Classifying Interest, Overdraft and Contingent Items in a Cash Flow Statement
During 2023–24, Meghdoot Ltd earned a profit before tax of ₹8,00,000. Depreciation charged was ₹1,20,000. A machine with a book value of ₹80,000 was sold for ₹1,20,000. Interest on long-term borrowings was ₹60,000 and income tax paid was ₹1,50,000. Trade receivables increased by ₹80,000, inventory decreased by ₹30,000 and trade payables increased by ₹50,000. The company purchased machinery for ₹3,00,000, issued equity shares for ₹2,00,000, repaid a term loan of ₹1,00,000, paid dividends of ₹60,000 and increased its bank overdraft by ₹40,000. There were no interest or tax amounts outstanding at the year end. The accountant prepared the cash flow statement showing interest paid and the bank overdraft under operating activities, arguing that both are short-term in nature. The audit committee has asked for a review before the statement is signed.
1. Prepare the cash flow from operating activities using the indirect method, showing each adjustment.
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Cash flow from operating activities:
- Profit before tax: ₹8,00,000
- Add: depreciation: ₹1,20,000
- Less: profit on sale of machinery (1,20,000 − 80,000): (₹40,000)
- Add: interest on borrowings: ₹60,000
- Operating profit before working capital changes: ₹9,40,000
- Less: increase in trade receivables: (₹80,000)
- Add: decrease in inventory: ₹30,000
- Add: increase in trade payables: ₹50,000
- Cash generated from operations: ₹9,40,000
- Less: interest paid: (₹60,000)
- Less: income tax paid: (₹1,50,000)
- Net cash from operating activities: ₹7,30,000
The profit on sale is deducted because it is an investing gain already included in profit; the proceeds themselves are not operating cash. Depreciation is added back because it is a non-cash charge. Interest is added back solely to reach cash generated from operations before financing costs, and then deducted as a financing outflow. No outstanding interest or tax means the amounts paid equal the expenses.
2. Classify each of the following and identify the accountant's errors: interest paid, dividend paid, bank overdraft, sale proceeds of machinery, income tax paid.
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- Interest paid on long-term borrowings: financing activity for a company under AS-3. The accountant's classification as operating is wrong.
- Dividend paid: financing activity; it is a return to providers of equity finance.
- Increase in bank overdraft: financing activity, because an overdraft is a short-term borrowing. The accountant's classification as operating is wrong. Merely being short-term does not make it operating.
- Sale proceeds of machinery: investing activity; the ₹40,000 gain is removed from operating profit and the ₹1,20,000 proceeds are shown under investing.
- Income tax paid: operating activity, unless it can be specifically identified with an investing or financing transaction.
The accountant seems to have classified by duration rather than by the nature of the transaction. Classification follows the substance: operating items arise from revenue-producing activities, investing items from acquisition or disposal of long-term assets, and financing items from changes in capital and borrowings.
3. Compute net cash from investing and financing activities, reconcile the net increase in cash, and comment on the quality of the operating cash flow.
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Investing activities:
- Purchase of machinery: (₹3,00,000)
- Sale of machinery: ₹1,20,000
- Net cash used in investing: (₹1,80,000)
Financing activities:
- Issue of equity shares: ₹2,00,000
- Repayment of term loan: (₹1,00,000)
- Dividends paid: (₹60,000)
- Increase in bank overdraft: ₹40,000
- Net cash from financing: ₹80,000
Reconciliation: 7,30,000 − 1,80,000 + 80,000 = net increase in cash and cash equivalents of ₹6,30,000.
Quality check: profit after interest and tax is 8,00,000 − 60,000 − 1,50,000 = ₹5,90,000, while operating cash flow is ₹7,30,000. Operating cash exceeds accounting profit, mainly because depreciation is a non-cash charge; working capital movements are neutral. That is a healthy sign. However, the large investing outflow is funded partly by a share issue and partly by increasing the overdraft, so the company is relying on external finance for expansion. The audit committee should ensure the overdraft is disclosed as a financing inflow.