Operating cashflows

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

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

Watch out: 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 profit or loss (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

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 customers 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 expense for the year: $1,000. 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 customers

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	(1,200)
Net cash from operating activities	(500)

Indirect method

The indirect method starts with operating profit (IFRS 18 amended IAS 7 to make it the starting point) and then adjusts it for:

• non-cash items
• changes in working capital

Format

	$
Operating profit	X
Adjustments for:
Depreciation and amortisation	X
Loss on disposal of assets	X
Gain on disposal of assets	(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, amortisation, 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): A gain on disposal of a non-current asset increases profit, but the sale proceeds are an investing cash inflow, not an operating one, so the gain is deducted here. (A revaluation gain on a non-current asset is recognised in other comprehensive income under IAS 16, not in profit or loss, so it never needs this adjustment.)
3. Finance costs and investment income: operating profit is before both, so neither is adjusted here. Interest paid is shown under financing activities, and interest and dividends received under investing activities. A question that gives only profit before income taxes reaches operating profit first, by adding back finance costs and deducting investment income, as the illustration below shows.
4. Working capital changes: An increase in inventory or trade receivables ties up cash, so it’s deducted; a decrease frees up cash, so it’s added. An increase in trade payables means less cash was paid out, so it’s added; a decrease means more cash was paid out, so it’s deducted.

Illustration: indirect method

SBC Ltd statement of profit or loss extracts are given as:

	$
Profit before income taxes	180,000
Income tax expense	(38,000)
Profit for the year	142,000

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

• 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 income taxes	180,000
Add: finance costs	12,000
Less: investment income	(5,000)
Operating profit	187,000
Adjustments for:
Depreciation charge	45,000
Loss on disposal of assets	8,000
	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	135,000

The next chapter, Investing and financing cashflows, covers cash flows from investing and financing activities, completing the statement of cash flows.