Cash Flow Statement by Indirect Method

Cash Flow Statement by indirect method becomes easier when you stop treating it like a list of adjustments to memorise.

Think of it as a translation.

Profit is written in the language of accrual accounting. It includes credit sales, outstanding expenses, depreciation, provisions, gains, losses, and several items where cash may not have moved yet.

A cash flow statement asks a simpler question:

Where did cash actually come from, and where did it actually go?

The indirect method starts with profit and slowly cleans it until it becomes cash from operating activities.

Once this idea is clear, the format stops feeling random. Every adjustment has a reason.

This guide will help you understand the indirect method step by step, with the format, logic, solved example, and common mistakes.

What A Cash Flow Statement Shows

A cash flow statement explains the movement of cash and cash equivalents during a period.

It does not show profit only. It shows cash movement.

That is why a business can earn profit and still face a cash shortage. It may have sold goods on credit, built up inventory, paid old liabilities, or spent money on machinery.

The statement divides cash movement into three activities:

Activity	Simple meaning	Examples
Operating activities	Cash from the main business work	cash from customers, payment to suppliers, salaries, taxes
Investing activities	Cash from buying or selling long-term assets and investments	purchase of machinery, sale of building, purchase of investments
Financing activities	Cash from owners and borrowings	issue of shares, loans taken, debentures issued, loan repaid, dividend paid

For most Class 12 questions, the indirect method is used mainly for calculating cash flow from operating activities. Investing and financing activities are then shown separately.

Why The Indirect Method Starts With Profit

The Profit and Loss Account is prepared on the accrual basis.

This means income and expenses are recorded when they are earned or incurred, not only when cash is received or paid.

For example:

• credit sales increase profit, but cash may not be received yet
• depreciation reduces profit, but no cash is paid for depreciation during the year
• profit on sale of machinery increases profit, but the cash from selling machinery belongs to investing activity
• interest on loan reduces profit, but it is connected with financing activity in many school-level company questions

So profit is useful, but it is not the same as cash from operations.

The indirect method begins with profit because profit already summarises business performance. Then we adjust it to reach the real cash generated from operations.

That difference is the heart of the chapter.

The Basic Format Of Indirect Method

Here is the clean format for cash flow from operating activities by indirect method.

Cash Flow from Operating Activities

Net profit before tax and extraordinary items                       xxx

Add: Non-cash and non-operating expenses                            xxx
Less: Non-operating incomes                                         xxx

Operating profit before working capital changes                     xxx

Add: Decrease in current assets                                     xxx
Add: Increase in current liabilities                                xxx
Less: Increase in current assets                                    xxx
Less: Decrease in current liabilities                               xxx

Cash generated from operations                                      xxx
Less: Income tax paid                                               xxx

Net cash from operating activities                                  xxx

This is the main structure.

Different textbooks and teachers may arrange a few lines slightly differently, but the logic remains the same:

1. start with profit
2. adjust non-cash items
3. remove investing and financing effects
4. adjust working capital
5. deduct tax paid

Step 1: Choose The Correct Starting Profit

Many mistakes begin with the first line.

The usual starting point is:

Net profit before tax and extraordinary items

But questions may give information in different ways.

If the question gives	What you may need to do
Net profit before tax	Use it directly
Net profit after tax	Add back tax expense if required
Balance of Statement of Profit and Loss	Prepare a working note to find profit
Profit after appropriations	Add back appropriations like transfer to reserve, dividend, or proposed dividend if required by the question

Do not rush this step.

If the question gives a ready profit figure, read the wording carefully. If it gives opening and closing profit balance, you may have to reconstruct profit through a small working note.

Step 2: Add Back Non-Cash Expenses

Non-cash expenses reduce accounting profit, but they do not reduce cash during the year.

So they are added back.

Common non-cash expenses include:

Item	Treatment in operating activities
Depreciation	Add back
Goodwill written off	Add back
Amortisation of intangible assets	Add back
Provision for doubtful debts, if charged to profit	Add back
Loss due to writing off an asset	Add back if it reduced profit and no cash moved

The most common example is depreciation.

Suppose profit before tax is Rs. 80,000 and depreciation is Rs. 12,000.

Depreciation reduced profit, but the business did not pay Rs. 12,000 in cash for depreciation during the year.

So:

Profit before tax                    Rs. 80,000
Add: Depreciation                    Rs. 12,000
Adjusted amount                      Rs. 92,000

This does not mean depreciation is income.

It only means we are reversing a non-cash deduction from profit.

Step 3: Remove Non-Operating Incomes And Expenses

Operating activities should show cash from the main business work.

But profit may include items that belong to investing or financing activities.

The indirect method removes their effect from operating activities so they can be shown in the correct section.

Non-Operating Expenses And Losses

If a non-operating expense or loss has reduced profit, add it back while calculating cash from operations.

Examples:

Item	Why add back?
Loss on sale of machinery	The sale of machinery belongs to investing activity
Interest on borrowings	Often treated as financing activity for non-financial companies
Discount on issue of debentures written off	Connected with financing
Preliminary expenses written off	Not a normal operating cash payment for the current year

For example, if loss on sale of furniture is Rs. 5,000, profit has already been reduced by Rs. 5,000. But the sale of furniture is an investing activity, not an operating activity.

So we add back the loss while finding operating cash flow.

Non-Operating Incomes And Gains

If a non-operating income or gain has increased profit, deduct it while calculating cash from operations.

Examples:

Item	Why deduct?
Profit on sale of machinery	The cash from sale belongs to investing activity
Interest received	Usually investing activity for non-financial companies
Dividend received	Usually investing activity for non-financial companies
Rent received from an investment property, if treated separately in the question	Not part of the main operating calculation

For example, if profit on sale of machinery is Rs. 8,000, profit has already increased by Rs. 8,000. But the cash from selling machinery belongs to investing activity.

So we deduct the profit while finding operating cash flow.

Step 4: Find Operating Profit Before Working Capital Changes

After adjusting non-cash and non-operating items, you reach:

Operating profit before working capital changes

This is not the final cash from operations yet.

Why?

Because profit may still include credit sales, credit purchases, outstanding expenses, prepaid expenses, and inventory changes.

These are working capital items.

Working capital adjustments convert the operating profit figure into actual operating cash movement.

Step 5: Adjust Current Assets And Current Liabilities

This is the part students usually fear most.

But the rule is simple when you understand the cash logic.

Current Assets Rule

Change in current asset	Treatment	Why
Increase in current asset	Deduct	Cash is blocked or not yet received
Decrease in current asset	Add	Cash is released or received

Examples of current assets:

• inventory
• trade receivables
• bills receivable
• prepaid expenses
• accrued income
• other current assets connected with operations

If trade receivables increase, it usually means more credit sales are still unpaid. Profit may have increased, but cash has not come in yet. So the increase is deducted.

If inventory decreases, it may mean goods have been sold or stock has been converted into cash flow. So the decrease is added.

Current Liabilities Rule

Change in current liability	Treatment	Why
Increase in current liability	Add	Cash payment has been delayed
Decrease in current liability	Deduct	Cash has been paid

Examples of current liabilities:

• trade payables
• bills payable
• outstanding expenses
• income received in advance
• other operating current liabilities

If trade payables increase, the business has bought or used goods but has not paid all suppliers yet. That saves cash for now, so it is added.

If outstanding salary decreases, it usually means old dues have been paid. That uses cash, so it is deducted.

A Simple Way To Remember Working Capital Adjustments

Use the “cash stuck, cash saved” idea.

When a current asset increases, cash is stuck in that asset.

Examples:

• more inventory means cash is tied up in stock
• more receivables means cash has not been collected yet
• more prepaid expense means cash has been paid early

So current asset increases are deducted.

When a current liability increases, cash is saved for now.

Examples:

• more trade payables means suppliers have not been paid yet
• more outstanding expenses means payment is pending
• more income received in advance means cash came before income was earned

So current liability increases are added.

This one idea makes the adjustment table much easier to remember.

Step 6: Deduct Income Tax Paid

After working capital adjustments, you get:

Cash generated from operations

Then deduct income tax paid, unless the question clearly gives a different treatment.

The result is:

Net cash from operating activities

Sometimes tax paid is given directly.

Sometimes you must calculate it using Provision for Tax.

A common working note looks like this:

Provision for Tax Account

Opening provision for tax
Add: Tax provided during the year
Less: Closing provision for tax
= Tax paid during the year

In a simple question, if tax paid is directly given, use the given amount.

Step 7: Complete Investing And Financing Activities

After operating activities, prepare investing and financing activities separately.

Investing Activities

Investing activities usually include cash flows from long-term assets and investments.

Common items:

Cash inflow	Cash outflow
Sale of machinery	Purchase of machinery
Sale of building	Purchase of building
Sale of investments	Purchase of investments
Interest received, in many non-financial company questions	Loans or advances given, if applicable
Dividend received, in many non-financial company questions	Purchase of long-term assets

Financing Activities

Financing activities usually include cash flows from capital and borrowings.

Common items:

Cash inflow	Cash outflow
Issue of shares	Redemption of preference shares
Issue of debentures	Redemption of debentures
Loan taken	Loan repaid
Increase in long-term borrowings	Interest paid, in many non-financial company questions
	Dividend paid

Then combine the three sections:

Net cash from operating activities       xxx
Net cash from investing activities       xxx
Net cash from financing activities       xxx

Net increase or decrease in cash and cash equivalents
Add: Opening cash and cash equivalents
Closing cash and cash equivalents

This closing figure should match the cash and cash equivalents shown at the end of the period.

Full Format Of Cash Flow Statement By Indirect Method

Here is a simple full format you can practise.

Cash Flow Statement
for the year ended ............

A. Cash Flow from Operating Activities

Net profit before tax and extraordinary items                       xxx
Add: Depreciation                                                   xxx
Add: Goodwill written off                                           xxx
Add: Loss on sale of fixed asset                                    xxx
Add: Interest expense                                               xxx
Less: Profit on sale of fixed asset                                (xxx)
Less: Interest income                                              (xxx)
Less: Dividend income                                              (xxx)

Operating profit before working capital changes                     xxx

Less: Increase in inventory                                        (xxx)
Add: Decrease in inventory                                          xxx
Less: Increase in trade receivables                                (xxx)
Add: Decrease in trade receivables                                  xxx
Add: Increase in trade payables                                     xxx
Less: Decrease in trade payables                                   (xxx)
Add or less: Other operating current asset and liability changes     xxx

Cash generated from operations                                      xxx
Less: Income tax paid                                              (xxx)

Net cash from operating activities                                  xxx

B. Cash Flow from Investing Activities

Purchase of fixed assets                                           (xxx)
Sale of fixed assets                                                xxx
Purchase of investments                                            (xxx)
Sale of investments                                                 xxx
Interest received                                                   xxx
Dividend received                                                   xxx

Net cash from investing activities                                  xxx

C. Cash Flow from Financing Activities

Issue of shares                                                     xxx
Issue of debentures                                                 xxx
Loan taken                                                          xxx
Repayment of loan                                                  (xxx)
Interest paid                                                      (xxx)
Dividend paid                                                      (xxx)

Net cash from financing activities                                  xxx

Net increase or decrease in cash and cash equivalents               xxx
Add: Cash and cash equivalents at the beginning                     xxx
Cash and cash equivalents at the end                                xxx

Do not memorise this as a dead format. Read each line as a question:

• Did this affect profit but not cash?
• Did this belong to investing or financing instead of operations?
• Did this block cash in a current asset?
• Did this save cash through a current liability?
• Did actual cash move?

Solved Example: Indirect Method Step By Step

Let us take a compact example.

Balance sheet extracts:

Particulars	31 March 2025	31 March 2026
Inventory	Rs. 50,000	Rs. 65,000
Trade receivables	Rs. 40,000	Rs. 34,000
Trade payables	Rs. 30,000	Rs. 46,000
Outstanding expenses	Rs. 8,000	Rs. 5,000

Additional information:

• Net profit before tax: Rs. 1,20,000
• Depreciation: Rs. 18,000
• Profit on sale of machinery: Rs. 6,000
• Interest on loan: Rs. 10,000
• Income tax paid: Rs. 22,000

Prepare cash flow from operating activities by indirect method.

Step 1: Start With Net Profit Before Tax

Net profit before tax                         Rs. 1,20,000

Step 2: Add Back Non-Cash And Non-Operating Expenses

Depreciation is non-cash, so add it back.

Interest on loan is treated as financing in many non-financial company questions, so add it back while calculating operating activities.

Net profit before tax                         Rs. 1,20,000
Add: Depreciation                             Rs. 18,000
Add: Interest on loan                         Rs. 10,000

Step 3: Deduct Non-Operating Income

Profit on sale of machinery belongs to investing activity, so deduct it.

Less: Profit on sale of machinery             Rs. 6,000

Now calculate:

Operating profit before working capital changes
= 1,20,000 + 18,000 + 10,000 - 6,000
= Rs. 1,42,000

Step 4: Adjust Working Capital

Item	Change	Treatment
Inventory	Increased by Rs. 15,000	Deduct
Trade receivables	Decreased by Rs. 6,000	Add
Trade payables	Increased by Rs. 16,000	Add
Outstanding expenses	Decreased by Rs. 3,000	Deduct

Now write the operating activities section.

Cash Flow from Operating Activities

Net profit before tax                                      Rs. 1,20,000
Add: Depreciation                                          Rs. 18,000
Add: Interest on loan                                      Rs. 10,000
Less: Profit on sale of machinery                         (Rs. 6,000)

Operating profit before working capital changes            Rs. 1,42,000

Less: Increase in inventory                               (Rs. 15,000)
Add: Decrease in trade receivables                         Rs. 6,000
Add: Increase in trade payables                            Rs. 16,000
Less: Decrease in outstanding expenses                    (Rs. 3,000)

Cash generated from operations                             Rs. 1,46,000
Less: Income tax paid                                     (Rs. 22,000)

Net cash from operating activities                         Rs. 1,24,000

Notice what happened.

The business had profit before tax of Rs. 1,20,000, but net cash from operating activities became Rs. 1,24,000 after all adjustments.

That is exactly why cash flow statement is useful. It shows that profit and cash are connected, but not identical.

Common Adjustments And Their Treatment

Here is a quick treatment table.

Item	Operating activity treatment under indirect method
Depreciation	Add back
Goodwill written off	Add back
Loss on sale of fixed asset	Add back
Profit on sale of fixed asset	Deduct
Interest paid	Add back first if included in profit, then show as financing outflow in many non-financial company questions
Interest received	Deduct first if included in profit, then show as investing inflow in many non-financial company questions
Dividend received	Deduct first if included in profit, then show as investing inflow in many non-financial company questions
Increase in inventory	Deduct
Decrease in inventory	Add
Increase in trade receivables	Deduct
Decrease in trade receivables	Add
Increase in trade payables	Add
Decrease in trade payables	Deduct
Income tax paid	Deduct after cash generated from operations

The Three Most Important Working Notes

Cash flow questions often become easier when you prepare working notes before the final statement.

1. Provision For Tax

Use this when tax paid is not given directly.

Opening provision for tax
Add: Tax provided during the year
Less: Closing provision for tax
= Tax paid during the year

If the question gives tax paid directly, do not overcomplicate it.

2. Fixed Asset Account

Use this when you need to find purchase or sale of fixed assets.

Opening balance of fixed asset
Add: Purchases during the year
Less: Sale or disposal at book value
Less: Depreciation, if shown in the same account
= Closing balance of fixed asset

Depending on how the question gives accumulated depreciation, the working note may change. Read whether the asset is shown at gross value or written down value.

3. Loan Or Debenture Account

Use this when you need to find borrowing raised or repaid.

Opening loan or debenture balance
Add: Amount raised during the year
Less: Amount repaid during the year
= Closing loan or debenture balance

This helps you place the correct cash flow under financing activities.

Mistakes To Avoid In Indirect Method

Mistake 1: Adding Increase In Current Assets

An increase in a current asset is deducted, not added.

If receivables increase, cash has not yet been collected. If inventory increases, cash is tied up in stock.

Mistake 2: Deducting Increase In Current Liabilities

An increase in a current liability is added.

If trade payables increase, the business has delayed payment. That saves cash for now.

Mistake 3: Showing Profit On Sale Of Asset In Operating Activities

Profit on sale of asset is deducted from operating activities. The actual sale proceeds are shown under investing activities.

Do not write the profit amount as investing inflow. Investing activity needs actual cash received from sale, not only the profit.

Mistake 4: Forgetting To Add Back Depreciation

Depreciation is one of the most common adjustments.

It reduces profit, but it does not reduce cash during the year. Add it back.

Mistake 5: Mixing Up Interest Treatment

For many non-financial company questions, interest paid is shown as financing activity and interest received is shown as investing activity.

But always read the question. If a question gives a specific instruction, follow it.

Mistake 6: Treating Every Current Liability As Operating

Not every liability should enter working capital adjustments.

Trade payables and outstanding operating expenses usually belong to working capital. But items like bank loan, debentures, dividend payable, and proposed dividend need separate thinking.

A Practical Order For Solving Questions

Use this order while practising:

1. Read the full question once without writing anything.
2. Mark the starting profit figure.
3. List non-cash items.
4. List non-operating incomes and expenses.
5. Compare current assets and current liabilities.
6. Prepare tax working note if needed.
7. Prepare fixed asset or investment working notes if needed.
8. Prepare loan, debenture, share capital, and dividend working notes if needed.
9. Write operating activities first.
10. Write investing and financing activities.
11. Reconcile opening and closing cash and cash equivalents.

This order keeps the answer organised.

How To Check Your Final Answer

Before you stop, check these points:

• Have you started with the correct profit figure?
• Have you added back depreciation and other non-cash expenses?
• Have you removed profit or loss on sale of fixed assets from operating activities?
• Have you adjusted current assets in the correct direction?
• Have you adjusted current liabilities in the correct direction?
• Have you deducted income tax paid?
• Have you shown purchase and sale of fixed assets under investing activities?
• Have you shown loans, shares, debentures, interest paid, and dividend paid under financing activities where applicable?
• Does closing cash and cash equivalents match the given closing balance?

If the final cash balance does not match, do not panic. Recheck working capital changes first. That is where the most common sign errors happen.

Why The Indirect Method Is Actually Logical

At first, the indirect method feels backwards because it starts with profit instead of starting with cash receipts and payments.

But it is practical.

Most questions already give profit, balance sheet figures, and additional information. The indirect method uses those figures to explain why profit and cash are different.

It is not asking you to memorise a trick.

It is asking you to answer a real business question:

“If the business earned this much profit, why did cash change by a different amount?”

Once you see it that way, every adjustment becomes a small explanation.

Depreciation says: profit fell, but cash did not.

Receivables say: profit may be recorded, but cash is still waiting.

Payables say: expense may be recorded, but cash has not gone out yet.

Profit on sale of asset says: this gain belongs to another activity.

Tax paid says: now show the actual cash outflow.

That is the story of the indirect method.

Frequently Asked Questions

What is the indirect method in cash flow statement?

The indirect method is a way of calculating cash flow from operating activities by starting with profit and then adjusting it for non-cash items, non-operating items, and changes in current assets and current liabilities.

Why is depreciation added back in the indirect method?

Depreciation is added back because it reduces accounting profit but does not involve cash payment during the year. Adding it back reverses the non-cash deduction.

Is an increase in inventory added or deducted?

An increase in inventory is deducted. More inventory means more cash is tied up in stock, so it reduces cash from operations.

Is an increase in trade payables added or deducted?

An increase in trade payables is added. It means the business has delayed payment to suppliers, so cash is saved for the time being.

Where is profit on sale of machinery shown?

Profit on sale of machinery is deducted while calculating operating activities because it increased profit but does not belong to operations. The actual cash received from sale of machinery is shown under investing activities.

Where is interest paid shown in a cash flow statement?

In many non-financial company questions, interest paid is shown as a financing activity. If it has already been deducted in the profit figure, it is first added back in operating activities and then shown as a financing outflow.

What is operating profit before working capital changes?

It is the profit figure after adjusting non-cash items and non-operating items, but before adjusting current assets and current liabilities. It is an intermediate step, not the final operating cash flow.

What is cash generated from operations?

Cash generated from operations is the amount after working capital adjustments but before deducting income tax paid. After tax paid is deducted, you get net cash from operating activities.

Should all current assets and current liabilities be adjusted?

No. Adjust operating current assets and operating current liabilities. Items connected with financing or investing, such as bank loans, debentures, and some dividend-related balances, need separate treatment.

How can I avoid sign mistakes in the indirect method?

Remember the working capital rule: increase in current assets is deducted, decrease in current assets is added, increase in current liabilities is added, and decrease in current liabilities is deducted. Then apply the rule slowly instead of guessing.