net profit before tax and extraordinary item

B. Adjustments for non-cash and non-operating items:

     Add: Amount written off in respect of depreciation, goodwill, preliminary expenses, underwriting commission etc.

     Add/Less: Other non-operating items

C. Adjustment for gains and losses on the sale of fixed assets and investments:

     Add: Loss on sale of fixed assets/investments Less: Profit on sale of fixed assets/investments

D. Adjustments for changes in current assets (except cash and cash equivalents) and current liabilities (except bank overdraft)

     Add: Decrease in accounts of current assets e.g. debtors, bill receivable, stock, prepaid expenses etc.

    Less: Increase in accounts of current assets.

    Add: Increase in accounts of current liabilities; e.g., creditors, bills payable, outstanding expenses, etc.

    Less: Decrease in accounts of current liabilities.

E. Cash generated from operations

    Less: Income tax paid.

F. Adjustments for extra-ordinary items if any

G. Net cash from (used in) operating activities

The computation of net cash inflow or cash outflow from operating activities by the indirect method takes a path that is very different from the computation by the direct method. However, the two methods arrive at the same amount of net cash flow from operations.

 

Example of cash flow from operating activities using Indirect Method

Question

Income Statement (Profit and Loss Account) of ABC Co Ltd for the year ended De 31, 2021 

Particulars

Amount in $

i) Revenue from Operations

1,00,000

ii) Other Income

1 2,000

iii) Total Revenues (i+ii)

1,02,000

   

iv) Expenses

 

     Cost of Materials Consumed

30,000

     Purchases of stock-in-trade

10,000

     Employees Benefits Expenses

10,000

     Finance Costs

5,000

     Depreciation

5,000

     Other Expenses

12,000

Total Expenses (iv)

72,000

   

v) Profit before Tax (iii-iv)

30,000

Note: Other income includes profit on the sale of land.

 

Solution

Cash Flows from Operating Activities Indirect Method- ABC Co Ltd

Particulars

($)

(Net Profit before Taxation and Extraordinary Items (Note 1)

42,000

Adjustments for–

 

   + Depreciation

20,000

   = Operating Profit before working capital changes

62,000

   – Increase in Trade Receivables

(3,000)

   – Increase in Inventories

(5,000)

   – Increase in Prepaid Insurance

(500)

   – Decrease in Trade Payables

(2,000)

   + Increase in Outstanding Employees Benefits Expenses

+1,000

   = Cash generated from Operations

52,500

   – Income tax paid

(11,000)

   = Net cash from Operating Activities

41,500

Working Notes :

The net profit before taxation and extraordinary items has been worked out as under:

 Net Profit                                                                                     =          $ 32,000

+ Income Tax                                                                              =          $ 10,000

= Net Profit before Tax and Extraordinary Items                  =          $ 42,000

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