Competitive Exams: Management Accounting (Part 3 of 3)

The indirect method for calculating cash flow statement

Indirect method

Cash flow statement

Cash flow from operating activity + B-Cash flow from investing activity + C-cash flow from financing activity + opening balance of cash book = Closing balance of cash book A-category regarding cash flow from operating activity is different from direct method, other part is as same as direct method

According to indirect method when we calculate cash flow statement, we will care 8 points. The main aim is to calculate cash net profit or loss for operating activity like sale and purchase of goods. Now I am explaining all 8 points deeply 1st point

Taking the net profit as per profit and loss account. This is ( + ) item. This is the base for calculating cash net profit. Other 7 points are the just games of ( + ) and (-)

2nd point

Now we add all non cash and non operating expenses and losses in Ist point.

I want to tell you why we will ( + ) it in net profit. The answer is that because when we made of profit and loss account we had deducted these non cash and non operating expenses in our profit and loss account. Now our duty is to add them.

Now I am telling about these expenses and losses

  1. Depreciation

  2. Preliminary expenses written off

  3. Discount on issue of shares and deb. w/o

  4. Goodwill written off

  5. Patent and trade marks written off

  6. Interest on borrowing and deb.

  7. Loss on sale of fixed assets

Net Profit

One more question you can ask to me

Why non operating expenses are added in net profit?

Ans. Because it is true that these expenses in cash but we deems as cash outflow from financing activity or investing activity so there is no need to adjust in operation.

3rd Point

After adding 2nd point items, we must deduct 3rd point items. It means that all non cash or non operating income must be deducted from net profit for calculating cash net profit. In this, we can include

  1. Dividend income (For non financial co.)

  2. Rental income

  3. Profit on sale of fixed asset

4th point

= Ist point + 2nd point 3rd point

5th point

Now we add decrease in current assets because it must increase the cash inflow and also add increase in current


  1. Decrease in stock

  2. Decrease in debtors

  3. Decrease in accrued income

  4. Decrease in prepaid expenses

  5. Increase in creditors

  6. Increase in bill payables

  7. increase in outstanding expenses

  8. Increase in advance income

  9. Increase in provision for doubtful debts

6th point

Increase in current assets and decrease in current liabilities must be deducted

  1. Increase in stock

  2. Increase in debtors

  3. increase in accrued incomes

  4. increase in prepaid expenses

  5. decrease in creditors

  6. Decrease in bill payables

  7. decrease in outstanding expenses

  8. decrease in advance incomes

  9. Decrease in provision for d/d

General hint

  • Increase in current assets means cash outflow so deduct
  • Decrease in current liabilities is also cash outflow so deduct
  • Decrease in current assets means cash inflow so add
  • Increase in current liabilities is also cash inflow so add

7th point

Total cash flow from operating activity

= 4th point + 5th point 6th point

8th point

Deduct income tax paid from 7th point

After this you can get net cash flow from operating activity

All other B and C category as same as first method.

Definition of Securitisation

Securitisation is the process of getting cash on the basis of different security notes and papers. Even some company issues shares or debenture for getting fixed assets, this is also securitisation. In simple english securitisation create the relationship of company with outer world in which company gets fund for doing work.

Benefit of Securitisation

  1. Increase the rate of return

  2. Raise of fund or finance through securitisation when other source are not supported.

  3. I take one example explaining the third benefit suppose a person want to purchase a building for giving it rent, if he purchases with his cash then all risk of fund is his own. But if he takes loan to make building then he becomes issuer of finance so from earning of building, he can pay the debt of building.

Factors to provide Loans

1st Financial factors

  1. Rate of Return: It is the duty of account manager to find the rate of return. Select all those party which want to give us high rate on our investment in the form of loan.

  2. Risk Factor: Before giving credit to company, we also see our risk factor.

    1. personal risk-dishonesty, corruption

    2. trade risk see previous profit and loss account

    3. Debt equity ratio

    4. Income interest ratio

  3. Security: Before giving credit or loan account manager have to see what asset of business, businessman want to give as security for getting loan.

  4. Marginal of requirement: Before giving loan or credit, it is the duty of bank's account manager under govt. Policies that he must see difference between security and loan Suppose Security $10000 Loan $8000 = Marginal requirement $2000 If our providing loan is less than the value of asset which we have received in the form of security, then this is good.

2nd Non-financial factors

  1. Social factors: Through social responsibility accounting, account manager is also check, whether providing of loan at low rate is benefited for social popularity or not.

  2. Political factors: Account manager also check political and tax policies regarding providing of loan.

How to prepare Fund Flow statement

Before preparing of fund flow statement, you must know different accounting terms in fund flow statement.

Academic need to learn the fund flow statement

  1. AS 3 units 1: Accounting standard 3 units 1 of Institute of Chartered Accountant of India explains preparation and presentation of statement of changes in financial position or fund flow statement

  2. CBSE UGC NET Commerce: If you want to clear CBSE UGC NET in commerce subject, you should also learn fund flow statement. Because it includes in paper II and paper III A syllabus in the form of fund flow analysis.

  3. Graduate/Post Graduate Classes: Fund flow statement is full subject in BCom, BBA, BCA and MCom, MBA, MCA classes. For succeeding in these classes, you should know the whole system of fund flow statement.

  4. Helpful in Practical business environment: Fund flow statement is very helpful for solving following practical problems of business Why are current assets are decreasing, even there are high profit?

Other Important POints

  1. Why did Company not issue dividend, even company has obtained profit?

  2. What happened with net profit, where did it go?

  3. What did Company do with the fund received from selling of shares and debentures? What are main sources of company to repay his debts? So, above questions'answer can be given after making fund flow statements.

Definition of Fund

Fund means working capital. If current assets of company is more than current liability of business, it is called working capital and working capital's other name is Fund.

Fund = Working capital = Current assets Current liability

Definition of Flow of Fund

Flow of fund means movement of fund. I take the example of air; we can feel its movement or flow of air. Same thing is happen with fund, due to the activity of business fund is transfer from one asset to another assets. If fixed assets are converted into current asset or fixed liability is converted into current liabilities, these are the flow of fund. But if current assets are changed with current assets or current assets are changed into current liabilities, then, there is no flow of fund because there is no change working capital. Suppose, we get the money from debtor, this is not flow of fund because, working capital is not changed. Both items of current assets and when current assets change into current assets, there will not be change in working capital.

Flow of Fund = Fixed asset changes into current asset or current asset changes into fixed assets


Fixed liability changes into current liability or current liability changes into fixed liability.

Definition of fund flow statement

Fund flow statement is a statement which shows the inflow and out flow of funds between two dates of balance sheet. So, it is known as the statement of changes in financial position. We all know that balance sheet shows our financial position and inflow and outflow of fund affects it. So, in company level business, it is very necessary to prepare fund flow statement to know what the sources are and what are applications of fund between two dates of balance sheet.

Generally, it is prepare after getting two year balance sheet.

According to Prof. Anthony, The funds flow statement describes the sources from which additional funds were derived and the use of which these funds were put.

Fund flow statements are known with different names

Statement of source and uses of funds Or summary of financial operations Movement of working capital statement Or Fund received and distributed statement Or Fund generated and expended statement.

Steps for making Fund flow statement

First Step

Making of statement of Changes of Working Capital

For making of fund flow statement. It is very necessary to make statement of changes of working capital. Because net increase in working capital is use of fund and net decrease in working capital is source of fund. So, it is duty of accountant to make statement of changes of working capital. Making of statement of changes working capital is very easy and simple.

We take two balance sheets, one is current year balance sheet and other is previous year balance sheet. Then we separate current assets and current liabilities.

If current assets are more than previous year current assets, it means increase in working capital. If current assets are less than previous year current assets, it means decrease in working capital. Because, relationship between current assets and working capital is positive and if any changes in current assets, working capital will change in same direction.

If current liabilities are more than previous year current liabilities, it means decrease in working capital.

If current liabilities are less than previous year current liabilities, it means increase in working capital.

Relationship between working capital and current liabilities are inverse

Statement or schedule of changes in working capital
Current Assets
  • Cash in hand

  • Bills receivable

  • Sundry debtors

  • Temporary investments

  • Stocks/inventories

  • Prepaid expenses

  • Accrued incomes

  • Total current assets? xxxx? xxxxx?

Current liabilities
  • Bills payables

  • Sundry creditors

  • Bank overdraft

  • Short term advances

  • Dividends payables

  • Provision for taxation

  • Total current Liabilities? xxxx? xxxx?

  • Working capital CA-CL

  • Net increase or decrease in working capital = Increase in working capital Decrease in working capital

2nd Step: Statement showing the fund from operation

Because is the source of fund and will show in fund flow statement's source side. So before making fund flow statement, we must make statement showing the fund from operation. Operation means business activity and fund from operation means profit from business activity. So, you will easy understand that profit from business activity between two accounting period must be the source of fund.

Statement of fund from operations

Closing balance of profit and loss account or retained earning as

Given in the Balance sheet

Add non fund and non operating items which have been already

Debited to profit and loss account

  1. depreciation

  2. amortization of fictitious and intangible assets

    1. goodwill

    2. patents

    3. trade marks

    4. preliminary expenses

    5. discount on issue of shares

  3. Appropriation of retained earning such as

    1. Transfer to general reserve

    2. Dividend equalization fund

    3. Transfer to sinking fund

    4. Contingency reserve etc.

  4. Loss on sale of any non current or fixed assets such as

    1. Loss on sale of land and building

    2. Loss on sale of machinery

    3. Loss on sale of furniture

    4. Loss on sale of long term investments

  5. Dividends including

    1. Interim dividend

    2. Proposed dividend

    (If it is an appropriation of profit and not taken as current liability)

  6. Provision for taxation (if it is not taken as current liability)

  7. Any other non fund/non operating items which have been debited to P/L account

Less Non Fund or non operating items which have already been credited to profit and loss account

  1. Profit or gain from the sale of non current/fixed assets such as

    1. Profit on sale of land and building

    2. Profit on sale of plant and machinery

    3. Profit on sale of long term investment etc.

  2. Appreciation in the value of fixed assets such as increase in the value of land if it has been credited to profit and loss account

  3. Dividends received

  4. excess provision retransferred to profit and loss account or written back.

  5. any other non operating item which has been credited to profit and loss account

  6. opening balance of profit and loss account or retained earnings as given in the balance sheet Funds received from operation or business activities = total (A) Total (B) You can make also above statement in t shape adjusted profit and loss account form.

Step 3: Fund flow statement

Source of funds

  1. fund from operation (balance of second step)

  2. issue of shares capital

  3. issue of debentures

  4. raising of long term loans

  5. receipts from partly paid shares, called up

  6. amount received from sales of non current or fixed assets

  7. non trading receipts such as dividend received

  8. sale of investments (Long term)

  9. decrease in working capital as per schedule of changes in working capital

Applications or uses of funds

  1. Funds lost in operations (Balance negative in second step)

  2. redemption of preference share capital

  3. redemption of debentures

  4. repayment of long term loans

  5. purchase of long term loans

  6. purchase of long term investments

  7. non trading payments

  8. payment of tax

  9. payment of dividends

  10. increase in working capital (As per positive balance of 1st step)