While computing the net cash flows, in theory, it is assumed that all revenues are received in cash and all expenses are paid in cash. However, in practice, cash receipts and cash payments are different from revenues and expenses as noted in the profit and loss account. This change is primarily caused by changes in accounts receivable (trade debtors), accounts payable (trade creditors), and stock of goods (inventory).
It is also impossible for firms to make all payments and receipts in cash and in such situations, changes must be done in the calculation of net cash inflow from operations.
It is notable that since debtors, inventory, and creditors impact the bottom-line of financial operations, these changes must be considered important for a firm to keep a check over the actual changes.
Any mismatch in keeping track of expenses or payments may inflate or deflate the accounts and hence, correct calculation of the items is necessary.
Receivables may increase due to non-payment of bills by customers.
As revenues or sales account for the credit sales, it will overstate cash inflow.
Therefore, an increase or decrease in sales or receivables must be subtracted or added to revenues depending on the situation for computing actual cash receipts.
The firms usually pay cash for materials and the production of unsold goods.
Unsold outputs increase the inventory. Expenses do not include the cash payments for unsold inventory. Therefore, expenses underreport the actual cash payments.
Thus, the increase or decrease in inventory must be added or subtracted from expenses for computing the actual cash payments.
Changes in accounts payable may occur due to the lateness of the firm paying for material and production of sold output (sales). This will increase the accounts payable.
As accounts payable is considered in expenses, it will overstate actual cash payments.
Therefore, an increase or decrease in accounts payable must be subtracted from (or added to) actual cash expenses in the computation of cash flow from operations.
The changes in working capital items should be considered while computing the net cash inflow from the profit and loss account. In such a case, instead of adjusting each working capital item, one can simply adjust the changes in net working capital. This can be done by taking into account the difference between the change in current assets (inventory and receivables) and changes in current liabilities (creditors) to profit.
An increase in net working capital must be subtracted from and a decrease in net working capital must be added to after-tax operating profit.