Operating cash flow

As known, profit before tax is using the accruals concept, but net cash flow from operating activities only records the cash inflows and outflows according to the trading. Some operating activities impact profit before tax, but not operating cash flow, because of the the accruals concept.

The indirect method starts with profit before tax, and adjusts according to the depreciation, profit/loss on disposal of non-current asset, balance sheet change in receivables, balance sheet change in inventories, and balance sheet change in payables.

Then you should understand the reconciliation between profit before tax and net cash flow from operating activities as the following:

1. Depreciation.
   Depreciation is a book write-off of capital expenditure. But please note that capital expenditure will be recorded into investing activities. Therefore, the depreciation represents an addition to reported profit in deriving cash inflow.
2. Profit/loss on disposal of non-current asset.
   If the profit or loss on the sale has been included in profit before tax, an adjustment is necessary in computing operating cash flow. A loss means added to reported profit, a profit means deducted from the reported profit.
3. Balance sheet change in receivables.
   The figure changed in receivables is using the accruals concept, the receivables mean that you haven’t received it, but it can impact the profit before tax. For example, there’s a revenue in ledger, you haven’t received the cash, but it’ll generate the related tax. So you should consider this part.
4. Balance sheet change in inventories.
   The inventories will impact the cash flow, because cash was spent on its purchase or a payable incurred, it represent an actual or potential cash outflow. A corresponding adjustment would be made to payables to the extent that the expense relating to such payables will not have been charged in the income statement. The practical difficulties is to determine how much inventory has not been paid for at the balance sheet date.
5. Balance sheet change in payables.
   It does not represent a cash outflow until paid. An increase in payables between two balance sheet dates is an addition to reported profit, a decrease means a deduction from reported profit. If the purchase doesn’t result in charge to the income statement in the current year, the corresponding payable is not included in the reconciliation of profit to net cash inflow. For example, a payable in respect of non-current asset is not included.

As the direct method, you should know:

1. the sales to derive cash received from customers
2. the purchases to derive cash payments to suppliers
3. the wages to derive cash paid to and on behalf of employees.

And interest paid is shown as part of operating activeites, but dividends paid are shown as part of financing activities. Cash flow arising from taxes on income should be separately disclosed as part of operating activities unless they can be specifically identified with financing and investing activities.

Related posts:

1. Cash flow from operating activities
2. The direct and indirect method of cash flow
3. Cash flow statement template
4. Cash flow analysis
5. Cash flow from investing activities