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Cash Flow Statement Basics Explained - YouTube
Channel: Leila Gharani
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Today we'll talk about
the cash flow statement.
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It's one of the three
main financial statements,
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but often overlooked.
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Sure, the income statement
provides information
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on revenue and profits over
a certain period of time,
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and the balance sheet gives a snapshot
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of the financial health at
a certain point in time.
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But it's the cash flow
statement where you can find out
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how effective a business
is in managing its cash,
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and what it spends it on.
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And in the end, cash is the
lifeblood of any business.
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If you can't pay your employees,
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your vendors or your taxes
anymore, it's game over.
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(computerized electronic music)
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So let's get started.
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(upbeat music)
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In a previous video we
talked about the difference
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between cash and accrual accounting.
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We said it's important to understand
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that profits and cash can
be two different things.
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Profit is defined as
revenue minus expenses.
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And in accrual accounting
we report revenue
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when it's earned, and expenses,
when they're incurred.
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But earning revenue doesn't always
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increase cash immediately.
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And incurring expenses doesn't always
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decrease cash right away.
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Remember this important
difference to cash accounting.
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If you want to find out how
much cash a business has,
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you could just look in the balance sheet.
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There you're going to be able
to see if the cash position
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has gone up or down.
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But this way you won't see how the cash
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came into the business and
maybe even more importantly,
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what it was spent on.
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Therefore, to get a complete
picture of the business,
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we also need to look at
its cash flow statement.
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Just think of this as
a report that shows you
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how cash was entering
or leaving the business.
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If you see a positive figure,
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it means cash came into the company,
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and negative figure means
cash left the business.
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A cash flow statement looks like this.
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It consists of three main parts.
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The first one is the cash
flow from operations.
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This is the most important part,
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because it shows you how
much cash is generated
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with the actual operations
of the business,
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meaning by selling the
company's products and services.
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Then, we have the cash flow
from investing activities.
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As the name says, this is
either cash spent on investments
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or cash received from
sales of investments.
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In other words, it's outside
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of the primary business activities
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of selling products and services.
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In this section we can see if
the company purchased assets
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like machinery and equipment,
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or maybe even acquired another business.
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Last one is the cash flow
from financing activities.
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This section summarizes cash transactions
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that involved raising,
borrowing and repaying capital.
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For instance, here we can see
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if the company issued new shares,
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if dividends were paid, if
a bank loan was taken out,
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or if a debt principal was repaid.
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At the very bottom of the statement
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you see the reconciliation
to the balance sheet.
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It shows you the starting point
of cash from the last period
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and the ending balance from
the current balance sheet.
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The difference between the
two is the net change of cash
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which has to equal the sum
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of the three cash flow sections above.
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In other words, beginning balance of cash,
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plus the cash flows from
operations, investing and financing
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must equal the ending balance
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from the current balance sheet.
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Let's look at the three main
sections in a bit more detail.
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First, cash flow from operations.
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To calculate cash flow from operations,
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there are two different methods in use.
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One is the indirect method
which takes net income
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from the income statement
as starting point.
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But we already know
income doesn't equal cash.
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So in order to arrive at a cash flow,
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a lot of adjustment lines must be added.
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Therefore it's not the most
intuitive method to understand.
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The other one is the direct method
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which doesn't start with a net income,
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but instead lists different
types of transactions
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that produce cash amounts
received and paid.
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For instance, it will have lines
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like cash received from
customers, cash paid to suppliers,
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to employees or interest and taxes paid.
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GAAP and IFRS allow both methods,
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and both will get you the same result.
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While the direct method is easier to read
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and provides a better insight,
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it's very time-consuming to prepare.
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The indirect method on the other hand,
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is linked to the P&L and balance sheet.
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It's less intuitive, but
it's much easier to prepare,
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which is why most
companies use this method.
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So, we're going to skip the direct method
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and only concentrate on the
indirect method in this video.
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As we said, we start out with net income,
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which is taken directly
from the income statement.
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Then, we adjust net income
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for multiple effects to
arrive at the cash flow.
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Let's look at the most common ones.
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Depreciation and amortization,
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these are expenses in the income statement
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that don't have any impact in cash.
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We call this a non-cash transaction.
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Think about it, when we account
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for the wear and tear of using an asset,
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no cash leaves the business.
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It's just how we allocate the expenses
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over the useful life of the asset.
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The only time cash is affected
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is when we actually buy the asset.
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But depreciation and
amortization reduce net income.
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And since net income is
the starting point up here,
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we need to add this expense back.
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Same goes for the gain or loss
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on the disposal of non current assets.
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Let's say the business
is selling a forklift,
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which it acquired for
$10,000 two years ago,
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but now doesn't need it anymore.
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And let's see the current
asset value of the forklift
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is 5,000 because the
company has been using it
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for two years, in its warehouse.
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The company is able to sell it for $8,000.
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What we'll see in the
income statement is a gain
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on the disposal of the forklift of $3,000.
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But in the cash flow
statement we want to see
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the full cash impact, not
the profit on the disposal.
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So we need to take away the 3,000
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included in net income above
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and show the full $8,000 cash in.
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But since selling off
equipment is not part
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of the ongoing operations
of this business,
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we're not going to show
$8,000 cash in here,
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but further down in the
section for cash flow
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from investing activities.
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Next is the adjustment for
changes in working capital,
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which merely consist of inventory,
receivables and payables.
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To understand why we need to adjust
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for these balance sheet items,
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you need to think about how
these positions influence
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the amount of money the
company has in the bank.
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First, inventory.
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Let's say at the end of last year,
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your inventory value in
the balance sheet was 100,
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and now it's 150.
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It increased by 50, which means
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you're keeping more inventory in stock.
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And you had to pay for
this increased inventory,
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so more cash was living the business.
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Is this increase reflected
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in the starting point
up here, the net income?
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It's not, right?
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Net income just includes the
expenses for cost of good sold,
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but not if you're buying more
inventory than you're selling.
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That's why we need to adjust for it here.
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A higher inventory means
cash is decreasing,
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a lower inventory would increase it.
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Next, receivables.
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These work the same way.
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Let's say you're selling
someone products for 100,
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but on credit.
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You didn't receive the cash yet.
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In the income statement
under the accrual method,
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we would show the earned revenue,
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which increases our net income.
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And our starting point
would include the 100.
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However, cash wasn't received, was it?
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We are still waiting for the cash.
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So, if accounts receivable increase,
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we adjust with a negative number.
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If they're lower, we adjust
with a positive figure.
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Then, payables.
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They work the other way around,
because of the liabilities.
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If we increased this position,
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we paid out less to our suppliers.
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We're working with their money,
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which is good for our cash balance.
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So a higher figure for payables
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is a positive cash increase in change.
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If they decrease though, it's
negative for a cash balance,
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because we use more of our
cash to pay the suppliers.
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Now, all that's left to do
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is to sum up these adjustments
with net income on top
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to get to the cash flow from operations.
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Obviously, Microsoft's cash flow is huge,
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but even if you look at a smaller company,
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you want to see a positive number here.
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Otherwise, the business
is not generating cash,
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with its core business, which should raise
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all kinds of red flags.
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Another important thing to take away here
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is the crucial role of working
capital for most companies.
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If you keep a lot of inventory,
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grant long payment terms to your customers
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or have a lot of overdue receivables,
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you're using a lot of
cash to finance that.
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Cash, which you then don't
have to add capacity,
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expand to new markets
or invest in marketing.
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Now speaking of investing, let's
talk about the next section
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in the cash flow statement.
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Cash flow from investing activities.
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Remember when we adjusted for depreciation
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and gain or losses from
sale of assets before?
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The reason was that these
were non-cash transactions.
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They don't affect your cash balance.
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What does affect it, though,
is the cash in or outflow
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when the business is buying
or selling these assets.
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And that's exactly what we see here.
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When a company purchases
new property or equipment,
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we will see the full cash
outflow in this section.
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Likewise, if it acquires a
company or other investments,
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we're going to see that they're here too.
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Last part is the cash flow
from financing activities.
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This section summarizes
the cash transactions
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that involve raising,
borrowing and repaying capital.
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So just to make this clear,
let's look at an example
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and how it affects this
section of the cash flow.
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When a company borrows money from a bank
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or issues bonds or
shares, it receives cash.
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This cash will be reported
as a positive amount
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in the cash flow from
financing activities.
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A positive amount informs the reader
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that cash was received, which increased
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the company's cash balance.
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On the other hand, when a company
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repays the principal portion of its loans,
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purchases its own shares or
pays dividends to its owners,
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the amount of cash used will be reported
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as a negative amount here.
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The negative amount informs
the reader that cash was used
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which reduced the company's cash balance.
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All right, so these are the three sections
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of the cash flow statement.
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It's important to be able to distinguish
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among these elements, as
it's going to give you
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a good idea of where the company
makes and spends its money.
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And as we've seen in the
beginning of this lecture,
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the sum of these three types of cash flow
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gives us the company's change
in net cash for the period.
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The net cash flow is the difference
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between the amount of cash the company had
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in the beginning of the period,
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versus the amount of cash it
had at the end of the period.
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I hope this video was helpful
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to better understand
the cash flow statement.
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If you enjoyed it, please
give it a thumbs up.
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And if you want to improve your
skills, consider subscribing.
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And don't forget to hit that bell,
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so you don't miss any new videos.
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Thank you for watching, and
I'll see you in the next video.
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