Cash Flow Statement

The full picture

You already know that a Profit and Loss Account is prepared on an accrual basis: revenue is recorded when it is earned and expenses when they are incurred, regardless of when cash actually moves. A Cash Flow Statement works differently — it records only actual cash receipts and payments. This is the critical distinction. A textile wholesaler in Thrissur can show a healthy net profit of ₹8 lakh for the year while simultaneously struggling to pay salaries because most of that profit sits in unpaid invoices from retailers. The P&L calls it profit; the cash flow statement calls it what it is — cash not yet received.

Every Cash Flow Statement is divided into three sections. Operating Activities capture cash from the business's core work: cash collected from customers, cash paid to suppliers and employees, income tax paid, and so on. This section tells you whether the day-to-day business earns real cash. Investing Activities record cash spent on or received from long-term assets — buying machinery, constructing a godown, selling old equipment, or buying and selling investments. Financing Activities cover how the business raises or returns money to its owners and lenders: issuing shares, taking bank loans, repaying loans, and paying dividends. These three sections together explain the full journey of every rupee.

In India, Cash Flow Statements are prepared under Accounting Standard AS-3 (revised), issued by the Institute of Chartered Accountants of India. AS-3 permits two methods for calculating cash from Operating Activities: the Direct Method and the Indirect Method. The Direct Method lists actual cash receipts from customers and actual cash payments to suppliers, employees, and others. The Indirect Method — more commonly tested in board exams — starts with the net profit from the Statement of Profit and Loss and then makes adjustments to convert it to a cash basis. Both methods give the same final cash figure for operating activities; only the presentation differs.

Under the Indirect Method, the starting point is net profit (or net profit before tax, depending on the format). You then add back non-cash expenses — the most important being depreciation. Depreciation reduces profit, but no money actually leaves the business when you record it; the cash already left the business when the asset was originally purchased. So you add it back. Similarly, you reverse any non-operating gains or losses (like profit on sale of machinery) because those belong in the Investing Activities section, not here. After those adjustments, you account for changes in working capital. If your debtors (customers who owe you money) increased during the year, you collected less cash than your revenue suggests — subtract the increase. If your creditors (suppliers you owe) increased, you held on to more cash than your expenses suggest — add the increase. The rule is simple: increases in current assets reduce operating cash flow; increases in current liabilities increase operating cash flow.

Once you have Cash from Operating Activities, you list Cash from Investing Activities (machinery bought or sold, investments purchased, etc.) and Cash from Financing Activities (loans taken or repaid, shares issued, dividends paid). Add all three totals together. This net change in cash, added to the opening cash balance, must equal the closing cash balance on the Balance Sheet. That reconciliation is your proof that the statement is correct — and examiners check it every time.

An Indian example

Meera runs a stationery shop in Kozhikode. In the financial year 2024-25 her Profit and Loss Account shows a net profit of ₹2,40,000. She also charged depreciation of ₹30,000 on her shelves and display racks. During the year, her debtors (mostly schools she supplies on credit) increased by ₹50,000, and she bought ₹20,000 extra stock that is still unsold. But she negotiated better credit terms with her distributor, so her creditors increased by ₹35,000. Her operating cash flow works out like this: ₹2,40,000 profit + ₹30,000 depreciation added back − ₹50,000 debtor increase − ₹20,000 inventory increase + ₹35,000 creditor increase = ₹2,35,000. She also spent ₹80,000 on a new billing computer (investing outflow) and repaid ₹40,000 of a bank loan (financing outflow). Her net cash change is ₹2,35,000 − ₹80,000 − ₹40,000 = ₹1,15,000. You can verify this: if her opening cash was ₹85,000, her closing cash should be ₹2,00,000 — and that is exactly what her year-end balance sheet shows.

Common misconceptions to watch for

• A profitable company always has positive cash flow. Wrong — a company can be very profitable yet cash-poor. If Meera's school customers all delay payment, her debtors balloon, her profit is real but her cash is locked up. Profit is an accrual concept; cash flow is a timing concept. They diverge whenever sales are on credit or when large non-cash charges (like depreciation) exist.
• When creditors (payables) increase, it means the company is in financial trouble. The opposite is true. An increase in creditors means the company successfully delayed cash payments to suppliers, so it has more cash on hand right now — this is added to operating cash flow. It only signals trouble if the company cannot pay when the credit period expires.
• Depreciation is added back to profit because it is a 'profit' that was hidden. No — depreciation is added back because it was subtracted from profit without any cash leaving the business. The cash was spent when the asset was originally purchased; depreciation is just how that original cost is spread over time in the P&L. Adding it back simply removes that non-cash deduction so the profit figure accurately reflects cash earned.