Indirect Method of Cash Flow Statement:

Objective: To Start from Net Profit and to reconcile the Opening Balance and Closing Balance of Cash

While arriving at net profit, we consider the following items:

1. Non-Cash Items such as Depreciation (this amount will have no impact on the Cash flows of the
entity. Since the said amount is debited to Profit and Loss account, the same shall be added back
in operating activities)
2. Non-Cash Profits / Losses – such as Profit / Loss on sale of Fixed Assets (since loss / profit on sale
of Fixed Assets are notional in nature and do not entail any cash flow, profits which are credited
to Profit and Loss Account are to be deducted and Losses which are debited to Profit and Loss
Account are to be added back). However, any cash received by sale of Assets (or investments) is
cash inflow from Investing Activity and hence to be added in Investing Activity. Similarly any
outflow of cash owing to purchase of new asset is deducted from Investing Activity. Many times
the amounts are not clearly stated in question. We have to prepare Assets Account and have to
find out the balancing figure. Depending upon the side in which the balancing figure arises in
ledger, the nature of such cash flow (whether Outflow or Inflow) is determined.
3. Credit Purchases & sales which do not have any impact on Cash Balance

The following items are not at all considered in computing Net Profit:

1. Collection from Debtors – because the corresponding sale would have been considered in
preparation of Profit & Loss Account for the period in which such sale occurred and it will not have
any impact on profit of current year. But this will have an impact on Cash Balance (So Added to
the Net Profit)
2. Payment to Creditors – because the corresponding purchase would have been considered in
preparation of Profit and Loss Account for the period in which such Purchase occurred and it will
not have any impact on profit of current year. But this will have impact on Cash balance (So
deducted from the Net Profit)

Other things to be considered:

1. Increase in Creditors – It reflects the Credit purchases that were considered in preparation of
Profit and Loss Account but will not have any impact on Cash balance and since it was deducted
while arriving at Net Profits, it is added in the Cash flow Statement. Vice versa in case of Decrease
in Creditors
2. Increase in Debtors – It reflects the Credit Sales that were considered in preparation of Profit and
Loss Account but will not have any impact on Cash Balance and since it was added while arriving
at Net Profits, it is deducted in Cash Flow Statement. Vice Versa in case of Decrease in Debtors
3. Increase in Bills Payable – Same as Increase in Creditors
4. Increase in Bills Receivable – Same as increase in Debtors.
5. Increase in Inventory – It reflects unsold portion of Goods that are considered in preparation of
Profit and Loss Account but will not have any impact on Cash balance and since it was added while
arriving at Net Profits, it is deducted in Cash Flow Statement. Vice versa in case of Decrease in
Inventory
6. Provision for Taxation (Taxation) is not the actual amount of tax that is paid during the year. But
this is considered in Profit and Loss account while computing the Net Profit as an expense and
hence should be added back. In order to find out the Actual Tax expense paid during the year, we
have to draft the ‘Provision for Taxation’ Account and the balancing figure will be Tax Expense for
the year which was paid in cash which will result in decrease of cash balance and hence to be
deducted in Cash flow statement
7. In case of any other Payable Account – Same as that of Provision for Taxation.
8. In case of any other Receivable Account – any amount which is credited to Profit and Loss account
should be deducted in Cash flow statement. Then corresponding Income Account should be
prepared and balancing figure is the amount actually received in cash and hence to be added
back.
9. Expenses like Interest, Dividend paid (if considering retained earnings as base for arriving at Net
Profits) which are not related to Operating Activity but which were deducted in Profit and Loss
Account are to be added back. However since the payment of these expenses are Financing
Activities and these payment render outflow of cash, these items are to be deducted in Financing
Activities
10. Other Incidental Income such as dividend received, interest on investments etc., credited to profit
and loss account. But these are not operating activities and hence are to be deducted from
Operating Activity as they were included in arriving at Net Profits. However since the cash flows
are arising out of investing activities, amount to the extent actually received in cash in form of
aforesaid incomes shall be added in investing activities.
Example: Let us consider Interest Income of Rs. 100000 credited to Profit and Loss Account out
of which only Rs. 60000 has been received in cash. In this situation, we will deduct the entire Rs
100000 from operating activities since the entire amount is credited to Profit and Loss Statement
(owing to Accrual Concept) but while considering the inflow in Investing Activity only that portion
of amount which is actually realized in cash is considered. I.e., in our example, Rs. 60000/- is
considered.