Cash flow statement

In short

A cash flow statement reports the actual movement of cash and cash equivalents during an accounting period, classified into operating, investing and financing activities, and reconciles opening cash with closing cash. It answers a question the Profit and Loss Account cannot: a company can show a healthy accounting profit and still run out of cash, because profit is accrual-based while cash is not. In India it is a statutory part of financial statements under Section 2(40) of the Companies Act, 2013, prepared under AS 3 (Accounting Standards) or Ind AS 7 (Indian Accounting Standards), and submitted half-yearly by listed entities under SEBI LODR Regulation 33. It is examined heavily in B.Com and M.Com papers, in CA/CMA/CS foundation and intermediate exams, and is a standard question in finance, audit, FP&A, credit-analyst and banking interviews.

Explained

What it is and the standards that govern it

• Definition: a statement showing inflows (receipts) and outflows (payments) of cash and cash equivalents during a period, grouped by the nature of the activity that caused them.
• Purpose: to assess liquidity, solvency, the quality of reported profit, the ability to generate cash internally, and the ability to pay dividends, interest and loan instalments.
• AS 3 (Revised), Cash Flow Statements — issued by ICAI, notified in the Companies (Accounting Standards) Rules, 2021; applies to companies still on Indian GAAP.
• Ind AS 7, Statement of Cash Flows — notified under the Companies (Indian Accounting Standards) Rules, 2015; applies to listed and large companies (net worth ₹250 crore and above, in phases). Ind AS 7 additionally requires a reconciliation of changes in liabilities arising from financing activities (the "net debt" note, para 44A).
• Section 2(40), Companies Act 2013: "financial statements" include a cash flow statement — so it is audited, not optional. Exempt: One Person Company, small company, dormant company, and a private company that is a start-up (as per the proviso and the Rules).
• Schedule III does not prescribe a format for the cash flow statement; the illustrative formats in AS 3 / Ind AS 7 are followed. Comparative figures for the previous year are mandatory.

Cash, cash equivalents and the three activities

• Cash: cash in hand and demand deposits with banks. Cash equivalents: short-term, highly liquid investments readily convertible into known amounts of cash with insignificant risk of change in value — normally those with an original maturity of three months or less (treasury bills, commercial paper, liquid mutual-fund units held for cash management, short-term deposits).
• Equity investments are *not* cash equivalents (value fluctuates), except redeemable preference shares acquired shortly before redemption.
• Movements between cash and cash equivalents are not cash flows — shifting ₹10 lakh from current account to a 60-day deposit is internal cash management, so it is excluded.
• Operating activities: the principal revenue-producing activities — receipts from customers, payments to suppliers and employees, operating expenses, income tax (unless specifically identifiable with investing/financing). This is the engine of the business.
• Investing activities: acquisition and disposal of long-term assets and investments not held as cash equivalents — purchase/sale of PPE, intangibles, investments, loans given to others and their recovery, interest and dividend received (non-financial entity).
• Financing activities: changes in the size and composition of owners' capital and borrowings — issue/buyback of shares, securities premium received, proceeds and repayment of debentures and loans, interest paid, dividend paid, share issue expenses.
• Financial enterprises (banks, NBFCs, insurers): interest paid, interest received and dividend received are operating, since lending and investing are their core business.
• Bank overdraft / cash credit: under AS 3 it is a financing activity; under Ind AS 7 an overdraft repayable on demand that is integral to cash management is included *within* cash and cash equivalents (as a negative balance). State which framework you are using.

Indirect method — step by step

The method asked for in most Indian exams, because only two balance sheets plus adjustments are given.

1. Start with net profit before tax and extraordinary items. If only the Reserves and Surplus balances are given, work back: Opening P&L balance + PAT − dividend paid − transfer to reserves = Closing P&L balance; then PBT = PAT + provision for tax made.
2. Add back non-cash charges: depreciation, amortisation of intangibles and goodwill, impairment, provision for doubtful debts, preliminary/discount on issue written off, unrealised foreign-exchange loss.
3. Add back non-operating charges: interest on debentures and loans, loss on sale of PPE or investments.
4. Deduct non-operating incomes: interest received, dividend received, rent from let-out property, profit on sale of PPE/investments — they are counted again under investing.
5. You now have Operating profit before working capital changes.
6. Adjust working capital: an increase in a current asset is an outflow, a decrease an inflow; an increase in a current liability is an inflow, a decrease an outflow. Include inventories, trade receivables, prepaid expenses, trade payables, outstanding expenses, advances from customers. Exclude cash, cash equivalents, short-term borrowings, provision for tax and proposed dividend.
7. Result is Cash generated from operations.
8. Less income tax paid (cash, not the P&L charge) → Net cash from operating activities.
9. Build investing and financing sections from asset and liability ledger movements; add the three to get the net change and reconcile with the opening and closing cash balances. If it does not reconcile, something is misclassified or omitted.

Direct method and the AS 3 format

• The direct method reports gross operating receipts and payments: cash received from customers, cash paid to suppliers, cash paid to employees, other operating payments, tax paid.
• AS 3 and Ind AS 7 encourage the direct method (more informative for users), but almost all Indian companies publish the indirect method. Both give exactly the same cash flow from operating activities; only the presentation of the operating section differs. Investing and financing sections are identical under both.
• Gross versus net reporting: major classes of receipts and payments must be shown gross (purchases of ₹7 crore and sales of ₹1.3 crore of plant are not netted to ₹5.7 crore). Netting is allowed only for quick-turnover items and for a financial enterprise's short-term borrowings/deposits.

Special items and classification rules

• Income tax paid: operating, unless a specific flow is clearly attributable to investing or financing (e.g., capital gains tax on sale of land). Shown as a separate line after cash generated from operations. Tax deducted at source on interest income is part of tax paid.
• Dividend paid: financing. Proposed dividend of the current year is not a liability until declared, so the outflow recognised is the *previous* year's dividend actually paid (dividend distribution tax, once paid alongside it, was abolished for dividends declared from 1 April 2020).
• Interest paid: financing for a non-financial entity under Ind AS 7 and AS 3. Interest capitalised to an asset under construction is part of the investing outflow for that asset.
• Non-cash transactions are excluded from the statement and disclosed separately in a note: conversion of debentures into equity, issue of shares to acquire a business, acquisition of an asset under a lease, bonus issue, revaluation of assets, bad debts written off against provision.
• Extraordinary items: AS 3 requires their cash flows to be classified and disclosed separately. Ind AS (and Schedule III Division II) no longer recognise extraordinary items; Division I (AS companies) still has an extraordinary-items line.
• Foreign currency: translate each cash flow at the rate on the date of the flow (or a weighted average). Unrealised exchange gains/losses are not cash flows, but the effect of rate changes on foreign-currency cash balances is shown as a separate reconciling line.
• Acquisition or disposal of a subsidiary/business: investing, shown as one line, net of cash and cash equivalents acquired or disposed of.
• Advantages: reveals real liquidity; exposes poor-quality profit (profit up, operating cash flow down is a classic warning sign of aggressive revenue recognition or receivables build-up); comparable across companies because cash is harder to manipulate than accruals; used for valuation and for lending decisions.
• Limitations: historical and period-end based; it is not a substitute for the P&L (ignores non-cash costs such as depreciation that must eventually be funded); classification choices can shift flows between sections; it says nothing about profitability or about commitments not yet paid; it can be window-dressed by delaying supplier payments or advancing collections near the year end.

Key points

• Cash flow statement - a statement reconciling opening and closing cash and cash equivalents through operating, investing and financing flows.
• AS 3 / Ind AS 7 - the governing standards in India; Ind AS 7 also needs a financing-liabilities (net debt) reconciliation.
• Section 2(40) - makes the statement part of audited financial statements; OPC, small, dormant and start-up private companies are exempt.
• Cash equivalents - original maturity of three months or less, insignificant risk of value change; equity shares do not qualify.
• Operating activities - core trading flows plus income tax paid; the single most important number in the statement.
• Investing activities - purchase and sale of long-term assets and investments; interest and dividend received by a non-financial entity.
• Financing activities - share capital, premium, borrowings, interest paid and dividend paid.
• Financial enterprises - interest and dividend received and interest paid are operating, not investing/financing.
• Working capital rule - current asset up = cash out; current liability up = cash in.
• Non-cash items - depreciation, amortisation and provisions charged to the P&L are added back; revaluation, which never touches the P&L, is simply not a flow at all.
• Direct and indirect methods - differ only in the operating section; both reach the same cash from operations.
• Gross reporting - purchases and sales of assets are shown separately, not netted.
• Tax paid - the cash figure derived from the provision account, disclosed as a separate line.
• Dividend paid - financing outflow in the year of actual payment, not the year of proposal.
• Non-cash transactions - debenture conversion, bonus issue and share-for-asset deals are disclosed in a note only.
• Profit is not cash - a growing company can report profit and negative operating cash flow because of inventory and receivables build-up.
• Free cash flow - operating cash flow less capital expenditure; a management and valuation measure, not an AS 3 line item.
• Reconciliation check - CFO + CFI + CFF must equal closing cash minus opening cash; otherwise the answer is wrong.

Formulas and examples

Symbols and units: all amounts in rupees (₹) of the reporting period; CFO/CFI/CFF = net cash from operating/investing/financing activities; WDV = cost less accumulated depreciation.

Example 1 - Cash from operating activities (indirect method) Net profit before tax ₹5,00,000. Depreciation ₹1,20,000; goodwill amortised ₹40,000; loss on sale of machinery ₹15,000; interest on debentures ₹60,000; profit on sale of investments ₹25,000; interest received ₹20,000; dividend received ₹10,000. Inventories rose ₹90,000; trade receivables fell ₹50,000; trade payables rose ₹35,000; prepaid expenses rose ₹5,000; outstanding expenses fell ₹10,000. Income tax paid ₹1,45,000.

1. Add non-cash and non-operating charges: 5,00,000 + 1,20,000 + 40,000 + 15,000 + 60,000 = ₹7,35,000
2. Less non-operating incomes: 25,000 + 20,000 + 10,000 = 55,000 → Operating profit before working capital changes = ₹6,80,000
3. Working capital: −90,000 + 50,000 + 35,000 − 5,000 − 10,000 = −₹20,000
4. Cash generated from operations = ₹6,60,000
5. Less income tax paid ₹1,45,000 → Net cash from operating activities = ₹5,15,000

Example 2 - Complete cash flow statement (figures in ₹'000)

Additional information: depreciation charged ₹150; machinery of gross cost ₹200 (accumulated depreciation ₹50) sold for ₹130; investments purchased ₹50; dividend received ₹15; debentures ₹200 redeemed at par on 31-03-2026 and interest ₹50 paid; provision for tax made ₹110; dividend of ₹100 paid during the year.

*Derivations:* PPE purchased = 2,000 − 1,500 + 200 = ₹700. Accumulated depreciation check = 350 + 150 − 50 = 450 ✓. WDV of asset sold = 200 − 50 = 150, sold for 130 → loss ₹20. Tax paid = 70 + 110 − 90 = ₹90. PAT = 620 − 500 + 100 = 220 → PBT = 220 + 110 = ₹330.

Example 3 - Direct method, cross-checked with indirect Credit sales ₹20,00,000; cost of goods sold ₹12,00,000; wages and other operating expenses paid ₹4,00,000; depreciation ₹1,00,000; tax paid ₹60,000. Trade receivables 3,00,000 → 3,80,000; inventories 2,00,000 → 2,50,000; trade payables 1,80,000 → 2,20,000.

• Collections = 20,00,000 + 3,00,000 − 3,80,000 = ₹19,20,000
• Purchases = 12,00,000 + 2,50,000 − 2,00,000 = ₹12,50,000; payments to suppliers = 12,50,000 + 1,80,000 − 2,20,000 = ₹12,10,000
• Cash generated from operations = 19,20,000 − 12,10,000 − 4,00,000 = ₹3,10,000; less tax ₹60,000 → CFO = ₹2,50,000
• *Indirect check:* PBT = 20,00,000 − 12,00,000 − 4,00,000 − 1,00,000 = 3,00,000; + depreciation 1,00,000 = 4,00,000; working capital −80,000 − 50,000 + 40,000 = −90,000 → 3,10,000; less tax 60,000 → ₹2,50,000 ✓

Example 4 - Classification drill

Example 5 - Profit versus cash, and free cash flow A company reports PAT ₹60 lakh. Depreciation ₹25 lakh; receivables rose ₹70 lakh; inventories rose ₹40 lakh; payables rose ₹10 lakh; tax paid ₹20 lakh; capex ₹35 lakh. Assume PBT ₹80 lakh.

• Operating profit before working capital changes = 80 + 25 = ₹105 lakh
• Working capital = −70 − 40 + 10 = −₹100 lakh → cash generated ₹5 lakh; less tax ₹20 lakh → CFO = −₹15 lakh
• FCF = −15 − 35 = −₹50 lakh. A profit of ₹60 lakh with negative operating cash flow: growth is being funded entirely from outside the business — fresh borrowing, fresh equity or existing cash reserves — the classic examiner's and credit analyst's point.

Where it is used

• Statutory financial reporting and audit: every company other than those exempted under Section 2(40) files it with the Board's report and ROC; auditors verify classification and the reconciliation. Listed entities file it half-yearly under SEBI LODR Regulation 33.
• Bank and NBFC credit appraisal: CMA data (Credit Monitoring Arrangement) submitted for working-capital and term-loan sanction includes past and projected cash flows; debt service coverage depends on operating cash flow, not profit.
• Corporate finance and FP&A roles: operating cash flow and free cash flow feed DCF valuation, dividend and capex decisions in companies such as Infosys, TCS, Reliance, HUL and L&T; treasury teams manage cash equivalents and overdraft limits.
• Equity research and rating agencies (CRISIL, ICRA, CARE): compare CFO with PAT over several years to test earnings quality; a persistent gap is a red flag for receivable or inventory manipulation.
• Infrastructure, real estate and EPC companies: long cash conversion cycles mean projects are profitable on paper years before they are cash-positive; cash flow statements drive milestone billing and retention follow-up.
• Insolvency, restructuring and MSME lending: resolution professionals and lenders use historical cash flows to judge going-concern viability and to build repayment schedules.

Interview questions

• Q: Why is a cash flow statement needed when we already have a Profit and Loss Account? A: The P&L is accrual-based and includes non-cash items and credit transactions; the cash flow statement shows the actual cash generated and used, which determines whether the company can pay salaries, interest and dividends.
• Q: What are the three activities and which is most important? A: Operating, investing and financing. Operating cash flow matters most, because a business must ultimately fund itself from its own trading rather than from borrowings or asset sales.
• Q: How is depreciation treated and why? A: It is added back to profit, because it is a non-cash charge that reduced reported profit without any payment of cash.
• Q: A company shows rising profit but falling operating cash flow. What would you check? A: Receivables and inventory build-up, revenue recognised but not collected, capitalisation of expenses, and changes in credit terms — it can signal poor working-capital control or aggressive accounting.
• Q: Where do interest paid and interest received go? A: For a non-financial company, interest paid is financing and interest received is investing; for a bank, NBFC or other financial enterprise both are operating.
• Q: Do the direct and indirect methods give different answers? A: No — both give identical cash from operating activities; only the presentation of the operating section differs.
• Q: Is a bank overdraft an operating, investing or financing item? A: Under AS 3 it is a financing flow; under Ind AS 7, if it is repayable on demand and integral to cash management, it is included within cash and cash equivalents as a negative balance.
• Q: How do you treat conversion of debentures into equity shares? A: It is a non-cash transaction, excluded from the statement and disclosed separately in a note, because no cash moved.
• Q: Which companies in India need not prepare a cash flow statement? A: One Person Companies, small companies, dormant companies and private companies that qualify as start-ups, under the proviso to Section 2(40) of the Companies Act, 2013.
• Q: How do you compute income tax paid from the accounts? A: Opening provision for tax plus the provision charged in the P&L minus the closing provision, adjusted for advance tax and TDS balances.
• Q: What is free cash flow and is it part of AS 3? A: Operating cash flow less capital expenditure; it is a management and valuation measure and is not a prescribed line in AS 3 or Ind AS 7.
• Q: Can a cash flow statement be window-dressed? A: Yes — by delaying supplier payments, pushing collections into the last few days of the year, or using bill discounting and channel financing; so the trend over several years, not one year, should be read.

Common mistakes

• Reversing the working-capital sign: treating an increase in debtors or stock as an inflow, or a rise in creditors as an outflow.
• Putting the P&L tax provision instead of tax actually paid, and omitting the tax line from operating activities altogether.
• Showing proposed dividend of the current year as an outflow instead of the dividend actually paid during the year.
• Double counting: adding back loss on sale of an asset but then also showing the WDV instead of the sale proceeds under investing.
• Netting the purchase and sale of fixed assets or investments into a single figure, when AS 3 requires gross disclosure.
• Including non-cash items as flows — bonus issue, revaluation surplus, debenture conversion, bad debts written off against an existing provision.
• Classifying interest paid or dividend received by habit without asking whether the entity is a financial enterprise, and not checking that CFO + CFI + CFF equals the actual change in cash.

Related topics

Ratio analysis · Budgeting and standard costing · Marginal costing and break-even analysis · Working capital management · Financial statement analysis and Schedule III · Cost accounting: elements of cost