Hi, I'm Rick Lambert, Miller-Sherrerd Professor of the Wharton School. And we're going to be continuing module three of our course Decision Making and Scenarios. Here we are going to be talking about the cash flow statement. So our objective is to figure out how business transactions and activities and other events impact the cash flow statement. And to learn how to derive the cashflow statement from the other two statements we've talked about, the income statement and the balance sheet. The cashflow statement, it's going to keep track of the inflows and the outflows of cash. And remember those are the things that we're going to plug into our present value calculation, so these are important. The cashflow statement classifies the inflows and the outflows into three categories operating, investing and financing activities. The operating activities are transactions related to providing goods and services to customers and paying the expenses related to the revenue generating activities. Operating cash flows are closely linked to income statement transactions, but differ mostly because of timing differences. Investing activities on the other hand, are transactions related to the acquisition or disposal of long term assets. Investing activities are the things we do today to help generate operating activities in the future. Then the financing activities is how are we paying for all this. These are transactions related to owners or creditors such as issuing debt, or equity, paying back loans, paying dividends. So from earlier, these were all of the transactions that we had looked at. So from earlier here's a summary of all of the transactions that we had looked at. And note that a subset of them involved the cash account. One way that we can construct the cash flow statement, and this would be the direct method of doing it, would be to simply look at those transactions that impacted the cash account. And then classify them into the three categories. While straightforward in concept to do, for complex firms this becomes too difficult, and so we're going to come up with a different way to do this. But if we did the direct method, looking back at those transactions. The cash we collected from customers, the cash we paid to suppliers, to employees and for taxes, those would all be operating activities so we would group those in the operating section. And we would have a total of $26,120 that we got from operations during this period. From the investing category there's just one transaction. That was the purchase of property, plant and equipment for 70,000. Negative number here means an outflow, whereas a positive number means an inflow. And then two financing activities. We got cash by issuing shares, and we paid out some cash when we paid a dividend. Overall, cash started at zero and went up to $191,120. Now, interpreting the cashflow. So far our cash is coming primarily from financing activities. Our cash balance is up $191,120, but this isn't because the firm's projects generated cash. Instead the cash is increased because of the financing activity specifically because we issued some shares. For our purposes, which is mostly about the project valuation and evaluation, we want to focus on the other two categories, the operating and investing section. This is how our projects are performing. So let's take a look at those, operations and investing. We add those together overall, our projects have caused cash to go down by $43,880 so far. But this is a misleading measure of our performance because most of the decline is because of the investment in property plant and equipment. But that's going to have additional benefits beyond the first year, those aren't in this year's cash flow statement. This is why accounting income spreads this cash flow out over time in the form of depreciation. This is also why we're going to want to forecast the financial statements for the future years. To see how much benefits we still expect to get from this investment. Now, let's take a look at cash from operations. Note that cash from operations is plus $26,120. Whereas, remember, the income statement was plus $31,120. So, it's a $5,000 difference. Close in this case, it's not always close, but they're not exactly the same. Well why are they different? Well, if we remember, not all of the sales were for cash, so that's going to be one difference. And not all the expenses in the income statement are for cash either. Anything else? Well understanding why they're different requires looking to the balance sheet, okay? So that's what we want to try to do. Our example is simple enough to where we can actually lay out the income statement and the cash flow statement head to head and see how they're different, and then relate this to the balance sheet. On the income statement we've got sales revenue, but the cash flow statement wants the cash collected from the customers. Income statement has cost of goods sold, the cash flow statement wants how much did you actually pay to suppliers? Income statement wants the wage expense, cash flow statement wants how much did you actually pay? Income statement has depreciation expense, but there's nothing in the cash from operations section about that because that's not a cash flow. Taxes paid in the income statement is the same as taxes paid on the cash flow statement, at least in this case. Now, if we look at those in more detail, why are they different? Well sales revenue is not the same as cash collected from customers, because not all the sales were collected. The rest are still on the balance sheet, in the form of receivables. Cost of goods sold on the income statement, is not the same as purchases from suppliers, because not all inventory was sold. They still have some inventory in the balance sheet as an asset. Also, not all of the purchases were paid for. We still have some payables on the balance sheet as well. Wage expense is not the same as wages payable because they weren't all paid in cash. And we see that on the balance sheet with the wages payable account going up. Depreciation expense isn't a cash flow, but it is related to the balance sheet equation, or the balance sheet line item, property plant and equipment. And because we paid all our taxes in cash, there's no difference between those two in our case. All of the items that reconcile cash and income are related to changes in the other balance sheet accounts. This follows automatically from the balance sheet equation. Any difference between how cash changed and how retained earnings changed, has to be reflected in some other balance sheet account. We can see that graphically or visually by again looking at the relationship between the financial statements. We've got a balance sheet that balances at the beginning of the year, and a balance sheet that balances at the end of the year, so the changes in the balance sheets also have to balance. The cash flow statement is about the change in the cash account. The income statement is about the change in the retained earnings account. If the cash balance changed in the way that matches the change in retained earnings income and cash for the same, we're good. But if there's something in cash that's not in retained earnings, it has to be in one of the other balance sheet accounts to keep the balance sheet in balance. If we look through what those are, we can figure it out. Similarly if there's something in income that's not in cash, it's got to be in some other account to keep the balance sheet in balance. And so what we're going to do is systematically look through the other balance sheet accounts to reconcile cash and income. If we do that in equation form, assets equals liability. So the change in assets equals the change in liabilities plus the change in owner's equity. Expand assets into cash and noncash, expand owners equity into contributed capital in retained earnings, just like before. And now expand the change in retained earnings in net income minus the dividends. Now we can express the change in cash exactly as the income plus or minus the change in all the other balance sheet accounts. So what we've done is we've provided an alternative and a more common way to present the cash flow statement. We're going to start with net income and then use the change in the other balance sheet account to infer the implied cash flow statement. Even though that looks more complicated, it's actually easier to forecast as we'll see. So the relationship between cash, income, and other balance sheet items. Start with net income. For a given level of income if assets go up, cash goes down. Note that there's a negative sign here, on the change in assets. An increase in assets uses up cash, so it's going to make the cash flow statement go down. An increase in assets means some of our income was invested in these assets, instead of cash. We don't have the cash so there's a subtraction on the cash flow statement. On the other hand, if liabilities go up, cash goes up. An increase in liabilities means we haven't paid them yet. If owners' equity accounts go up, cash goes up also. An increase in owners' equity means we've gotten new funding from owners and that's cash. So, we've got a relationship now between the cash flow statement, the income statement, and the change in the other balance sheet items. If we expand the assets and liabilities into short-term and long-term, we can put specific changes in balance sheets accounts into our categories that we've talked about. The cash from operations is going to include the income. And add back for depreciation and the change in working capital. So at the bottom of the slide, working capital is defined as the short-term assets other than cash minus the short-term liabilities. We'll expand on that in a minute. The investments in long-term assets versus the disposal of long-term assets, is our cash from investing. And the changes in the long-term liabilities and the contributed capital and dividends from the stockholders equity section, are the cash from financing. So again, we've got the cash flow statement in terms of income. And the other balance sheet accounts. So what about these working capital accounts? One of them would be receivables. Those are sales that aren't cash yet. This is an asset because it's going to generate cash in the future when those sales finally collected. Inventory is production that wasn't sold yet. It's an asset because it's going to generate future cash when the sale happens. But it's not cash yet, so our cash that we invested in inventory is still tied up. Accounts payable or purchases that weren't paid yet, this is going to save cash or delay paying cash. And then wages payable is work done that hasn't been paid for yet, either. Each of these items is often easier to forecast than forecasting the cash flow directly. Many of these are closely related to the level of sales and the expense accounts, say some proportion of those, that are in the income statement. So let's put together our cash flow statement using the more common presentation. Okay, it's going to look like this. The investing section and the financing section are exactly the same as before. So let's focus on the top part, Cash From Operations. The cash from operations number is the same but the presentation is different. So we start with net income. Here I've laid out the specifics of the calculation of income. Income was $31,120 but this isn't all cash and what the adjustments do is to try to take out the non-cash part to get to the cash part. So one reason why income isn't cash, is because income contains a $10,000 subtraction for depreciation. But this isn't cash, so we have to add it back. The subtraction in depreciation plus the add back cancel each other out. Net to zero, which is the cash associated with depreciation. None, it's not cash. Secondly, another reason why income is not the same as cash is because some of it was invested in working capital. In particular, $15,000 was invested in working capital. How do we know it was 15,000? Well, add up those other changes, okay, they add up to a subtraction of $15,000. So this is saying some of the income, $15,000, is not in the form of cash. It's tied up in working capital. So in this case, working capital is using up cash, that's common when firms are growing. On the other hand, when firms are declining or contracting, we often see some of this working capital being released. So, the individual lines in the operating section actually provide more details about the components of working capital. Sales of $200,000 weren't all cash. $20,000 is still invested in receivables, that's that first subtraction on the cash flow operating of $20,000. The cost of goods sold of 90 wasn't all paid in cash. $9,000 of it is because we actually bought more than we sold. But there's $5,000 that we bought that we didn't pay for. Both of those adjustments help reconcile the cost of goods sold to what we actually purchased. The wage expense of $55,000 wasn't all paid yet. $9,000 of it is still in the liability account, wages payable, so we've got an adjustment there as well. So, to summarize, we've learned how to represent business transactions and events in the balance sheets, income statements, and cash flow statements. We've learned to be able to express the cash flow statement, in terms of the balance sheet, and the income statement. And in particular the tricky part was, cash from operations you can write as income, plus depreciation, minus the change in working capital. And each of those three things are relatively easy to forecast out, compared to forecasting out the cash flow directly. So, in our next module, we're going to apply these skills to evaluating a potential new product venture. We're going to add multiple periods. So the balance sheet at the end of one period, is the starting balance sheet at the beginning of the next period. The income statements and the cash flow statements will reset the zero and start accumulating for each individual period. We're going to lay out a strategic plan and what this plan implies about the future business activities, transactions, and events. Then we're going to take what we learned in this module and translate those forecasted future financial statements, ultimately into forecasted future cash flows. We're going to take what we learned in module one and two, now that we've got the forecast of the future cash flows. Use present value techniques to calculate the value of adopting this strategy. Once we've got all that laid out, we can rethink the strategy along several dimensions. See what kinds of risks we face and examine alternative scenarios and what those imply for the present value. So thanks for joining me in this module and I look forward to seeing you in the next module.
