📌 Snapshot
- Cash flow statement made simple: operating, investing and financing activities with solved sums.
- Why a profitable company can still run out of cash, and how the statement shows where the cash went.
- The indirect method step by step, with the direction rule for every working capital change.
- Classification of tricky items such as interest, dividend, tax, non cash deals and cash equivalents.
📖 Detailed Notes
Written and reviewed by Devendra Dubey, Mathematics & Commerce faculty at UniDrill (M.Sc. Mathematics, Osmania University · 10 years teaching). Based on NCERT Accountancy Class XII (Accountancy Part II), Chapter 6.
Profit in the books, empty cash box
Meera runs a garment company. This year it reports a profit of ₹8 lakh. Yet on salary day the bank balance is short. The reason is simple. Customers owe the company ₹12 lakh from credit sales, and a large pile of unsold stock sits in the godown. Profit is a figure in the books. Cash is what pays salaries, suppliers and loans. The cash flow statement is the statement that shows where cash came from and where it went, so a profitable company can see why its bank balance is low.
Profit and cash are not the same thing
| Point | Statement of Profit and Loss | Cash flow statement |
|---|---|---|
| Basis | Accrual: revenue when earned, expense when incurred | Cash: only when cash actually moves |
| Credit sale of ₹1,00,000 | Counted in revenue | No cash flow until the customer pays |
| Depreciation | An expense that reduces profit | Not a cash flow at all |
| Purchase of machinery | Not an expense (only depreciation is) | A large cash outflow |
| Question answered | How much did we earn? | Where did the cash come from and go? |
The cash flow statement is prepared as per Accounting Standard 3 (Revised). It is a part of the financial statements as defined in the Companies Act, 2013, and it shows the historical changes in cash and cash equivalents of the year by classifying cash flows into three activities. Its main benefits are to show changes in net assets and financial structure (liquidity and solvency), to let users compare enterprises by removing the effect of different accounting treatments, and to show whether the firm can generate cash and what it needs cash for.
Cash and cash equivalents
Cash means cash in hand and demand deposits with banks. Cash equivalents are short term, highly liquid investments that can be converted into a known amount of cash with an insignificant risk of change in value. To qualify, an investment normally has a short maturity of three months or less from the date of acquisition, such as treasury bills or commercial paper. Investments in shares are usually excluded, unless they are cash equivalents in substance (for example, preference shares bought shortly before their redemption date).
Cash flows are the inflows and outflows of cash and cash equivalents. Moving money between cash and a cash equivalent (say, buying 60-day treasury bills with bank cash) is cash management and is not shown as a cash flow.
The three activities
Every cash flow is placed in exactly one of three groups.
| Activity | What it covers | Inflows | Outflows |
|---|---|---|---|
| Operating | Principal revenue-producing activities, anything not investing or financing | Cash from sale of goods and services; royalties, fees and commission | Payments to suppliers and employees; insurance premiums; income tax paid |
| Investing | Buying and selling long-term assets and investments not in cash equivalents | Sale of fixed assets and intangibles; repayment of loans by others; sale of shares and debentures of other firms; interest and dividend received | Purchase of fixed assets and intangibles; purchase of shares and debentures of other firms; loans and advances to others |
| Financing | Changes in the size and make-up of owners' capital (including preference capital) and borrowings | Proceeds from issue of shares and debentures; loans taken | Repayment of loans; redemption of debentures; interest paid; dividend paid |
For a financial enterprise such as a bank or finance company, loans given and taken are part of its main business, so they are operating activities. For other enterprises they are not.
Items that need special care
| Item | Non-financial enterprise | Financial enterprise |
|---|---|---|
| Interest paid | Financing | Operating |
| Interest received | Investing | Operating |
| Dividend received | Investing | Operating |
| Dividend paid | Financing | Financing |
| Income tax | Operating, generally | Operating |
| Tax on capital gains from sale of fixed assets | Investing | Same |
| Extraordinary items (theft, earthquake, flood) | Shown separately, under the activity they relate to | Same |
Other rules in this group: a non-cash transaction such as buying machinery by issuing shares, or redeeming debentures by issuing shares, moves no cash, so it is left out of the statement and disclosed elsewhere in the accounts. And the proposed dividend of the previous year, once approved at the Annual General Meeting and paid, is shown as an outflow under financing activities. It is also added back to net profit in the operating section, because it was charged to the surplus and reduced the profit figure you start from.
Beyond the textbook. For the exam: interest and dividend paid by a non-financial company go under financing, and interest and dividend received go under investing. In reality: the Indian Accounting Standard on cash flows (Ind AS 7), followed by larger companies, lets a company classify interest and dividends paid as operating or financing, and those received as operating or investing, as long as the choice is applied consistently. Why it matters: the same payment can sit in different sections in different companies' statements, which is why the exam fixes one rule for you to follow.
Beyond the textbook. For the exam: tax paid on the distribution of dividend goes with the dividend, under financing. In reality: the dividend distribution tax was abolished with effect from 1 April 2020, and dividends are now taxed in the hands of the shareholder. Why it matters: recent questions may not mention this tax, but older material still does, so know both facts.
Worked example: classify the transactions. Place each item under the right activity of a non-financial company.
| Transaction | Activity | Reason |
|---|---|---|
| Cash received from customers | Operating | Core business |
| Royalty and commission received | Operating | Revenue-producing |
| Salaries paid | Operating | Day-to-day cost |
| Income tax paid | Operating | Generally operating |
| Purchase of machinery for cash | Investing | Long-term asset |
| Old furniture sold for cash | Investing | Disposal of a fixed asset |
| Dividend received on shares held | Investing | Return on an investment |
| Interest received on debentures of another company | Investing | Return on an investment |
| Equity shares issued for cash | Financing | Owners' capital |
| Debentures redeemed in cash | Financing | Repayment of borrowings |
| Interest paid on debentures | Financing | Cost of borrowings |
| Dividend paid on equity shares | Financing | Return to owners |
| Treasury bills of 60 days bought with bank cash | No cash flow | Cash equivalent; cash management |
| Machinery received in exchange for shares | No cash flow | Non-cash transaction |
Common wrong step. Putting interest paid under operating because "interest is an expense". For a non-financial enterprise, interest paid is a financing cost, and it is added back to profit in the operating section so that it is not counted twice.
Direct and indirect methods
Only the starting point of the operating section differs. Investing and financing sections are the same either way.
| Point | Direct method | Indirect method |
|---|---|---|
| Starts with | Gross cash receipts from customers | Net profit before tax and extraordinary items |
| Shows | Major classes of gross cash receipts and payments | Adjustments to profit for non-cash and non-operating items and working capital changes |
| In practice | Less common | Used by most companies, and the method this chapter follows |
The indirect method: from profit to cash
The indirect method starts with profit and removes everything that is not an operating cash flow. It follows five moves.
| Move | What you do | Why |
|---|---|---|
| 1 | Start with net profit before tax and extraordinary items | The base figure from the Statement of Profit and Loss |
| 2 | Add non-cash and non-operating expenses: depreciation, amortisation, goodwill written off, provisions, loss on sale of fixed assets, interest paid | They reduced profit but did not use operating cash |
| 3 | Deduct non-operating incomes: profit on sale of fixed assets, interest received, dividend received | They raised profit but belong to investing |
| 4 | Adjust for changes in working capital (the rule below) | Profit is on credit basis, cash is not |
| 5 | Deduct income tax paid, then adjust for extraordinary items | Gives net cash from operating activities |
After move 3 you have the operating profit before working capital changes.
The working capital rule. Think of what happens to cash. If customers owe you more at the end of the year than at the start (trade receivables up), you earned profit but did not yet collect cash, so you deduct. If you owe suppliers more (trade payables up), you kept cash you would otherwise have paid, so you add.
| Change | Effect on cash | Treatment |
|---|---|---|
| Increase in a current asset (inventories, receivables) | Cash tied up | Deduct |
| Decrease in a current asset | Cash released | Add |
| Increase in a current liability (payables) | Cash retained | Add |
| Decrease in a current liability | Cash paid out | Deduct |
Worked example: cash from operating activities. Anand Ltd. has these details for the year (₹): net profit before tax 6,00,000; depreciation 1,50,000; loss on sale of machinery 30,000; interest paid 70,000; dividend received 20,000; decrease in inventories 40,000; increase in trade receivables 90,000; decrease in trade payables 25,000; income tax paid 1,80,000. Find the net cash from operating activities.
| Step | What we do | Amount (₹) |
|---|---|---|
| 1 | Net profit before tax | 6,00,000 |
| 2 | Add depreciation, loss on sale, interest paid: 1,50,000 + 30,000 + 70,000 | 2,50,000 |
| 3 | Deduct dividend received (belongs to investing) | (20,000) |
| 4 | Operating profit before working capital changes | 8,30,000 |
| 5 | Decrease in inventories (add) | 40,000 |
| 6 | Increase in trade receivables (deduct) | (90,000) |
| 7 | Decrease in trade payables (deduct) | (25,000) |
| 8 | Cash generated from operations (8,30,000 − 75,000) | 7,55,000 |
| 9 | Income tax paid | (1,80,000) |
| 10 | Net cash from operating activities | 5,75,000 |
Common wrong step. Deducting the decrease in inventories because "a decrease sounds negative". A decrease in a current asset releases cash, so it is added. A second common slip is forgetting that profit on sale of machinery is deducted and loss is added back.
Pause and predict: a machine with a book value of ₹70,000 is sold for ₹60,000. What appears under investing, and what adjustment is made in the operating section?
Check your answer: investing shows an inflow of ₹60,000, the full amount received. In the operating section, the loss of ₹10,000 is added back to profit, because it reduced profit but is not an operating cash flow.
Pause and predict: inventories fall by ₹30,000 during the year. Does this add to or reduce the cash from operations?
Check your answer: it adds ₹30,000. Stock that was consumed or sold did not need to be bought again, so less cash was spent than the expenses suggest.
Finding the missing figures: a complete example
Worked example: a complete cash flow statement. Real problems give two balance sheets and some extra notes. The method is to rebuild each section from the changes. Take Orbit Ltd.
| Particulars | 31 March 2024 (₹) | 31 March 2025 (₹) |
|---|---|---|
| Equity and liabilities | ||
| Share capital | 10,00,000 | 12,00,000 |
| General reserve | 1,00,000 | 1,40,000 |
| Surplus (balance in Statement of Profit and Loss) | 1,00,000 | 1,60,000 |
| 12% debentures | 4,00,000 | 3,00,000 |
| Trade payables | 1,50,000 | 1,80,000 |
| Provision for tax | 60,000 | 80,000 |
| Total | 18,10,000 | 20,60,000 |
| Assets | ||
| Machinery at cost | 12,00,000 | 12,50,000 |
| Less accumulated depreciation | (3,00,000) | (2,80,000) |
| Non-current investments | 2,00,000 | 2,50,000 |
| Inventories | 3,00,000 | 3,50,000 |
| Trade receivables | 2,00,000 | 2,40,000 |
| Cash and cash equivalents | 2,10,000 | 2,50,000 |
| Total | 18,10,000 | 20,60,000 |
Additional information: (a) a machine that cost ₹2,00,000, with accumulated depreciation of ₹1,20,000, was sold for ₹90,000; (b) depreciation charged for the year was ₹1,00,000; (c) ₹40,000 was transferred to general reserve; (d) the proposed dividend of last year, ₹40,000, was approved and paid in this year (this year's proposed dividend of ₹50,000 is not recorded); (e) income tax paid during the year was ₹50,000; (f) interest on debentures paid was ₹42,000, and debentures worth ₹1,00,000 were redeemed at par in cash; (g) dividend of ₹15,000 was received on investments; (h) shares of ₹2,00,000 were issued at par for cash, and investments of ₹50,000 were bought for cash.
Part 1: net profit before tax. The Statement of Profit and Loss is not given, so we work backward from the surplus.
| Step | What we do | Amount (₹) |
|---|---|---|
| 1 | Increase in surplus: 1,60,000 − 1,00,000 | 60,000 |
| 2 | Add transfer to general reserve (profit used, not lost) | 40,000 |
| 3 | Add last year's proposed dividend paid in this year | 40,000 |
| 4 | Profit after tax | 1,40,000 |
| 5 | Provision for tax of the year = closing 80,000 + paid 50,000 − opening 60,000 | 70,000 |
| 6 | Net profit before tax (1,40,000 + 70,000) | 2,10,000 |
Common wrong step. Taking the ₹60,000 increase in surplus as the profit. The surplus has been reduced by the transfer to reserve and the dividend, so those must be added back to find the profit that was actually earned.
Part 2: the fixed asset accounts. Use the Machinery account at cost and the Accumulated depreciation account to find what is missing.
| Machinery account | ₹ | ₹ | |
|---|---|---|---|
| To balance b/d | 12,00,000 | By machinery sold (cost) | 2,00,000 |
| To bank, purchases (balancing figure) | 2,50,000 | By balance c/d | 12,50,000 |
| 14,50,000 | 14,50,000 |
| Accumulated depreciation account | ₹ | ₹ | |
|---|---|---|---|
| To machinery sold | 1,20,000 | By balance b/d | 3,00,000 |
| To balance c/d | 2,80,000 | By depreciation for the year | 1,00,000 |
| 4,00,000 | 4,00,000 |
The book value of the machine sold is 2,00,000 − 1,20,000 = ₹80,000. It fetched ₹90,000, so the profit on sale is ₹10,000.
Part 3: the statement.
| Cash flow statement for the year ended 31 March 2025 | ₹ | ₹ |
|---|---|---|
| A. Cash flow from operating activities | ||
| Net profit before tax | 2,10,000 | |
| Add: depreciation | 1,00,000 | |
| Add: interest on debentures | 42,000 | 1,42,000 |
| Less: profit on sale of machinery | (10,000) | |
| Less: dividend received | (15,000) | (25,000) |
| Operating profit before working capital changes | 3,27,000 | |
| Increase in inventories | (50,000) | |
| Increase in trade receivables | (40,000) | |
| Increase in trade payables | 30,000 | (60,000) |
| Cash generated from operations | 2,67,000 | |
| Less: income tax paid | (50,000) | |
| Net cash from operating activities | 2,17,000 | |
| B. Cash flow from investing activities | ||
| Purchase of machinery | (2,50,000) | |
| Sale of machinery | 90,000 | |
| Purchase of investments | (50,000) | |
| Dividend received | 15,000 | |
| Net cash used in investing activities | (1,95,000) | |
| C. Cash flow from financing activities | ||
| Issue of shares | 2,00,000 | |
| Redemption of debentures | (1,00,000) | |
| Interest paid | (42,000) | |
| Dividend paid | (40,000) | |
| Net cash from financing activities | 18,000 | |
| Net increase in cash (A + B + C) | 40,000 | |
| Add: cash and cash equivalents at the beginning | 2,10,000 | |
| Cash and cash equivalents at the end | 2,50,000 |
The closing figure of ₹2,50,000 matches the cash in the 2025 balance sheet. That tie is the check on every cash flow statement: if it does not match, something has been left out or placed with the wrong sign.
Common wrong steps. Adding the profit on sale of machinery (₹10,000) instead of deducting it, which would make the operating profit ₹20,000 too high. Showing only the ₹10,000 profit under investing instead of the full ₹90,000 received. Reporting interest paid in the operating section without adding it back first. In each case the sum fails to reach ₹2,50,000.
Exam traps
| The trap | Why it's tempting | The truth |
|---|---|---|
| "Interest paid is an operating cash flow." | It is an expense on the profit statement | For a non-financial company it is financing; for a bank it is operating |
| "Dividend received is a financing inflow." | Dividends sound like shares | Received = investing; paid = financing |
| "Profit on sale of machinery is added to profit." | A profit feels like an inflow | Deduct it from profit; show the full proceeds under investing |
| "An increase in trade receivables is added." | Higher receivables look like more income | Cash is tied up, so deduct |
| "Machinery bought by issuing shares is an investing outflow and a financing inflow." | Both sides seem to occur | No cash moved, so it is left out and disclosed elsewhere |
| "Buying 60-day treasury bills is an investing outflow." | An investment is being bought | A cash equivalent, so it is cash management, not a cash flow |
| "Depreciation is a source of cash." | It is added back in the sum | It is a non-cash expense; the add-back only cancels its deduction |
| "The proposed dividend for this year is a financing outflow." | It is called a dividend | Only the previous year's dividend, once approved and paid, is an outflow |
Formula sheet
| Quantity | Formula | When to use |
|---|---|---|
| Operating profit before working capital changes | $\text{NPBT} + \text{depreciation} + \text{interest paid} + \text{loss on sale} - \text{profit on sale} - \text{dividend and interest received}$ | Start of the operating section |
| Cash from operations | $\text{Operating profit before WC changes} \pm \text{changes in working capital}$ | After the working capital adjustments |
| Net cash from operating | $\text{Cash generated from operations} - \text{tax paid}$ | End of operating section |
| Net change in cash | $\text{CFO} + \text{CFI} + \text{CFF}$ | Total of the three activities |
| Closing cash | $\text{Opening cash and equivalents} + \text{Net change}$ | Must match the balance sheet |
| Net profit before tax from surplus | $\Delta\text{Surplus} + \text{Transfer to reserves} + \text{Dividend paid} + \text{Provision for tax of the year}$ | When the profit statement is not given |
| Tax charge for the year | $\text{Closing provision} + \text{Tax paid} - \text{Opening provision}$ | Provision for tax account |
| Purchase of fixed assets at cost | $\text{Closing cost} + \text{Cost of assets sold} - \text{Opening cost}$ | Machinery account |
| Depreciation | $\text{Closing accumulated depreciation} + \text{on assets sold} - \text{Opening accumulated depreciation}$ | Accumulated depreciation account |
| Profit or loss on sale | $\text{Sale proceeds} - (\text{Cost} - \text{Accumulated depreciation})$ | Fixed asset disposals |
60-second revision
| Topic | Lock this in |
|---|---|
| Standard | AS 3 (Revised) |
| Three activities | Operating, investing, financing |
| Cash equivalents | Highly liquid, maturity of three months or less from acquisition |
| Operating (indirect) | Start with net profit before tax and extraordinary items |
| Add back | Depreciation, amortisation, loss on sale, interest paid |
| Deduct | Profit on sale, dividend and interest received |
| Working capital rule | Current assets up: deduct. Current liabilities up: add |
| Interest and dividend | Paid: financing. Received: investing (non-financial company) |
| Dividend paid | Financing for every company |
| Tax | Operating, generally |
| Non-cash transactions | Excluded and disclosed elsewhere |
| Proposed dividend | Previous year's, once paid: added back, then financing outflow |
| Final check | Opening cash + net change = closing cash in the balance sheet |
Where this chapter connects
- Previous: Accounting Ratios measured liquidity and profit from the statements; this chapter looks at the cash itself.
- Back to the base: Financial Statements of a Company lists the cash flow statement as the third financial statement and gives the balance sheet heads you read changes from.
- Financing items: Issue and Redemption of Debentures and Accounting for Share Capital create the issue and redemption flows shown under financing.
- Class XI link: Depreciation, Provisions and Reserves explains why depreciation is a charge against profit that moves no cash.
🎯 Practice MCQs
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Q1. The cash flow statement is prepared as per which Accounting Standard?
▸ Show answer & explanation
Answer: A
AS 3 (Revised) deals with the cash flow statement. AS 4 deals with contingencies and events after the balance sheet date, which governs proposed dividend.
Q2. An investment qualifies as a cash equivalent only when its maturity from the date of acquisition is normally:
▸ Show answer & explanation
Answer: B
A cash equivalent must be readily convertible to cash with insignificant risk of change in value, which is why the maturity is three months or less from the date of acquisition.
Q3. Which of the following is an investing activity of a non-financial company?
▸ Show answer & explanation
Answer: C
For a non-financial enterprise, dividend received is an investing inflow. Sale of goods and tax paid are operating, and debenture issue is financing.
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Q4. Match List I with List II for a non-financial company. List I: (i) Interest paid on debentures (ii) Interest received on investments (iii) Dividend paid on equity shares (iv) Cash received from customers. List II: (p) Operating (q) Investing (r) Financing.
▸ Show answer & explanation
Answer: A
Interest paid and dividend paid are financing. Interest received is investing. Cash received from customers is operating. Only option A matches all four.
Q5. Which of these adjustments are correct while computing cash from operating activities by the indirect method? (i) Depreciation is added. (ii) Profit on sale of machinery is deducted. (iii) Dividend received is added. (iv) Interest paid by a non-financial company is deducted.
▸ Show answer & explanation
Answer: D
Depreciation is a non-cash expense, so it is added. Profit on sale belongs to investing, so it is deducted. Dividend received is deducted (it belongs to investing), and interest paid is added back (it belongs to financing). So (iii) and (iv) are wrong.
Q6. While preparing a cash flow statement by the indirect method, an increase in trade receivables during the year is:
▸ Show answer & explanation
Answer: B
Higher receivables mean sales were made on credit and cash has not yet come in, so the increase is deducted.
Q7. Net profit before tax ₹4,00,000; depreciation ₹1,00,000; profit on sale of machinery ₹40,000; increase in trade receivables ₹30,000; increase in trade payables ₹50,000; income tax paid ₹90,000. Net cash from operating activities is:
▸ Show answer & explanation
Answer: C
4,00,000 + 1,00,000 − 40,000 = 4,60,000 before working capital. Then − 30,000 + 50,000 gives 4,80,000. After tax of 90,000 the answer is ₹3,90,000. Option A forgets the tax and option B adds the profit on sale instead of deducting it.
Q8. A machine of cost ₹1,00,000 and accumulated depreciation ₹60,000 is sold for ₹50,000. Machinery at cost was ₹4,00,000 at the start and ₹4,80,000 at the end. The net cash flow from investing activities is:
▸ Show answer & explanation
Answer: D
Purchases = closing 4,80,000 + cost of machine sold 1,00,000 − opening 4,00,000 = ₹1,80,000. Sale proceeds are ₹50,000. Net = 50,000 − 1,80,000 = outflow of ₹1,30,000.
Q9. Acquisition of machinery by issuing equity shares is:
▸ Show answer & explanation
Answer: A
No cash or cash equivalent moves in the transaction, so it is left out of the statement and disclosed in the notes.
Q10. The previous year's proposed dividend is approved and paid in the current year. In the cash flow statement it is:
▸ Show answer & explanation
Answer: C
The dividend reduced the surplus, so it is added back when finding profit, and the cash paid is a financing outflow.
Q11. Assertion (A): Depreciation is a source of cash for a company. Reason (R): Depreciation is added back to net profit in the indirect method.
▸ Show answer & explanation
Answer: D
Depreciation is a non-cash expense, so it is not a source of cash. It is added back only to cancel its deduction when profit was calculated, so R is true and A is false.
Q12. Net profit before tax and extraordinary items ₹6,00,000; depreciation ₹80,000; interest paid ₹50,000; decrease in inventories ₹20,000; decrease in trade receivables ₹30,000; decrease in trade payables ₹10,000; income tax paid ₹1,20,000; loss by flood (extraordinary) ₹40,000. Net cash from operating activities is:
▸ Show answer & explanation
Answer: B
6,00,000 + 80,000 + 50,000 = 7,30,000. Working capital: +20,000 + 30,000 − 10,000 = +40,000, giving 7,70,000. Less tax 1,20,000 gives 6,50,000. Less the extraordinary flood loss of 40,000 gives ₹6,10,000.
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