Operating Cash Flow Classification Errors
The following figures relate to Ganges Manufacturing Ltd for the year ended 31 March 2025. Net profit before tax was ₹8,00,000 after charging depreciation ₹1,20,000 and after crediting profit on sale of machinery ₹40,000. Interest on 9% debentures of ₹60,000 was charged to the statement of profit and loss. Income tax paid during the year was ₹1,50,000. Trade receivables increased by ₹80,000; inventory decreased by ₹30,000; trade payables decreased by ₹45,000; and outstanding expenses increased by ₹10,000. The company paid the previous year's proposed dividend of ₹50,000 and an interim dividend of ₹30,000. A machine costing ₹2,00,000 with accumulated depreciation of ₹50,000 was sold for ₹1,90,000. The accountant has computed net cash from operating activities by starting with ₹8,00,000, adding back depreciation and interest on debentures, deducting the profit on sale, adjusting working capital, and then deducting tax and dividend paid.
1. Compute the correct net cash from operating activities. Identify the errors in the accountant's treatment.
Read the worked answer
Net cash from operating activities (indirect method) Net profit before tax: ₹8,00,000 Add depreciation: ₹1,20,000 Less profit on sale of machinery: ₹40,000 Add interest on debentures: ₹60,000 Operating profit before working capital changes: ₹9,40,000
Working capital adjustments: Trade receivables increase: (₹80,000) Inventory decrease: ₹30,000 Trade payables decrease: (₹45,000) Outstanding expenses increase: ₹10,000 Net working capital change: (₹85,000) Cash generated from operations: ₹8,55,000 Less income tax paid: (₹1,50,000) Net cash from operating activities: ₹7,05,000
Errors:
- Dividend paid is a financing outflow, not an operating item. Deducting ₹80,000 of dividends here understates operating cash.
- Interest on debentures is added back to remove it from operating profit; for a manufacturing company it is then shown as a financing outflow under AS-3. It should not be deducted again in operating activities.
- Tax paid is correctly an operating outflow. The sale proceeds of ₹1,90,000 are investing, not operating.
2. Classify the interest paid, the two dividends and the sale proceeds, and explain the AS-3 logic.
Read the worked answer
Interest on debentures paid ₹60,000: financing outflow. AS-3 treats interest paid by a non-financial enterprise as a financing cash flow because it is a cost of obtaining debt finance. The standard permits an alternative operating classification, but it must be applied consistently and disclosed.
Proposed dividend of the previous year paid ₹50,000: financing outflow. Under AS-3 (revised), a proposed dividend is not recognised as a liability until it is approved. When it is eventually paid, it is a distribution to owners, not an operating expense. It should not be deducted in arriving at operating cash flow.
Interim dividend paid ₹30,000: financing outflow for the same reason.
Sale proceeds of machinery ₹1,90,000: investing inflow. The sale of a long-term asset is an investing activity. Only the profit of ₹40,000 was included in net profit; that profit is removed and the full proceeds are shown under investing.
Logic: Operating activities arise from revenue-producing activities; investing from acquisition/disposal of long-term assets; financing from changes in capital and borrowings. Classification follows the nature of the cash flow, not the ledger account in which the item was recorded.
3. Why is profit on sale deducted and depreciation added back? What would operating cash flow be if interest paid were classified as operating?
Read the worked answer
Depreciation added back: It is a non-cash charge. It reduced accounting profit but did not use cash, so it is added back to convert profit into cash flow.
Profit on sale deducted: The ₹40,000 profit is included in net profit, but the sale itself is an investing activity. If the profit were left in operating activities, operating cash would be overstated and the investing inflow would be understated. Removing the profit and showing the full ₹1,90,000 proceeds under investing avoids double counting.
Alternative interest classification: If the company classifies interest paid as operating, operating cash flow becomes ₹7,05,000 − ₹60,000 = ₹6,45,000, and financing cash outflows fall by ₹60,000. Total cash flow is unchanged. The important exam point is that the same classification must be used consistently and disclosed; the accountant's real error was deducting dividends in operating activities, not the add-back of interest.