4. CASH FLOW STATEMENT CONTINUED: CASH FLOW FROM OPERATING ACTIVITIES: STAGE 2: CALCULATE OPERATING PROFIT BEFORE WORKING CAPITAL CHANGES

Format and Steps to prepare Cash Flow From Operating Activities:

Learning Objectives:

After going through this lesson, you shall be able to understand the following concepts. 

• Steps to Prepare Cash Flow from Operating Activity
• Appendix- Some Important Terms and DefinitionS

Steps to Prepare Cash Flow Statement
To prepare a Cash Flow Statement we need to follow the given below stages.




Stage I:  Ascertain Cash Flow from Operating Activities

In the Stage I, we ascertain Cash Flow from Operating Activities by following the below given steps (Step 1, 2, 3 and 4).




Step 1: Compute Net Profit before Taxation and Extraordinary items:

For this we begin with Net Profit or Net Loss. If the balance of Profit and Loss Account increases, then it is shown as Net Profit, else in case of decrease it is shown as negative figure (in brackets) as Net Loss. Next, we need to Add the following items to the Net Profit.

1. Transfer to Reserve- The increase in the balance of Reserve from Previous Year to Current Year is added to the Net Profit.
2. Proposed Dividend- Proposed Dividend of the (Previous year) paid is added to the Net Profit
3. Interim Dividend- Interim Dividend given in the adjustment (i.e. paid during the year) is added to the Net Profit.
4. Provision for Taxation- Provision for Tax made during the Current year is also added to the Net Profit
5. Extraordinary items( debited to Statement of P/L)

1. Less:
2. Transfer to Reserve (Decrease)
3. Tax Refund (credited to Statement of P/L)
4. Extraordinary items (credited to Statement of  P/L)

WE DID STEP - 1 IN THE PREVIOUS CLASS.

Step 2: Compute Net Profit before Working Capital Changes- 

For this, we need to adjust the Net Profit before taxation (ascertained above) for the Non-Cash Transactions. These transactions do not involve any cash flows but as they affect net profit, so such items must be taken into consideration.
 The non-cash and non-operating transactions can be classified under two sub-headings as presented diagrammatically.

1. Non-Cash and Non-Operating Expenses and Losses-   These expenses and losses do not result in any cash outlays from the business. The following are the non-operating expenses and losses that are added to the Net Profit before Taxation.

Add: Non-Cash and Non-Operating Losses and Expenses

1. 1. Depreciation- Amount of depreciation charged/provided during the year.
   2. Goodwill, Patents and Trade Marks Amortised (written-off)- The decrease in the value of Goodwill, Patents and Trade Marks from previous year to current year is added.
   3. Interest on Bank Overdraft/ Cash Credit
   4. Interest on Borrowings (Short - term/Long - term) and Debentures
   5. Premium on Redemption of Preference Shares/ Debentures
   6. Writing off Underwriting Commission/ Share Issue Expenses
   7. Loss on Sale of Fixed Assets/ Investments
   8. Increase in Provision for Doubtful Debts*

2. Deduct: Non-Cash and Non-Operating Incomes and Gains from the Net Profit before Taxation
1. Interest Received­
2. Dividend Received
3. Rent Received
4. Profit on Sale of Fixed Assets
5. Decrease in Provision for Doubtful Debts*

Step 3: Compute Cash Generated From Operations-

 Now, to the Net Profit before Working Capital Changes (ascertained in Step: 2), we need to:

1. Add: Decrease in Current Assets- (If Current Year’s Balance < Previous Year’s Balance)
2. Add: Increase in Current Liabilities- (If Current Year’s Balance > Previous Year’s Balance)
3. Deduct: Increase in Current Assets- (If Current Year’s Balance > Previous Year’s Balance)
4. Deduct: Decrease in Current Liabilities- (If Current Year’s Balance < Previous Year’s Balance)

* It should be noted that Provision for Doubtful debt is considered as a Current Liabilities.


Step 4: Compute Net Cash from (or used in) Operating Activities-
 Lastly, we need to consider Income Tax and Extra-ordinary Items. In order to get Net Cash from Operating Activities, we need to:

1. Deduct: Income Tax paid
2. Add:Income Tax Refund
3. Add: Extraordinary Items that lead to cash inflows to the business due to operating items.
4. Deduct: Extraordinary Items that lead to cash outflows from the business due to operating items.

SOME IMPORTANT TERMS:

1. ACCOUNTING TREATMENT OF PROPOSED DIVIDEND IN CASH FLOW STATEMENT: 

PROPOSED DIVIDEND OF PREVIOUS YEAR IS ADDED BACK TO CURRENT YEAR'S PROFIT TO DETERMINE NET PROFIT BEFORE TAX AND EXTRA ORDINARY ITEMS. 

PROPOSED DIVIDEND OF PREVIOUS YEAR IS ALSO SHOWN AS PAYMENT UNDER FINANCING ACTIVITIES.

IMPORTANT POINT:

* NO EFFECT IS GIVEN TO PROPOSED DIVIDEND FOR THE CURRENT YEAR IN THE CASH FLOW AS IT IS NOT PROVIDED FOR AND IS A CONTINGENT LIABILITY. 

* ANY UNPAID DIVIDEND IS TRANSFERRED TO DIVIDEND PAYABLE ACCOUNT / UNPAID DIVIDEND ACCOUNT WHICH IS SHOWN IN THE CURRENT YEAR'S BALANCE SHEET AS OTHER CURRENT LIABILITIES UNDER CURRENT LIABILITIES.

* IN THE ABSENCE OF ANY INFORMATION TO THE CONTRARY, IT IS ASSUMED THAT PROPOSED DIVIDEND OF PREVIOUS YEAR HAS BEEN DECLARED AT THE AGM IN THE CURRENT YEAR AND HAS ALSO BEEN PAID DURING THE CURRENT YEAR.

2. INTERIM DIVIDEND:

INTERIM DIVIDEND IS THE DIVIDEND DECLARED BY THE BOARD OF DIRECTORS AND ALSO PAID WITHIN THE FINANCIAL YEAR.

IT IS ADDED BACK TO THE NET PROFIT TO CALCULATE NET PROFIT BEFORE TAX AND EXTRAORDINARY ITEMS.

IT IS SHOWN AS AN OUTFLOW OF CASH UNDER FINANCING ACTIVITIES.

3. PROVISION FOR TAX:

PROVISION FOR TAX IS AN ESTIMATE OF TAX LIABILITY FOR A GIVEN YEAR. 

# PROVISION FOR TAX MADE DURING THE YEAR IS ADDED TO CURRENT YEARS PROFIT.

# TAX PAID (NET OF REFUND OF TAX) IS AN OPERATING ACTIVITY : TAX PAID (NET OF REFUND) IS DEDUCTED FROM CASH GENERATED FROM OPERATING ACTIVITIES TO DETERMINE CASH FLOW FROM OPERATING ACTIVITIES.

# WHEN BOTH OPENING AND CLOSING BALANCES ARE GIVEN: 

# IF OPENING AND CLOSING BALANCES OF PROVISION FOR TAX IS GIVEN AND NO OTHER INFORMATION IS GIVEN, THEN OPENING BALANCE IS TREATED AS TAX PAID DURING THE YEAR. IT IS RECORDED AS AN OUTFLOW OF CASH UNDER CASH FLOW FROM OPERATING ACTIVITIES.

# CLOSING BALANCE IS TREATED AS TAX PROVISION MADE IN THE CURRENT YEAR. IT IS ADDED TO THE CURRENT YEARS PROFIT. 

#  WHEN ADDITIONAL INFORMATION IS GIVEN IN ADDITION TO THE OPENING AND CLOSING BALANCES IN SUCH CASE, PROVISION FOR TAX ACCOUNT IS PREPARED, AS SHOWN BELOW:

                                   FORMAT OF PROVISION FOR TAX ACCOUNT

Particulars                                         Amount       Particulars                                 Amount

 To Bank (Tax Paid)                               -----          By Bal b/d (opening balance)     ------

To Bal c/d (closing balance)                -----          By Statement of

                                                                                  P & L A/c (provision made)        -----                  

                                                             _________                                                     ________

                                                             _________                                                     ________

                                                                                                                            

EXAMPLE                                                                            

From the following information, calculate Operating Profit before Working Capital Changes:

                                                                                                           ₹

Net profit before tax and Extraordinary items                              223500 
Depreciation                                                                                   42,000 

Interest on Borrowings                                                                      8400 
Goodwill amortized                                                                           9300 
Loss on Sale of Machinery                                                               9,000 

Premium on Redemption of Debentures                                           3000

Interest and Dividend Received on Investments                             13800 

Profit on Sale of Investment                                                              6000

Solution:

CALCULATION OF OPERATING PROFIT BEFORE WORKING CAPITAL CHANGES 

PARTICULARS                                                                                                         ₹

Net profit before tax and extraordinary items                                                          223500 
Adjustment for Non- cash and Non- operating items:

Add:

Depreciation                                                                          42,000 

Interest on Borrowings                                                             8400 

Goodwill Amortized                                                                9300 

Loss on Sale of Machinery                                                       9000                          68700 
                                                                                            ___________________________

                                                                                                                                  292200 

Less:

Interest and Dividend Received on Investments                   13800 

Profit on Sale of Investment                                                    6000                          19800 
                                                                                           _____________________________

Operating Profit before Working Capital Changes                                                  272400 
                                                                                                                                __________

Note: Premium on Redemption of Debentures is an item of Balance Sheet. Since it has not entered into Statement of Profit and Loss, adjustment will not be made in operating activities.