A cash flow statement answers one question: why did cash go up or down during the period? Profit cannot answer it on its own. A profitable business can run short of cash when customers pay late, inventory builds up or loan instalments fall due. This guide explains how the statement is built under Accounting Standard (AS) 3, Cash Flow Statements, as published by ICAI, how to classify the lines that cause most errors, and how to read the three sections together, with a direct-method and an indirect-method example that reconcile to the same figure.
For which companies must present the statement and the exemptions available to one person companies, small companies and dormant companies, see the CA Samaaj guide to cash flow statement applicability.
What AS 3 requires and the definitions that drive it
Paragraph 1 of AS 3 states that an enterprise should prepare a cash flow statement and present it for each period for which financial statements are presented. For non-company entities, ICAI grants exemption to micro, small and medium-sized entities (Levels II, III and IV), while encouraging them to comply.
Paragraph 5 sets out four definitions that decide where every line goes:
- Cash equivalents are short-term, highly liquid investments that are readily convertible into known amounts of cash and subject to an insignificant risk of changes in value.
- Operating activities are the principal revenue-producing activities of the enterprise and other activities that are not investing or financing activities.
- Investing activities are the acquisition and disposal of long-term assets and other investments not included in cash equivalents.
- Financing activities are activities that change the size and composition of the owners' capital and the borrowings of the enterprise.
Operating is the residual category. If a cash flow is neither investing nor financing, it is operating.
The three-month test for cash equivalents
Paragraph 6 says an investment normally qualifies as a cash equivalent only when it has a short maturity of, say, three months or less from the date of acquisition. A 91-day treasury bill bought at issue qualifies; a one-year fixed deposit does not, even in its final month, because the test runs from the date of acquisition. Paragraph 7 adds that movements between items that are cash or cash equivalents are excluded from the statement, because they are part of cash management rather than operating, investing or financing activity. Paragraph 42 requires disclosure of the components of cash and cash equivalents and a reconciliation to the balance sheet.
Classifying the three sections
| Section | Question it answers | Examples under AS 3 |
|---|---|---|
| Operating (para 12) | Is the main business generating cash? | Receipts from sale of goods and services, royalties, fees and commissions; payments to suppliers and employees; insurance premiums and claims for an insurer |
| Investing (para 15) | How is cash used for, or recovered from, long-term resources? | Purchase and sale of fixed assets; purchase and sale of shares and debt instruments of other enterprises; advances and loans to third parties |
| Financing (para 17) | How are owners and lenders funding the business? | Issue of shares and debt instruments; repayment of amounts borrowed |
Paragraph 13 settles two frequent doubts. When a fixed asset is sold at a gain, the gain is part of net profit, but the cash received is an investing cash flow. Securities held for dealing or trading are treated like inventory, so their purchases and sales are operating cash flows.
Interest, dividends and taxes
These lines should never be classified by habit. Under paragraphs 30 to 33, cash flows from interest and dividends received and paid are disclosed separately. For a financial enterprise, interest paid and interest and dividends received are operating cash flows. For other enterprises, interest paid is a financing cash flow, and interest and dividends received are investing cash flows. Dividends paid are financing cash flows.
Under paragraph 34, cash flows from taxes on income are disclosed separately and classified as operating activities unless they can be specifically identified with financing or investing activities. Paragraph 35 explains why operating is the default: it is often impracticable to identify the tax cash flow that relates to a particular investing or financing transaction.
Foreign currency, extraordinary items and acquisitions
- Foreign currency (paras 25 to 27). A foreign currency cash flow is recorded at the exchange rate on the date of the cash flow. Unrealised exchange gains and losses are not cash flows, but the effect of rate changes on cash held in foreign currency is shown separately in the reconciliation of opening and closing cash.
- Extraordinary items (para 28). Cash flows from extraordinary items are classified by activity and disclosed separately.
- Acquisitions and disposals (para 37). Aggregate cash flows from acquiring or disposing of subsidiaries or other business units are presented separately as investing activities, with the total consideration and the portion discharged in cash disclosed.
Non-cash transactions and restricted cash
Paragraph 40 excludes investing and financing transactions that do not use cash, such as converting debt into equity or acquiring an asset by issuing shares. Paragraph 41 explains that they have no direct impact on current cash flows but still affect capital and asset structure, so they are disclosed elsewhere in the financial statements. Paragraph 45 requires disclosure, with management commentary, of significant cash and cash-equivalent balances that the enterprise holds but cannot use.
Direct method and indirect method
Paragraph 18 allows operating cash flows to be reported either by the direct method, which discloses major classes of gross cash receipts and payments, or by the indirect method. Under paragraph 20, the indirect method starts from net profit or loss and adjusts for changes in inventories and operating receivables and payables, non-cash items such as depreciation, provisions, deferred taxes and unrealised exchange differences, and any item whose cash effect is investing or financing. Both routes reach the same net cash from operating activities. Paragraphs 21 and 22 permit net reporting only in limited cases, such as receipts and payments on behalf of customers or items with quick turnover, large amounts and short maturities.
Worked example: one year, both methods
A company records these cash flows for the year (₹ lakh):
| Cash flow item | ₹ lakh | Section |
|---|---|---|
| Cash collected from customers | 120 | Operating |
| Paid to suppliers and employees | (84) | Operating |
| Income tax paid | (6) | Operating |
| Machine purchased | (24) | Investing |
| Old equipment sold (book value 3) | 4 | Investing |
| New loan received | 15 | Financing |
| Loan principal repaid | (8) | Financing |
| Dividend paid | (5) | Financing |
Direct method. Net operating cash is ₹30 lakh (120 minus 84 minus 6). Net investing cash is negative ₹20 lakh (4 received minus 24 spent). Net financing cash is ₹2 lakh (15 received minus 8 repaid minus 5 dividend). The net increase in cash is ₹12 lakh. With opening cash of ₹8 lakh, closing cash must be ₹20 lakh; if the balance sheet shows a different figure, something is missing.
Indirect method. Assume profit before tax of ₹36 lakh, depreciation of ₹8 lakh, the ₹1 lakh gain on the equipment sale, an increase in trade receivables of ₹6 lakh, an increase in inventory of ₹4 lakh and an increase in trade payables of ₹3 lakh. Tax expense equals tax paid at ₹6 lakh.
| Indirect method line | ₹ lakh |
|---|---|
| Profit before tax | 36 |
| Add: depreciation | 8 |
| Less: gain on sale of equipment (cash shown under investing) | (1) |
| Less: increase in trade receivables | (6) |
| Less: increase in inventory | (4) |
| Add: increase in trade payables | 3 |
| Cash generated from operations | 36 |
| Less: income tax paid | (6) |
| Net cash from operating activities | 30 |
Both methods give ₹30 lakh. Profit after tax is also ₹30 lakh, so operating cash flow is 1.0 times profit: every rupee of profit arrived as cash.
Now change one fact. Suppose receivables had risen by ₹25 lakh instead of ₹6 lakh. Cash generated from operations falls to ₹17 lakh, and after tax of ₹6 lakh net operating cash is ₹11 lakh, about 0.37 times profit of ₹30 lakh. That company could not have funded the ₹20 lakh net investment, the loan repayment and the dividend from operations. The same profit hides a very different cash position.
Reading the three sections together
Operating cash. Compare it with profit over several years. Repeated profit without matching operating cash calls for a look at collections, stock levels and revenue recognition. A jump in payables can make one year look stronger than it is, and one-off tax refunds or settlements can distort a comparison.
Investing cash. A negative figure is not automatically bad; it may be new capacity. A positive figure is not automatically good; it may come from selling assets the business needs. Use the notes to separate replacement from expansion spending and to identify acquisitions or disposals reported under paragraph 37.
Financing cash. Compare new borrowings with repayments, then compare both with operating cash. A company that repays debt and funds routine capital spending from operations carries a different risk from one that must refinance to meet regular commitments.
A seven-step review
- Reconcile cash. Match opening cash, net movement and closing cash to the balance sheet, as paragraph 42 requires.
- Test cash equivalents. Check that every investment counted as a cash equivalent had a maturity of about three months or less when acquired.
- Read operating cash first. Compare it with profit and identify the main working-capital movements.
- Review capital spending. Confirm that sale proceeds sit in investing and that any gain has been removed from operating cash.
- Trace financing. Identify new debt or equity, repayments, buy-backs and dividends.
- Check classification. Test interest, dividends and taxes against paragraphs 30 to 35 and the entity's status as a financial or non-financial enterprise.
- Find non-cash and restricted items. Review the notes for debt-to-equity conversions, share-settled acquisitions and cash balances not available for use.
Common reading mistakes
- Calling every increase in cash good, when it may come from new borrowing or asset sales.
- Calling every investing outflow bad, when productive capital spending supports future growth.
- Treating profit as cash, when accruals and working capital can open a large gap.
- Leaving the gain on an asset sale inside operating cash under the indirect method, which double counts it.
- Treating unrealised exchange gains as cash inflows.
- Reading one year in isolation instead of a trend across the business cycle.
Updated on 27 September 2026: merged the separate AS 3 explainer into this page, retitled it, linked the ICAI text of AS 3 with paragraph references, and added the three-month cash-equivalent test, foreign currency, acquisition and restricted-cash rules, and an indirect-method reconciliation with a receivables stress case.
