In order to prepare cash flow statements, there are two options to present the cash flow from operating activities, direct method and indirect method. Here, we are going to discuss the indirect method and its implications.
Under indirect method, accountant has to start with income before interest and taxes/ EBIT figure and need to add back non-cash items of the income statements such as depreciation expense and amortization expense. The reason behind this is that income statement is prepared in accordance with the accrual basis of accounting.
Formula
Net cash flow from operating activities = EBIT + non-cash expense items (such as depreciation and amortization) + non-operating losses (such as loss on sale of fixed assets) – gain on sale of fixed assets (such as gain on sale of fixed assets) + decrease in current assets (such as decrease in accounts receivable, stock/ inventory and prepaid expenses) – increase in current assets + increase in current liabilities (such as increase in accounts payable, sales tax payable, income tax payable and accrued expenses) – decrease in current liabilities.
Specimen Format and Example
ABC Company
Staement of Cash Flows
For the Year Ended 30th June, 2015
| $ millions | |
| Cash flow from operating activities | |
| Earning before interest and taxes (EBIT) | 13 |
| Add: Adustyements to get net cash generated from operating activities | |
| Depreciation on fixed asets | 2 |
| Amortization expense | 3 |
| (Increase) / decrease in current assets | |
| Accounts receivable | (3) |
| Stock/ Inventory | (2) |
| Prepaid expenses | 4 |
| Increase / (decrease) in current liabilities | |
| Accounts Payables | 3 |
| Accued Expenses | 4 |
| Unearned revenue | (2) |
| Net cash provided by operating activities | 22 |
| Cash flow from investing activities | |
| Paid for the purchase of machinery | (8) |
| Sale proceed from sale of computers | 4 |
| Net cash used in investing activities | (4) |
| Cash flow from financing activities | |
| Received loan from directors | 5 |
| Paid installment of long term bank loan | (2) |
| Net cash provided/ (used) in financing activities | 3 |
| Net increase (decrease) in cash | 21 |
| Cash and Cash Equivalent – Opening balance | 10 |
| Cash and Cash Equivalent – Closing balance | 31 |
Example
JPC is a private limited company operating in food sector. It is a well established organization with operations in 05 countries. It has gained a lot of organic growth in the last 05 years. The success of JPC largely depends upon its efficient supply chain process, economies of scale and heavy advertisement which has cut down unnecessary activities which were causing a lot of losses to the company and production of goods at a cheap price. The following data is available for JPC for year ended 31st December, 2016.
Income statement
For the year ended 31st December, 2016 (All figures are in $000)
Sales revenue 444
Operating expenses 312
Operating profit 132
Interest expenses 18
PBT – Profit before tax 114
Income tax 42
PAT – Profit after tax 72
The details of operating expenses amounting to $312 are as follows:
Salaries 72
External audit fees 12
Depreciation expenses 84
Gain on sale of fixed assets 60
Rent Income from property 18
Material consumed 222
Total 312
The details of receivables, payables and inventories are as follows:
2016 2015
Accounts receivables 48 42
Accounts payables 30 18
Inventories 42 24
Required
Prepare the cash flow from operating activities of JPC using indirect method.
Solution
Operating profit 132
Depreciation expense 84
Gain on disposal of fixed assets (60)
Change in accounts receivable – increase (6)
Change in accounts payables – increase 12
Change in inventory level – increase (18)
Net cash flow from operating activities 144