Moving now to the Linkages and Preparation of the
Cash Flow Statement. This has three subsections;
the first two are important, the second one, in fact is
extremely important and highly testable, the
third subsection here is part of the learning objectives,
but I would say relatively less important. Linkages of cash
flow statements with income statement and balance
sheet. Here is a very simple link, the beginning
balance for cash is available on the balance sheet.
So, if we look at the balance sheet at the start of
the period say 1st, January 2010, the beginning balance is
100, and then from the cash flow statement
for the year, we can look at all the cash receipts,
let's say cash receipts equal 50. We can look at all
the cash payments, say that cash payments are 40, and
this is money out. The ending balance 110
would be 100 + 50 - 40 so, that shows the link between
the cash on the balance sheet, and the statement of
cash flows. Here is another example. Let's look at
accounts receivable, again, at the start of the year
accounts receivable is 200, this comes from the
balance sheet, then from the income statement we see that
revenue for the whole period was 5,000 and statement of cash
flows tells us that the cash collected from customers
was 4,800. This means that receivables must have
gone up by 200 because cash collected is less than
revenue shown, and this 200 then is reflected in the
fact that accounts receivable is 200 more at the
end relative to what it was at the start of the period. This
demonstrates the link between the balance sheet,
income statement, and cash flow statement. Coming
now to steps in Preparing the Cash Flow Statement.
As discussed before, the cash flow statement has
three segments; the operating activities, investing
activities, and financing activities. With operating
activities, we can either have the direct method,
or the indirect method. If we use the direct method,
then essentially, we have what's called a direct
cash flow statement that would simply be a statement
that is showing these three activities. If we say
that we have an indirect method cash flow statement,
then the operating activities would be shown using
the indirect method. For investing and financing
activities, there is only the direct method. We don't
have any indirect method for investing and financing
activities. We'll now look at each segment of the
cash flow statement in a little more detail. Operating
Activities: Direct Method. The top line here, is the cash
collected from customers. This can be computed
quite easily. The starting point is revenue which
we get from the income statement. Let's say that
the revenue from the income statement is equal to
100, and then we look at the balance sheet and we look
at how the accounts receivable has changed over
the period. Let's say that, accounts receivable increased
from 20 to 25. The accounts receivable went up, this means
that, the cash collected from customers must be less
than a 100, in fact, the cash collected from
customers is 95. How did we come up with this 95?
This 95 is 100 minus the change in accounts receivable. The
change in accounts receivable is the final value
minus the beginning value which is 5.Sso a simple formula
for cash collected from customers is revenue from
the income statement minus the change in accounts
receivable. Sometimes you might see this expressed
as increase in accounts receivable. Obviously,
if in another period, the accounts receivable goes down then
that would mean that the cash collected from customers
is greater than revenue. Next, we look at cash paid
to suppliers. The starting point here, would be the cost
of goods sold from the income statement, say the cost
of goods sold is a 100, and here we actually need
to look at two elements on the balance sheet. We need
to look at how inventory has changed, and we also need
to look at how accounts payable has changed. For simplicity,
let's say initially that accounts payable does
not change over the period, and let's say that inventory
at the start of the period was 0, and end of the period inventory
has gone up to 10. So, what was the cash paid to suppliers?
Notice, with the cost 100, we use the 100
as a starting point, so minus 100. If inventory
goes up by 10 that means that we must have paid 10 to our
suppliers, these are numbers let's say in dollars,
so, if inventory has gone from a value of 0 to a value
of 10, then 10 must have been paid to suppliers, so
that was 10 out--out means out from the company.
So, we subtract 10 that means a total of 110 must have
been paid to the suppliers. Now, let's look at accounts
payable. Earlier, I said accounts payable doesn't
change, but now let's say that accounts payable
goes from 20 to 25. What does this mean? Accounts payable
is going up, this means that we are actually holding
cash back from our suppliers. An increase in accounts
payable is, to some extent, like borrowing from your
suppliers. So, this will have a positive impact on
cash. We are talking about the expense, so we already
have - 110 over here. Since accounts payable is
going up, this is going to have a positive impact,
so + 5. The net effect is that cash paid to suppliers
equals -100 - 10, which is -110, + 5 which is -105.
I hope you are beginning to see a pattern over here.
When an asset account, such as accounts receivable,
goes up that has a negative effect, so notice the negative
number associated with a change in accounts receivable.
Similarly, inventory which is an asset, where this
goes up that has a negative impact on the cash flow.
So we were already up -100 from the income statement.
Inventory, which is an asset, goes up we have a negative
impact. When we are talking about the cash flow statement,
very simplistically, we can think of two kinds of
assets; cash and non-cash. When a non-cash asset,
such as accounts receivable or inventory goes up that
means there will be a negative impact on the cash situation.
On the other hand, when a liability goes up, then that
has a positive impact. Now, before I come to these other
elements, I just want to summarize what I have been
saying and help you memorize a shortcut, then we will
come back to this items. So, when you are working on problems,
such as this, the first thing you do is determine whether
the cash flow is income or an expense. So if we are
talking about cash received from customers, we are starting
with revenue, which is an income element. If we are
talking about cost of goods sold, then we are dealing
with an expense so that would be a negative. You can
think of income as a source or inflow, and expense
as an outflow. When there is an increase in an asset,
this is going to have a negative impact on cash flow.
So if asset goes up, this might be inventory or this might
be accounts receivable or it might be any asset, if
this is going up that means that the impact on cash
is negative. This is called a use of cash, but decrease in
asset will have the opposite impact, or decrease
in accounts receivable, for example, will have a positive
impact on cash flow. Similarly, a decrease in inventory
will have a positive impact on cash flow. On the liability
side, an increase in liability will have a positive
impact on cash flow. So, if accounts payable is going
up then that will have a positive impact on cash flow.
If accounts payable is coming down, then that will
have a negative impact. This can be generalized
to other operating liabilities. So, if we come back
to this situation now; cash paid for operating expenses.
If you see any liability account, such as operating
expenses payable, then you can look at whether that
liability is going up or down and then figure out
the cash paid. Let's say cash paid for interest,
say you have interest expense is equal to 50 from the
income statement, this is a negative, it's an expense.
Interest payable on the balance sheet, let's say,
goes from 7 to 9. Interest payable is a liability,
liability going up has a positive impact on cash.
So you would actually add 2, and therefore, the cash
paid for interest would be negative 48. Hopefully, this
makes sense because what I have just been talking
about is extremely testable and highly likely to show
up on your exam. Once you have computed all this cash
elements and you've computed the cash collected
from customers. You can then come up with your operating
cash flow. Now, pause this video and do this question
before you look at the answer. What you should do
is the following; first of all recognize that we
are being asked for the cash received from customers.
We start with revenue, which is 10 million, expenses
are 7.5 million. This information is not needed. Profit
of 2.5 million is also not needed, but we are told that
accounts receivable increased by 4 million. So,
the asset account went up, that will have a negative
impact on cash, so we start with +10. There is
a negative impact of 4, so the cash collected
from customers must be 10 - 4 which is 6. Let us take
a look at this example now. An analyst collects the
following information and you are supposed to
calculate how much cash is paid to suppliers. Try
to come up with an answer before looking at the solution.
Here is what you need to do. Recognize, first of all,
that the cost of goods sold is 150,000 this is an expense so put
a negative, then you see an increase in inventory.
Inventory is an asset, asset is going up by 8,000 that
means that there is a negative impact on cash so
you put - 8000. There is an increase in accounts payable.
Liability which is going up, liability going up
has a positive impact on cash. So, you add 12,000 and
what you should end up with is - 146,000. So, the cash
paid to suppliers is 146,000.