Hello, I'm Professor Bryan Bushee. Welcome back. In this video, we're gonna talk about the two different methods that you need to know to put together a cash flow statement. Let's get started. There are two methods for preparing the statement of cash flows which are rather creatively titled the direct and indirect methods. In the direct method, You just list the cash receipts and disbursements by the source or use of funds. So where are all the places that the cash came from, where are all the places that you pay cash out to? This method is always used for investing and financing activities, but is rarely used for operating activities. Instead, for operating activities, companies tend to use the indirect method. This can only be used for operating activities and the goal is to reconcile net income with cash from operations by removing any noncash items from net income, and including any additional cash flows that were not in net income. So we're gonna see a statement that starts with net income, ends with cash from operations and shows all the differences between the two. Almost every company uses this method for their operating activities, and in fact, if you use the direct method, companies also have to provide the indirect method as well. So what this boils down to is for three buckets operating, investing and financing. Operating can be either direct or indirect. Where as investing and financing are always the direct method. >> Why does there have to be two methods? What's good for the goose is good for the gander. This is just more stupid over-complication. >> You know I am gonna agree with you that this probably is a stupid over complication. Because really every company uses the same approach for their cash flow statement. They do the investing and financing activities using the direct method, and then they use the indirect method for their operating section. Because even if they did the operating activities under the direct method, you still have to provide the indirect method anyway. The direct method's a piece of cake. You just list the cash flows based on where they're coming from or where they're going to. Really the one thing you have to learn that's difficult is this indirect method for operating. And we're going to spend much of the rest of the video, and much of the rest of the week trying to get a handle on this indirect method for the operating section. Let's talk about the indirect method in more detail. The indirect method section will start with Net Income. Then it's going to adjust for components of Net Income that are tied to noncash items or to investing activities. What we need to do is either add back the expenses or subtract the revenues to remove them from Net Income to to get the cash flow. So for example, Net income includes depreciation expense and amortization expense which are both noncash expenses. To remove those noncash expenses so that we can get from Net Income to cash from operations, we have to add them back. Because adding back expenses removes them. We can also have gains or loses on sale at of property point equipment or investments. Now there are cash flows associated with those, but we want to count those cash flows in the investing section. So we need to remove those gains and losses from the income statement. So, we're going to add back losses or subtract gains, to remove them from Net Income, on our way to cash from operations. Then, we need to adjust for components of Net Income tied to assets or liabilities created through operating activities. These are the working capital accounts, like accounts receivable, inventory, all of the payables. What we need to do here is add or subtract the change in the asset or liability account balance. And we're gonna use the balance sheet equation to determine whether we should add or subtract. For example, accounts receivable is a noncash asset. If accounts receivable went up, we would need to subtract it on the cash flow statement to stay in balance. Inventory's a noncash asset. If it went down, we would need to add it on the cash flow statement to stay in balance. On the other side of the equation, accounts payable is a liability. If accounts payable went up, we would need to add it on the cash flow statement to stay in balance. And if something like interest payable or wages payable went down, we'd have a liability going down, and we would have to subtract it on the cash flow statement. What? >> What? >> Really? >> What? Really? That example didn't make it crystal clear on how to do the indirect method? Okay, okay, we'll do an example, or maybe two, or maybe four our five. Let's look at some examples of how to put together an indirect method cash flow statement and how it gives you the same answer as the direct method. We're going to do this for various types of income statements with adding a little bit more complexity each example. In the simplest case, we have a company that had $100 of sales which were all in cash. Their cost of goods sold were $60, again all in cash. So they bough $60 of inventory with cash and sold it all during the period. And so they end up with net income of 40. Under the direct method we would have cash collections from customers of 100. Cash payments of suppliers of 60, gives us an operating cash flow of 40. And in this case the operating cash flow is exactly the same as Net Income, because everything the company did was in cash. If we go to the indirect method, under the algorithm we always start with net income. Then we adjust for any noncash expenses, or anything related to investing activities, which we don't have in this case. Then we adjust for changes in working capital. But again we don't have any in this case because we didn't create accounts receivable. All of our sales were cash. We didn't end or begin the year with inventory. And so there's no adjustments and we end up with an indirect method that gives us a cash flow 40, which is the same answer as the direct method. Now let's make this a little more complicated and bring in depreciation expense. So we start with cash sales and cash COGS like in the prior example. But now the company has a $10 noncash expense depreciation which gives the company a Net Income of 30. Under the direct method we have cash collections from customers, cash payments to suppliers. Of course there's no cash flow involved in the depreciation. So we end up with the same operating cash flow of 40. Now we need to make sure we get the same answer under the Indirect method. So for the indirect method we start with Net Income which is 30 now. We add back the depreciation expense of 10. It's a noncash expense so to remove it from Net Income we add it back. There are no changes in working capital, because again we didn't begin or end the year with receivables or inventory. So there's no other adjustments and we end up with operating cash flow of 40 under the indirect method. Which of course is the same answer under the direct method which always has to be the case. >> So let me get this straight. If a company had say $10 more in depreciation expense it would increase cash flow by $10? If a company had cash flow problems all it would have to do is take more depreciation. That's cool. >> Yes, the depreciation cash machine. Just crank up the depreciation expense, and watch that cash flow through the door. Well, obviously it can't work like that. And, in fact, I've heard stories about employers asking students this very question to see if they know anything about accounting. So let me jump back out to the slide and show you how this works. Okay, let's say we have another $10 of depreciation, that means we would have $20 of appreciation expense total, and we would add back 20. But our Net Income would be lower because more expense means less of an income. Now I'm going to ignore taxes for now. And just assume that our Net Income would drop from 30 down to 20 with the extra $10 of depreciation expense. So we have 20 plus 20 equals 40 instead of 30 plus 10 equals 40. It gets us to the same place. It has to get us to the same place because depreciation's a noncash expense. It can't create more cash flow. Now one thing I should note is that you can use different depreciation for tax purposes, than you see here on the financial statements. And changes in depreciation for tax purposes actually can save on taxes and can effect cash flow. But that's a topic that we're going to deal with much later in the course. In the next example we're going to still have a $100 of sales but this time lets assume that only $80 is received in cash the other $20 of sales remain on account so that we end the period with accounts receivable. We still have $60 of COGS which is all in cash and our $10 to depreciation. Gets us to the same Net Income as we saw in the last example of 30. When we look at the direct method operating section cash flow statement, we collected $80 of cash from customers. We paid 60 to our suppliers which gives us an operating cash flow of 20. So we have less cash flow here because we collected less cash from our customers. Now let's see if we can get the same answer under the indirect method. We start with Net Income and then as we saw in the prior example, add back depreciation expense because it's a noncash expense. But now we have a change in accounts receivable that we have to adjust for under that third step in the algorithm. What happened is accounts receivable started the period at 0, Ended the period at 20. So, that's a $20 increase in a noncash asset. Which means that we have to subtract it on the cash flow statement. And if we look, that makes it work. Because we've got 30 of Net Income, plus 10 of depreciation expense is 40, minus 20 for the increase in accounts receivable, gets us to an operating cash flow of $20, which is the same answer that we got under the direct method. >> Run that by me again. We sell $20 of goods, and yet, that reduces our cash flow. Isn't that like cutting off the nose to spite the face? >> Actually, I think throwing the baby out with the bath water would be a better analogy here. But anyway let's think through the intuition behind the indirect method. You want to start with Net Income. Make adjustments to get the cash from operations. Net income includes $100 in sales. All of those sales are legitimate, they meet the revenue recognition criteria. But $20 of those sales were never collected in cash. What we need to do is, start with Net Income, which includes the $100 of sales, and remove the non-cash sales. Fortunately, the increase in accounts receivable keeps track of the noncash sales. Cuz any time we make a sale on credit, we have to increase accounts receivable. So if we start with Net Income, which includes the $100 of sales. Subtract the increase in accounts receivable to take out the $20 of noncash sales. We're left with $80 of cash sales and cash from operations, making the nose, the face, the baby, and the bath water all safe in this case. One more example. We're going to start with sales of 100 again. With $80 in cash. $20 on account, just like before. Now, we're gonna make the inventory part a lot more complicated. So, we'll keep the $60 of cost of goods sold. But in this case, we actually bought $75 of inventory. So we bought $15 more of inventory than we sold. And we only paid $50 in cash. Which means that $25 of that inventory was acquired on an account, so we have accounts payable of 25. Then we subtract off the depreciation, and we end up with a net income of 30. Under the direct method, we collect $80 of cash from customers. We only paid $50 cash to our suppliers. So we don't use the COGS amount or how much inventory we bought. We use the actual cash we paid, which was 50. And we end up with an operating cash flow under the direct method of 30. Under the indirect method we start with Net Income. We add back depreciation expense, so we've seen those two steps before. We've also seen the subtraction of the increase in accounts receivable, to take into account that not all the sales were made in cash. Now we have to account for that mess with inventory. So, what happened was our inventory started the year at 0, and ended the year at 15. It went up by 15 because we purchased 75 of inventory but only sold 60. If a noncash asset goes up, we subtract it on the cash flow statement. So we subtract the increase in inventory. For accounts payable, they started the year at 0, ended the year at 25, so this liability accounts payable goes up by 25. That's on the other side of the equal sign, so cash has to go up by 25 to make this balance. So we can see on the indirect method cash flow statement we have increase in accounts payable of 25 gets added back. When we add everything up, we get the same operating cash flows under the direct method. So, quick word on the intuition here for inventory and accounts payable. If your inventory goes up during the year, it means that you're buying more inventory than you needed for your level of sales. Which means, you're spending extra cash on inventory, which is why it's a subtraction on the cash flow statement. For accounts payable, if your accounts payable went up. That means that you got stuff without paying your supplier. Not paying your supplier is a source of cash. That's an extra $25 of cash that you would not have had if you had paid off your supplier's amount. And so we add that to recognize that it's a source of cash. We're gonna go through a lot more examples like this in remaining videos to help you get down this intuition. >> Ok, this is quite complicated. Do you have some simple formula, or algorithm, we could use? >> Well I showed you a slide earlier in the video with a simple algorithm for doing the indirect method, and you all went, what, what, really?. Sorry to be a little peevish there, I guess that's what the cash flow statement will do to us. I understand that it is hard to get your head around how this indirect method works when you see it for the first time. So we're gonna do in the next video, is go back to the Relic Spotter case and step-by-step, work through how to put together an indirect method cash flow statement for Relic Spotter. And then you'll see many more examples later in the week. And hopefully as you get the mechanics down, we'll be able to talk more about the intuition for what this indirect method statement is telling us, which is the real thing that we want to get out of this effort of learning how to put together the indirect method cash flow statement. Anyway, I'll see you next video. >> See you next video!