Hello! Let's get started with today's lesson.
In our last two lessons, we built the foundation for the operating activities section. We started by calculating Net Profit before Tax and Extraordinary Items (NPBT), and then we adjusted that figure for various non-cash and non-operating items to arrive at Operating Profit before Working Capital Changes (OPBWCC).
Today, we will complete the final and crucial step. Our goal is to take the OPBWCC and adjust it for changes in current assets and current liabilities. By the end of this lesson, you will be able to calculate the final 'Net Cash Flow from Operating Activities'.
1. The Logic of Working Capital Adjustments
The OPBWCC figure you learned to calculate is a more accurate measure of operational profitability than net profit, but it's still based on the accrual concept. For example, it includes credit sales (revenue) even if cash hasn't been received, and it reflects expenses incurred, not necessarily paid.
To convert this accrual-based profit into a true cash flow figure, we must account for the changes in working capital items (current assets and current liabilities, excluding cash and cash equivalents).
The rules for these adjustments are logical and stem from how cash is affected:
-
Current Assets (CA): There is an inverse relationship between current assets and cash.
- An increase in a CA (like inventory or trade receivables) means cash has been used or tied up. For example, buying more inventory or selling more on credit reduces the cash available. Therefore, we subtract the increase.
- A decrease in a CA means cash has been released or collected. For example, selling off old inventory or collecting cash from debtors increases available cash. Therefore, we add the decrease.
-
Current Liabilities (CL): There is a direct relationship between current liabilities and cash.
- An increase in a CL (like trade payables or outstanding expenses) means you have deferred a cash payment, effectively holding onto your cash for longer. Therefore, we add the increase.
- A decrease in a CL means you have paid off a liability, resulting in a cash outflow. Therefore, we subtract the decrease.
Here is a summary table:
| Change in Working Capital | Effect on Cash | Adjustment to OPBWCC |
|---|---|---|
| Increase in Current Assets (e.g., Inventory) | Cash is blocked/used | Subtract |
| Decrease in Current Assets (e.g., Debtors) | Cash is released | Add |
| Increase in Current Liabilities (e.g., Creditors) | Cash payment is deferred | Add |
| Decrease in Current Liabilities (e.g., Bills Payable) | Cash is paid | Subtract |
To solidify your understanding of these rules, let's go through a clear textual explanation.
Cash Flow from Operating Activities
This article from GeeksforGeeks provides a detailed explanation for each type of working capital adjustment. It uses simple examples to illustrate why we add or subtract these changes.
Read the section titled 'II. Adjustment in respect of Changes in Current Assets and Current Liabilities'. Pay close attention to the logic behind the treatment of increases and decreases in both assets and liabilities. The summary formula at the end is an excellent memory aid.
2. Applying the Rules in the Cash Flow Statement
Now that you understand the logic, let's see how these adjustments fit into the standard format of the Cash Flow Statement.
Cash Flow Statement | Class 12 | Accounts | OPERATING ACTIVITY | Part 2
This short video clip by Rajat Arora shows exactly where these adjustments are made in the statement and reinforces the rules.
Watch the segment from 11:20 to 12:51. The instructor clearly outlines the two items to be added (Decrease in CA, Increase in CL) and the two items to be subtracted (Increase in CA, Decrease in CL) from the Operating Profit before Working Capital Changes.
After making these adjustments, you will arrive at a sub-total called Cash Generated from Operations.
3. The Final Step: Income Tax Paid
We are almost there! The very last step to arrive at the final 'Net Cash Flow from Operating Activities' is to subtract the Income Tax Paid during the year.
- Cash Generated from Operations
- Less: Income Tax Paid
- = Net Cash Flow from Operating Activities
Remember from our first lesson in this module, the 'Income Tax Paid' figure is often found by preparing a Provision for Tax Account.
4. A Comprehensive Example
Let's watch a complete example that ties everything together. The video will start from the OPBWCC and show how to apply the working capital adjustments and deduct the tax paid.
Cash Flow Statement | Class 12 | Accounts | OPERATING ACTIVITY | Part 2
This segment of the same video demonstrates the application of these rules with a practical example. Notice how the instructor compares the opening and closing balances of current assets and liabilities to decide whether to add or subtract the change.
Watch from 18:58 to 23:09. Working Capital Adjustments (18:58 - 21:50): The instructor calculates the changes in Trade Payables, Bills Receivable, and Prepaid Expenses and applies the rules. Final Calculation (21:50 - 22:30): The calculation leads to 'Cash Generated from Operations'. Recap (22:30 - 23:09): The video concludes with a quick recap of the entire operating activities section, which is a great summary.
Here is a visual summary of the complete section for your reference.
Test your understanding!
A company's Operating Profit before Working Capital Changes is ₹3,50,000.
The following information is available from its comparative balance sheets:
| Particulars | Year 1 (₹) | Year 2 (₹) |
|---|---|---|
| Trade Receivables | 1,00,000 | 1,30,000 |
| Inventory | 80,000 | 60,000 |
| Trade Payables | 50,000 | 65,000 |
| Outstanding Expenses | 15,000 | 10,000 |
Additionally, the company paid income tax of ₹45,000 during Year 2. Calculate the Net Cash Flow from Operating Activities.
Show answer
First, determine the change for each item:
- Trade Receivables: Increased by ₹30,000 (Use of cash) -> Subtract
- Inventory: Decreased by ₹20,000 (Source of cash) -> Add
- Trade Payables: Increased by ₹15,000 (Source of cash) -> Add
- Outstanding Expenses: Decreased by ₹5,000 (Use of cash) -> Subtract
| Particulars | Amount (₹) | Amount (₹) |
|---|---|---|
| Operating Profit before Working Capital Changes | 3,50,000 | |
| Add: | ||
| Decrease in Inventory | 20,000 | |
| Increase in Trade Payables | 15,000 | 35,000 |
| Less: | ||
| Increase in Trade Receivables | (30,000) | |
| Decrease in Outstanding Expenses | (5,000) | (35,000) |
| Cash Generated from Operations | 3,50,000 | |
| Less: Income Tax Paid | (45,000) | |
| Net Cash Flow from Operating Activities | 3,05,000 |
Conclusion
Congratulations! You have now mastered all the steps required to calculate the Cash Flow from Operating Activities using the indirect method. This is often the most detailed and challenging part of the statement, so this is a significant milestone.
Key Takeaways:
- To get from OPBWCC to cash flow, you must adjust for changes in working capital.
- The relationship between current assets and cash is inverse: add decreases, subtract increases.
- The relationship between current liabilities and cash is direct: add increases, subtract decreases.
- After these adjustments, you get 'Cash Generated from Operations'.
- The final step is to subtract 'Income Tax Paid' to find the 'Net Cash Flow from Operating Activities'.
Preview of the Next Lesson:
With the Operating Activities section complete, we will move on to the second major component of the statement. In our next lesson, we will learn to calculate Cash Flow from Investing Activities, which focuses on transactions involving the purchase and sale of non-current assets and investments.