Definition and Explanation
Certain items are debited to Profit and Loss Account (or Income Statement) as an expense though they are not paid out in cash in that particular period. The most obvious example of such non-cash expenses is depreciation.
By debiting the amount of depreciation in the Income Statement, we lower the amount of net profit; yet it has no cash outflow. To arrive at the correct cash flow on account of profits, we must therefore add back non-cash expenses to the figure of net profit disclosed by the Income Statement.
Another example of adjustment needed is loss on sale of a fixed asset. A loss on sale of fixed asset is in fact a form of additional depreciation. When a fixed asset is sold at a loss, the amount of cash that comes into the company is less than its book value.
The practice is to show the actual amount of cash received on sale of a fixed asset as a source of cash. This means that the amount shown as cash inflow is less than the net reduction in value of fixed assets. The way to balance this difference is to show the loss on sale of fixed asset as a sort of additional depreciation, and add it back to the amount of net profit (as disclosed by the Income Statement) to arrive at the correct cash flow generated by operational activities.