A company may show good profit but still face a cash crunch.
Why? Because profit ≠ cash.
The Cash Flow Statement explains:
• Where cash came from
• Where cash was used
• Whether the business can meet its short-term obligations
AS 3 ensures uniformity and clarity in preparing cash flow statements.
Objective of AS 3
To provide information about cash inflows and outflows of an enterprise during a period, classified into:
- Operating Activities
- Investing Activities
- Financing Activities
This helps users assess:
- Liquidity
- Solvency
- Financial flexibility of the business
Meaning of Cash and Cash Equivalents
Cash includes:
- Cash in hand
- Demand deposits with banks
Cash Equivalents include:
- Short-term (≤ 3 months)
- Highly liquid investments
- Readily convertible into known amount of cash
- Subject to insignificant risk of change in value
Example: Treasury Bills, Commercial Papers
Classification of Cash Flows
Cash Flow from Operating Activities (CFO)
These are the principal revenue-generating activities.
Examples:
- Cash received from customers
- Cash paid to suppliers
- Cash paid to employees
- Income tax paid (generally operating)
Cash Flow from Investing Activities (CFI)
Related to acquisition or disposal of long-term assets and investments.
Examples:
- Purchase of fixed assets (outflow)
- Sale of machinery (inflow)
- Purchase/sale of investments
- Interest received (for non-financial enterprises)
Cash Flow from Financing Activities (CFF)
Activities that result in changes in share capital and borrowings.
Examples:
- Issue of shares or debentures
- Eedemption of debentures
- Repayment of loans
- Dividend paid
Methods of Preparing Cash Flow Statement
AS 3 allows two methods for Operating Activities:
Direct Method:
Shows major classes of gross cash receipts and payments.
Format:
Cash received from customers
(-) Cash paid to suppliers
(-) Cash paid to employees
(-) Cash paid for expenses
= Net Cash from Operating Activities
This method is recommended by AS 3 but rarely used in exams.
Indirect Method (Most Important for Exams):
Starts with Net Profit and adjusts for:
- Non-cash items
- Non-operating items
- Changes in working capital
Indirect Method – Step by Step
Step 1: Start with Net Profit before Tax
Step 2: Add back Non-Cash Expenses
- Depreciation
- Amortisation
- Loss on sale of assets
Step 3: Deduct Non-Operating Incomes
- Profit on sale of assets
- Interest received
- Dividend received
Step 4: Adjust Working Capital Changes
| Item | Increase | Decrease |
| Current Assets | - | + |
| Current Liabilities | + | - |
Step 5: Deduct Income Tax Paid
Result = Net Cash from Operating Activities
Illustrative Example (Exam-Oriented)
Net Profit before tax: ₹5,00,000
Add:
- Depreciation: ₹80,000
- Loss on sale of machinery: ₹20,000
Less:
- Profit on sale of investment: ₹30,000
Working Capital Changes:
- Increase in Debtors: ₹40,000
- Decrease in Creditors: ₹10,000
Income tax paid: ₹50,000
Calculation:
Net Profit before tax = 5,00,000
Add: Non-cash items = +1,00,000
Less: Non-operating income = −30,000
Less: WC changes = −50,000
Less: Tax paid = −50,000
Net Cash from Operating Activities = ₹4,70,000
Extraordinary Items
Cash flows related to extraordinary items should be separately disclosed and classified as operating, investing, or financing.
Common Mistakes Students Make
- Treating profit as cash flow
- Wrong working capital adjustment
- Forgetting tax paid deduction
- Misclassification of interest/dividend
- Including non-cash transactions (like bonus shares)
Exam Tip
Most CA exams test:
- Indirect method adjustments
- Classification of items
- Theory question: “Explain Operating, Investing & Financing Activities”
Always write definitions first, then examples.
“Profit is opinion, cash is fact. Understand AS 3, and you’ll understand the real story of any business.” – CA Rohit Sethi
