Will you please explain me ?

Which is the best technique to keep remember the items need to deduct and which transactions should be added in Reconciliation of Profit from Operating activities to Net cash used in Operating activities.

I am confused and need to good way to learn.

Thank you in advance for your time and effort .

Will be appreciated.

Comments

  • peugeotpeugeot Experienced Mentor Posts: 624Registered
    You need to work out the effect on the actual cash. I will be publishing an article in the next day or so about IAS 7 (Cash Flow Statements) together with a link to a comprehensive worked example which will help. I will put a link to your thread.

    The main additions/subtractions to/from working capital are:

    Increases/decreases in trade receivables
    Increases/decreases in trade payables
    Increases/decreases in inventories

    Receivables
    An increase in trade receivables from the previous year means you have collected LESS money this year from customers. This gives rise to an 'outflow' of cash so it should be DEDUCTED from operating profit. Conversely, a decrease in trade receivables means you have collected MORE money this year from customers, so it should be ADDED to operating profit. Remember, if you receive a bonus from work, this gets added to your gross pay as it is an 'inflow' (relate this to a decrease in receivables i.e. more money). If you are off on unpaid holiday this is a reduction in your gross pay from the previous month, hence a deduction (i.e. an 'outflow' - relate this to a decrease in receivables i.e. less money).

    Payables
    The same principles as trade receivables, but the opposite way around. An increase in trade payables means you have paid less money to your supplier (hence they have increased), so this means more money remains in your bank so this is classed as an 'inflow' so an addition to operating profit. A reduction in payables means you have paid your payables quicker than the previous year, so more money has been used to pay your creditors, hence an 'outflow', therefore a deduction from operating profit.

    Inventories
    With inventories, I tend to advise to think about the 'order of liquidity' in the balance sheet. Inventories turn into receivables, receivables turn into cash, hence, current assets will always follow this order in the balance sheet (statement of financial position):

    Current Assets
    Inventories
    Trade and other receivables
    Bank and cash

    If inventories have increased this means more money is tied up in inventory waiting to be converted into receivables and then to cash, therefore this is essentially an 'outflow', resulting in a deduction from operating profit (in other words you have spent more money on inventory). A reduction in inventory means you have turned more inventory into receivables and then cash so an 'inflow' hence an addition to operating profit.

    To summarise:

    Increase in receivables = deduct
    Decrease in receivables = add
    Increase in payables = add
    Decrease in payables = deduct
    Increase in inventories = deduct
    Decrease in inventories = add

    Hope that helps.

    Kind regards
    Steve
  • BarryBarry Well-Known Posts: 101Registered
    Cheers Steve. This is another subject my so called teacher couldn't deal with. This really helps.
  • peugeotpeugeot Experienced Mentor Posts: 624Registered
    Hi Barry

    What study material are you working from?

    Kind regards
    Steve
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