Every company that looks profitable on paper doesn’t always have cash in the bank. A firm can report a healthy net profit and still struggle to pay its suppliers or employees on time. This gap between “profit” and “cash” is exactly what the operating activities section of the cash flow statement is designed to expose. It tells you, in hard cash terms, how much money the core business actually generated during the year, stripped of accounting adjustments and one-off investment or financing decisions.
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What counts as an operating activity
Operating activities are the transactions tied to a company’s principal revenue-generating operations, essentially everything that shows up in the trading and profit and loss account. This includes cash received from customers for goods or services sold, and cash paid out for raw materials, wages, rent, and other day-to-day operating expenses. According to the Accounting Standard 3 issued by the Institute of Chartered Accountants of India, operating activities are the principal revenue-producing activities of an enterprise, along with other activities that don’t qualify as investing or financing.
This is deliberately a residual, catch-all category. If a cash flow doesn’t belong to investing (buying or selling long-term assets and investments) or financing (raising or repaying capital and borrowings), it belongs here. So dividends received on investments, loan proceeds, or payments to buy machinery never show up in this section, no matter how routine they feel to the business.
Why this number matters more than net profit
Net profit is calculated on an accrual basis. It includes credit sales that haven’t been collected yet, expenses that are due but unpaid, and non-cash charges like depreciation. Cash flow from operating activities converts all of that into a cash reality check. A business can show rising revenue and profit while its operating cash flow turns negative, usually because receivables are piling up or inventory is growing faster than sales. That mismatch is often the first warning sign analysts look for when assessing the quality of a company’s earnings.
The two ways to calculate it
Accounting standards allow companies to present this section in one of two formats: the indirect method or the direct method. Both methods must arrive at exactly the same final figure for cash flow from operating activities. The only thing that changes is how you get there, and how much detail the reader sees along the way.
The indirect method
The indirect method starts with net profit before tax and extraordinary items, taken straight from the profit and loss statement, and works backward to cash. The logic is simple: reverse out everything in net profit that didn’t involve an actual movement of cash, and account for the fact that some cash came in or went out that never touched the income statement at all.
This adjustment happens in three broad steps:
- Add back non-cash and non-operating expenses: Depreciation, amortisation, provisions, and losses on the sale of assets are added back because they reduced profit without reducing cash.
- Remove non-operating incomes: Items like interest income, dividend income, or profit on sale of fixed assets are subtracted out, since they belong under investing activities, not operating.
- Adjust for changes in working capital: An increase in inventory or receivables means cash is tied up, so it’s subtracted. An increase in payables or other current liabilities means the company held on to cash longer, so it’s added.
The result is called “cash generated from operations,” from which tax paid is deducted to arrive at the final net cash flow from operating activities. This approach, according to research from the Corporate Finance Institute, helps analysts assess the quality of earnings and understand why reported profit and actual cash generated can differ so significantly.
| Particulars | Amount (Rs.) |
|---|---|
| Net profit before tax | 1,00,000 |
| Add: Depreciation | 20,000 |
| Add: Loss on sale of machinery | 5,000 |
| Less: Interest income | (3,000) |
| Operating profit before working capital changes | 1,22,000 |
| Less: Increase in inventory | (10,000) |
| Less: Increase in trade receivables | (8,000) |
| Add: Increase in trade payables | 6,000 |
| Cash generated from operations | 1,10,000 |
| Less: Tax paid | (15,000) |
| Net cash flow from operating activities | 95,000 |
The direct method
The direct method skips the reconciliation entirely and instead lists the actual cash receipts and payments related to operations. It shows cash collected from customers, minus cash paid to suppliers, employees, and other operating expenses, before arriving at the same final number as the indirect method.
This method requires converting each line item of the profit and loss account into its cash equivalent, usually by adjusting for the corresponding change in the related balance sheet account. For instance, cash received from customers is calculated as revenue from operations, adjusted for the change in trade receivables during the period. As the direct method framework explains, each revenue and expense line is individually converted into a cash figure this way.
| Particulars | Amount (Rs.) |
|---|---|
| Cash received from customers | 4,50,000 |
| Cash paid to suppliers | (2,80,000) |
| Cash paid to employees | (60,000) |
| Cash paid for other operating expenses | (20,000) |
| Cash generated from operations | 90,000 |
| Less: Income tax paid | (15,000) |
| Net cash flow from operating activities | 75,000 |
Notice that this method never mentions depreciation or provisions. Since it only tracks actual cash movements, non-cash items simply never enter the calculation in the first place.
Indirect vs direct: which is used more often
On paper, the direct method has an obvious advantage: it shows exactly where operating cash came from and where it went, which is more useful information for a reader trying to understand a business’s cash-generating ability. Yet in practice, almost every company prefers the indirect method, largely because it’s far easier to prepare directly from existing profit and loss and balance sheet figures, without needing to track individual cash transactions separately.
| Aspect | Indirect method | Direct method |
|---|---|---|
| Starting point | Net profit before tax | Individual cash receipts and payments |
| Ease of preparation | Easier, uses existing financial statements | Harder, needs cash-basis tracking of each item |
| Transparency | Reconciles profit to cash | Shows gross cash inflows and outflows directly |
| Popularity | Used by most companies | Rarely used in practice |
What the rules say in India
Accounting Standard 3 permits companies to use either method for cash flow from operating activities, but this choice isn’t unlimited. For listed companies, the erstwhile listing agreement requirements effectively made the indirect method compulsory, since unlisted companies retain the freedom to choose between the two. Under the Companies Act, 2013, a cash flow statement is a mandatory part of the financial statements for most companies, with specific exemptions carved out for One Person Companies, Small Companies, and Dormant Companies. A small company, for this purpose, is currently defined by paid-up capital and turnover thresholds that the Ministry of Corporate Affairs periodically revises, along with a separate carve-out for private start-up companies.
Common mistakes students make
A few errors show up repeatedly in exam answers and practical work alike. Students often forget that interest and dividend income received should be excluded from operating activities and moved to investing activities, since these arise from investments rather than core operations. Another frequent slip is treating an increase in a current asset as a cash inflow instead of an outflow, when the opposite is true: more inventory or receivables means more cash locked up, not released. Finally, many forget to deduct tax paid separately at the end of the indirect method calculation, even though it’s a genuine cash outflow tied to operations.
Putting it together
Cash flow from operating activities is the section of the cash flow statement that answers the most practical question a stakeholder can ask: is this business’s core operation actually generating cash, or just accounting profit? Whether prepared using the indirect method’s reconciliation approach or the direct method’s transaction-by-transaction listing, the final figure should be identical. What differs is the story each method tells along the way, and for Indian companies, regulation has largely settled that debate in favour of the indirect method for listed entities, while leaving the choice open for everyone else.
What do you think? If you were analysing two companies with identical net profit but very different operating cash flows, which one would you trust more as an investor, and why? Would you ever choose the direct method over the indirect method if you had a free choice as an accountant preparing the statement?
References
- https://www.icai.org/asb.html?a=106
- https://corporatefinanceinstitute.com/resources/accounting/indirect-method/
- https://biz.libretexts.org/Bookshelves/Accounting/Accounting_in_the_Finance_World/17:_In_a_Set_of_Financial_Statements_What_Information_Is_Conveyed_by_the_Statement_of_Cash_Flows/17.02:_Cash_Flows_from_Operating_Activities-_The_Direct_Method
- https://taxguru.in/company-law/cash-flow-statement-mandatory-companies-act-2013.html
- https://cleartax.in/s/as-3-cash-flow-statements
- https://assets.kpmg.com/content/dam/kpmg/in/pdf/2017/06/FirstNotes-MCA-issues-relaxations-Companies-Act-2013.pdf
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