Hello, I'm Professor Brian Bushee. Welcome back. In this video we're gonna to tackle a number of miscellaneous cash flow topics that I haven't gotten to yet. First we'll talk about how to treat a gain or loss on sale of property plant equipment on the cash flow statement. Then we'll talk about some complications in how things are classified on the statement of cash flows. And we'll wrap up with a discussion of earnings versus cash flow versus EBITDA versus free cash flows. It's a big agenda. So, let's get to it. First let's look at an example of how to treat a gain on sale of property, plant, and equipment under the indirect method cash flow statement. So let's say we sold property plant equipment worth $70 on the books for $75 cash. >> How are we able to sell PP&E for more than it is worth? I bet that never, ever happens in the real world. >> You're correct that we can't really sell something for more than it's worth, because what somebody pays for it is essentially what the asset is worth. But I said how much it's worth on the books or the financial statements. And remember the book value of property plant equipment is gonna be a function of our depreciation assumptions, because it equals the original cost minus the accumulated depreciation. So if the depreciation assumptions are incorrect, which they always are, then we're gonna end up selling it for more or less than it's on the books. So think of it this way, if we depreciate something too much, we drop its value too much, we end up having a gain on sale, which sort of brings it to the true amount of depreciation over the life of the asset. If we depreciate something too little, then we'll have a loss on sale, which again gets us to the true level of depreciation on the asset over its life. So this gain or loss on sale helps us adjust our incorrect assumptions and get the true amount of economic depreciation over the life of the asset. Anyway, that's gonna result in a gain of $5, which will go on the income statement. >> Excuse me, does this $5 gain count as revenue? >> Excellent question. Although this gain will go on the income statement and increase that income just like revenue would, we're not gonna consider it top line revenue because it's not part of our core business activities. In other words, we're not in the business of buying and selling buildings. One implication of this example is because it's not a core business activity, it's gonna be an investing activity. And because it's an investing activity, we need to remove that gain out of the operating section and place it into the investing section. So we're gonna consider all $75 of cash that we receive as an investing activity, which is another indication that we don't treat this as a revenue activity, because if it was, it would be part of operating cash flow. So I'm gonna bring back one of the basic example we did early on, where we have all of our sales in cash, all of our cost to goods sold in cash, and then depreciation of $10. We're gonna add to that the gain on sale of property plant equipment, which goes on the income statement, which would make our net income 35. Under the direct method cash flow, all of our sales for cash, so we have collections from customers of 100. All of our cost to goods sold was in cash, so we have payments to suppliers of 60. Depreciation, of course, is not cash. And the gain on sale of property plant equipment, we want to consider that part of the investing cash flow. So we ignore that and we end up with operating cash flow 40. And then we have investing cash flow as the full $75 proceeds from sale of PP&E. Under the indirect method, we start with net income, which is 35. We add back depreciation expense of 10, because it's a non-cash expense. And then we have to remove the gain, otherwise we'll double count that cash flow. A gain increases net income, so to remove it we need to subtract the gain. Once we do that, we end up with operating cash flow of 40, so it's the same under the indirect and direct method. And then we have again, the full cash flow from the sale of the PP&E, 75, as an investing cash flow. >> I believe that some students could be confused by this example. Could you provide the viewers a handy algorithm for remembering how to adjust for such gains? >> I do have a little memory device that I use when I teach this on campus. But I'm trying to think about whether I'm too embarrassed to put this on video. What the heck, let's do it. So the way to remember how to deal with gains and losses on investing activities in the operating section is the Hokey Pokey. I don't know if you remember this little song and dance, but it goes something like this. You put the gain in, you take the gain out, you put the gain in and you shake it all about. You do the hokey pokey and you turn yourself around, that's what it's all about. Next I want to talk about some of the complications you may run into when looking at a statement of cash flows. These are not things that we're gonna explicitly cover in the course, but I want you to be aware of them, because you will run into them in practice. And all these complications surround the question why doesn't the change in the balance sheet numbers often equal the number on the statement of cash flows? So in all of the examples that we've done so far, when you look at the change in the balance sheet numbers for, say, accounts receivable, it's the exact same number that you see in the operating section on the statement of cash flows. But in real financial statements, you often see it's not the case for one of these four reasons. First, there could be non-cash investing and financing activities that relate to the working capital accounts in the operating section. An example would be, let's say one of our customers who owes us an account receivable can't pay us cash, so instead they give us a piece of land. Well, that would be a non-cash transaction. It would be disclosed at the bottom of the statement of cash flows. It would also affect the balance sheet number for accounts receivable, but it wouldn't show up on the cash flow statement because there's no cash involved. A more common example would be acquisitions or divestitures of businesses. All the cash the companies pay when acquire another company is considered a investing cash flow. But, part of the things companies acquire are working capital assets and liabilities. So for instance, let's say a company made an acquisition. Part of the acquisition, they acquired some accounts receivable. Those accounts receivable would show up on the balance sheet but would not be part of the number in the operating section, because we want to call that cash flow and investing cash flow, and we don't wanna double count it, so we break it out. Third, there are foreign currency translation adjustments. For multinational companies, which have subsidiaries in multiple countries in different currencies, what we do is we take any effect of exchange rate movements and break them out of the operating section of the cash flow, showing them at the bottom. So a foreign exchange movement would effect the balance of say, accounts receivable or inventory in the balance sheet, but we wouldn't show it in the operating section of the statement of cash flows. >> Foreign currency what what whats? Does anyone even do these in the real world? >> Do you mean the MTV show The Real World, or in practice? Because you're talking about the MTV show The Real World. I don't think they did any foreign currency translation adjustments, it seems more like a Jersey Shore thing. Anyway, this is a pretty advanced topic, it's something I cover in a second year elective, so, we're not gonna go into this in detail in this course. I just wanted you to be aware of the fact that all of the effects of exchange rate movements on the cash flow statement are broken out on one line item in the bottom so that when you look at the operating section, what you're seeing are changes in accounts due to real activities, not due to exchange rate movements. The last complication is that sometimes companies have subsidiaries in different industries, which effect what is considered operating versus investing activities. So let's think back to our company before that made the pills to cure grey hair. Not that grey hair needs to be cured. Let's say this company goes out and buys a real estate subsidiary. What would happen then is the pharmaceutical company buys land. It would be considered an investing activity. But if the real estate subsidiary buys land, it would be considered an operating activity, cuz that's part of their core operations. So the same transaction of buying land could show up as either operating or investing. Now, companies in this situation will sometimes produce separate cash flow statements to help investors see these different activities match up in the different subsidiaries. Next I wanna talk about disagreements that analysts and investors have over the FASB classification, a couple items. I know it's hard to believe that people would disagree with the FASB, but there are a couple disagreements out there. The first, many investors and analysts prefer to classify interest payments as a financing activity and interest and dividends received on an investment as an investing activity. Under IFRS, a company could put those activities in the different buckets, but remember of the US GAAP, you're required to call those operating. So one thing that FASB did is they required a disclosure of cash paid for interest, so if investors or analysts wanna take it out of operating, they can easily subtract it because that disclosure's provided. Another disagreement is that all income tax effects are shown in the operating section, even if the income relates to financing or investing activities. So if there's an income tax effect from getting, say, a gain on selling property plant equipment, which would be an investing activity, the tax effects show up as operating. So the FASB requires that all cash taxes paid must be disclosed. Again, so if you don't think that cash taxes should be part of operating, you can take them all out in your calculation. Next I want to talk about this measure EBITDA, which is defined as earnings before interest, taxes, depreciation, and amortization. EBITDA is often used by investors and analysts as a proxy for operating cash flow. And because it excludes interest and taxes, it solves for that problem that we talked about on the last slide. However, EBITDA does not do a good job of measuring cash flow if there are large changes in working capital, like accounts receivable or inventory, and in fact, it suffers from the same manipulation potential as net income. So for example, let's think of a company that does channel stuffing. Channel stuffing is a situation where at the end of a quarter, the company's trying to meet an earnings target, so they ship a bunch of product to customers in order to book the revenue, which would then increase earnings, and of course then increase EBITDA. But there's no cash that's collected. The customers haven't paid us yet. Instead, accounts receivable will go up. So, EBITDA would consider this channel stuffing as a cash flow, but it's not a cash flow. Now, if we took EBITDA, and adjusted for this increase in accounts receivable, then we would have a good measure of cash flow. And I'm gonna talk about this more in the next video. >> I believe this is not correct. Everyone knows that EBITDA is the best measure of cash. >> Now, I feel pretty strongly that EBITDA is not a good measure of cash flow, because unless you adjust for these changes in working capital, then EBITDA is just as easy to manipulate as earnings is. What we're gonna do in the next video is a case where we'll highlight some of these drawbacks of EBITDA. And I'll show you when it's not a great measure of cash flow. And then one more point on this, you often hear people talking about cash is king, implying that you should only look at cash from operations or EBITDA as a proxy from cash operations and not even look at earnings because it's too easy to manipulate. Well, there's actually been a lot of academic research that's looked at this question of earnings versus cash flow. And it finds that earnings are a better predictor of future cash flows than current cash flow from operations. The reason is that earnings is trying to measure the creation of value. It's trying to answer the question, are you able to price your product or service high enough to cover all the costs of doing business? If so, you tend to get high cash flows in the future, even if it turns out you don't happen to have high cash flows this period, whereas cash from operations can be much more susceptible to timing effects, which is something we'll look at in the next video. But the good news is, you don't have to choose one or the other. You get both earnings and cash glow from operations, and academic research it's very clear that if you put both measure in together, you get the best predictions of how a company's gonna do in the future in terms of its future cash flows. >> I bet that accounting professors did the research to show that earnings is better than cash flow. Is that really the case in the real world? >> Yes, it was mostly accounting researchers that did this research, but is there anything wrong with that? The data that they looked at, though, came from real companies, looking at long time series of data from 1962 to the present, and it's a very robust result that earnings are a better predictor of future cash flows than current cash flows. But again, the research emphasizes the best prediction comes from including both measures together. The last topic of this video is that I wanna briefly talk about free cash flow. Now, this is more of a finance topic, where they use free cash flow a lot. But since we've been talking about cash flows and these finance approaches generally pull cash flow numbers out of the financial statements, I wanted to briefly give you some cautions that you should have in dealing with free cash flows.. When people talk about free cash flow, they generally mean operating cash flow minus cash used for long-term investments. There's valuation models out there that show if you forecast out a company's free cash flows, discount them back to present value, you'll get a measure of how much the company should be worth, what its stock price should be. The problem is that if you look across these measures of free cash flow, there's often no standard measure for operating cash flow. So I've got a number of accounting and finance textbooks lying around my office, and they all seem to define operating cash flows differently. One book defines it as cash from operations before interest expense, so using the FASB number and adjusting for interest expense. Another defines it as NOPLAT, which is net operating profits less adjusted taxed, which would be EBITDA minus cash tax on EBITDA, which is not a good measure of cash flow because it doesn't measure cash. Without changes in working capital, you won't get a measure of cash. The next one, NOPAT minus increases in working capital, is a better measure. NOPAT is net income adding back interest expense, and then adjusting for changes in working capital to get closer to cash flow. Another book called it net income adjusted for depreciation other non-tax, non-cash items minus an increase in working capital, which I guess would be okay as long as the depreciation was after tax, because net income is after tax. Another said gross up earnings before interest and taxes and add depreciation, and a lot of them just say EBITDA without defining what it is. On top of this, another problem you'll encounter is companies will often disclose free cash flows using their own custom definition. And what you'll find is that definition often changes across companies or companies will change it across years. So if you're using any kind of cash flow measure, the most important thing is to figure out how it's actually defined, because some of these measures are defined much better than others. >> I believe a better approach than telling us everyone is wrong would be telling us what is correct. >> I'm not saying everyone is wrong. I'm just saying some people are more correct than others. I think there's two approaches that would give you a really good cash flow from operations number. The first approach would be to take the cash from operations from the cash flow statement, which uses the FASB classification, and then subtract out cash paid for interest and cash paid for taxes, which are disclosed somewhere else in the report. The second way would be to start with EBITDA, and then adjust for these changes in working capital, like receivables, inventories, and payables, using the balance sheet equation like we do under the indirect method. In the next video, we'll look at a case which will better highlight some of these advantages and disadvantages of these different measures for cash operations. So, I know that was a lot to throw at you in one video. What we're gonna do in the next video is look at a couple examples which will give us more practice on putting together cash flow statements under the indirect method. It'll give us some practice on handling gains and losses on sale of property plant equipment in the cash flow statement, and it will allow us to continue our discussion of earnings, versus cash flow, versus EBITDA. I'll see you then. >> I believe that we will see you next video!