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:

1. Operating Activities
2. Investing Activities
3. 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