Cash Flows from Operating Activities 

Operating activities are the principal revenue producing activities of the enterprise and other activities that are not investing or financing activities. These cash flows refer to cash generated from or used in the core business activities of the enterprise. The net cash flow from operating activities thus represents the cash surplus or deficit for the period that results from the items that normally make up the operating profit in the profit and loss account.

The cash flows from operating activities comprise:

• Cash receipts from sale of goods and rendering of services.

• Cash receipts from royalties, fees, commission and other revenue.

• Cash payments to suppliers of goods and services.

• Cash payment to and on behalf of employees.

• Cash receipts and cash payments of an insurance enterprise for premiums and claims, annuities and other policy benefits.

• Cash payments or refunds of income tax unless they can be specifically identified with financing and investing activities, and

• Cash receipts and payments relating to future contracts, forward contracts, option contracts and swap contracts when the contracts are held for dealing or trading purposes.

Some transactions, such as the sale of an item or plant, may give rise to a gain or loss which is included in the determination of net profit or loss. However, the cash flows relating to such transactions are cash flows from investing activities.

An enterprise may hold securities and loans for dealing or trading purposes, in which case they are similar to inventory acquired specifically for resale. Therefore, cash flows arising from the purchase and sale of dealing or trading securities are classified as operating activities. Similarly, cash advances and loans made by financial enterprises are usually classified as operating activities since they relate to the main revenue producing activity of that enterprise.

There are two methods of ascertaining cash flows from operating activities - Direct Method and Indirect Method.

Direct Method

Under this method, information about major classes of gross cash receipts and gross cash payments may be obtained from the accounting records to determine cash flows from operating activities. For example, information about cash received from debtors, payments to creditors, cash expenses, etc. may be obtained by an analysis of the cash book. In actual practice, the relevant information is obtained from the income statement by adjusting sales and expenses.

Indirect Method

In the direct method, all items in the profit and loss account are analyzed for their includibility or otherwise for cash from operations. However, in case of big corporations where the profit and loss accounts are very large, this becomes very tedious and amounts to duplication of work. Therefore, a more flexible and easier approach is to start with the net profit and add or subtract from it any non-current items that may be found in the income statement. Simply stated, where direct method is top-down, indirect method is bottom-up. Generally, in practice this method is adopted because it is simpler and less time consuming.

The indirect method arrives at net cash flow from operating activities by starting with reported net income and working backwards to arrive at the cash from operations.

This involves adjusting net profits for the effects of transactions which are non-cash in nature, any deferrals or accruals of past or future operating cash receipts or payments, and items of income or expense associated with investing or financing cash flows. The net cash flow from operating activities is determined by adjusting net profit or loss for:

1. Changes during the period in inventories and operating receivables and payables;

2. Non-cash items such as depreciation, provisions, deferred taxes and unrealized foreign exchange gains and losses; and

3. All other items for which the cash effects are investing or financing cash flows such as profit or loss from sale of fixed assets, discount or premium on issue of shares, etc.

Alternatively, the net cash flows from operating activities may be presented under the indirect method by showing the operating revenues and expenses excluding non-cash items disclosed in the statement of profit and loss and the changes during the period in inventories and operating receivables and payables.              

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