This chapter explains how to calculate cash flows from operating activities using two methods:

• the direct method (showing actual cash receipts and payments)
• the indirect method (adjusting profit for non-cash items and working capital changes)

Learning objective

By the end of this chapter, you should be able to:

• Calculate the figures needed for the statement of cash flows in accordance with IFRS Accounting Standards, including:
  • Cash flows from operating activities (direct and indirect methods for calculating cash from operating activities before income taxes)
• Identify the treatment of given transactions in a statement of cash flows

There are two methods for presenting operating cash flows:

1. Direct method
2. Indirect method

IAS 7 encourages entities to report cash flows from operating activities using the direct method. However, in practice, the direct method is rarely used.

Direct method

The direct method reports major classes of gross cash receipts (money coming in) and payments (money going out). This method can be useful for estimating future cash flows because it shows cash movements directly - information you don’t see in the same way under the indirect method.

	$
Cash receipts from customers	X
Cash paid to suppliers	(X)
Cash paid to employees	(X)
Cash paid for operating expenses	(X)
Cash generated from operations	X
Income taxes paid	(X)
Net cash from operating activities	X

WARNINGS: Rarely will the amounts for these items be given straightforwardly in a question. Usually, you must calculate each amount (as applicable) using information from the statement of comprehensive income (for example, sales, cost of sales, and operating expenses) and the statement of financial position.

To do this, you’ll typically apply the double-entry principle and open up general ledger (T-) accounts to determine the cash payment or receipt. In many cases, the cash payment or receipt is the balancing figure - you find it by working backwards (a work back approach).

Work back approach example

A company reports revenue (credit) of $50,000 for a period in the statement of profit or loss. Trade receivables at the beginning of the period were $300,000, and during the period, the company received $150,000 from its debtors.

Determine the closing trade receivables for the period.

Do you know the answer?

In the example above, the cash received from debtors was given, and we used it to determine the closing trade receivables balance.

In many questions, you’ll be given the opening and closing balances of an account (plus any non-cash activity during the period). From that, you should be able to work backwards to determine the cash payment or cash receipt.

Let’s see how that works.

A company reports revenue (credit) of $50,000 for a period in the statement of profit or loss. Trade receivables at the beginning and end of the period were $300,000 and $150,000, respectively.

Determine the cash received from suppliers for the period.

Do you know the answer?

Rule of thumb: When the balancing figure in an account is on the debit side, it represents a cash outflow (payment). When it is on the credit side, it represents a cash inflow (receipt).

Illustration: direct method

Asempa Ltd had the following transactions during the year ended 31 December 2024:

• Inventory Purchases: Total purchases from suppliers during the year: $45,800. Amount still owing to suppliers at year-end: $6,200. Trade payables brought forward (opening balance): $4,500
• Rental Expenses: Rent expense for the year is given as $18,000. Rent accruals at year-end were $2,000, and rent owing at the beginning of the year is $1,200.
• Employee Costs: Salaries and wages expense: $28,400. Accrued salaries at year-end (unpaid): $3,100. Accrued salaries brought forward: $2,800
• Sales Revenue: Total sales revenue for the year: $92,500. The trade receivables at year-end and year beginning were given as $8,700 and $6,300, respectively.
• Income taxes: Income tax payable at year-end: $400. Income tax payable at the beginning of the year: $600

REQUIRED: Prepare the Cash flows from operating activities section of the Statement of Cash Flows for Asempa Ltd for the year ended 31 December 2024, using the Direct Method.

Suggested solution:

Hint: Calculate the cash payments and receipts carefully. You can use the T-account or statement approach - whichever works best for you. Just make sure you compute the figures yourself.

1. Compute the cash payments to suppliers

2. Compute cash paid for rent expenses

3. Compute cash payments for salaries

4. Compute cash received from suppliers

5. Compute income tax paid

Now prepare the cash flows from operating activities.

CASH FLOWS FROM OPERATING ACTIVITIES (Direct Method)

	$
Cash received from customers	90,100
Cash paid to suppliers	(44,100)
Cash paid for rent	(17,200)
Cash paid to employees	(28,100)
Cash generated from operations	700
Income tax paid	(200)
Net cash from operating activities	500

Indirect method

The indirect method starts with profit for the period and then adjusts it for:

• non-cash items
• changes in working capital
• items that belong in investing or financing activities

Format

	$
Profit before tax	X
Adjustments for:
Depreciation and amortization	X
Loss on disposal of assets	X
Gain on disposal of assets	(X)
Investment income	(X)
Finance costs	X
Changes in working capital:
Increase in inventory	(X)
Decrease in inventory	X
Increase in trade receivables	(X)
Decrease in trade receivables	X
Increase in trade payables	X
Decrease in trade payables	(X)
Cash generated from operations	X
Income taxes paid	(X)
Net cash from operating activities	X

Key adjustments explained:

1. Non-cash expenses (add back): Depreciation, amortization, and impairment losses reduce profit without using cash. These items are not actual cash outflows, but they were deducted when calculating profit. To move from accounting profit to operating cash flow, we add them back.
2. Non-cash income (deduct): Gains on asset disposal or revaluation increase profit without generating operating cash. These items are not operating cash inflows, but they were included in profit, so we deduct them when calculating operating cash flow.
3. Finance costs (add back): Interest expense reduces profit but is classified as a financing cash flow. It’s added back here and then shown separately under financing activities.
4. Investment income (deduct): Dividends or interest received increase profit but represent investing cash flows. They’re deducted here and then shown separately under investing activities.
5. Working capital changes: Movements in current assets and current liabilities affect cash differently than profit.

Illustration: indirect method

SBC Ltd income statement extracts are given as:

	$
Profit before tax	180,000
Income tax	38,000
Profit after tax	142,000

You have been given the following additional information. The items below were considered in the determination of profit before tax.

• Depreciation charge: $45,000
• Loss on disposal of equipment: $8,000
• Interest expense: $12,000
• Investment income: $5,000
• Income taxes paid during the year: £38,000

An analysis of the statement of financial position shows that:

• Inventory increased by £22,000
• Trade receivables increased by £31,000
• Trade payables decreased by £14,000

REQUIRED: Prepare the cash flows from operating activities section of the Statement of Cash Flows for the period, using the indirect method.

Suggested solution:

	$
Profit before tax	180,000
Adjustments for:
Depreciation charge	45,000
Loss on disposal of assets	8,000
Gain on disposal of assets
Investment income	(5,000)
Finance costs	12,000
	240,000
Changes in working capital:
Increase in inventory	(22,000)
Increase in trade receivables	(31,000)
Decrease in trade payables	(14,000)
Cash generated from operations	173,000
Income taxes paid	(38,000)
Net cash from operating activities	123,000