Moving now to Investing Activities using the direct
method. CFI or cash flow from investing is calculated by
examining the changes in the gross asset account
that results from investing activities. Typically,
we are considering purchases or sale of equipment
i.e. long-term assets. The first thing we will look at
is how to determine cash paid for new equipment.
To do so, we must analyze whether old assets are
sold or not, and here is the simple expression that
you need to know, the cash paid for new equipment
is equal to ending gross equipment balance plus
gross cost of equipment sold minus beginning gross equipment
balance. You need to make sure you understand what
gross means. If you buy equipment for 100, and let's say, this
equipment will be used for 10 years, and every year
the depreciation is 10, then after 1 year the net book
value of the equipment will be 100 - 10, assuming 10
is the depreciation every year so, you will have
a book value of 90. After two years, you'd appreciate
10, again and you will have a net book value of 80.
So, the 80 is referred to as net book value. The gross
equipment value is still 100. So, notice the gross value
is the net value plus the accumulated depreciation.
Accumulated depreciation, in this example, is 20
so, cash paid for new equipment is ending gross equipment balance
plus the gross cost of equipment sold minus beginning gross equipment balance.
Let's say that we start with a simple example, where nothing
was sold during the year. If the ending gross equipment
balance is 500, and the beginning gross equipment
balance is equal to 400, then this obviously means
that the cash paid for new equipment must be a 100,
assuming of course that nothing was sold during
the year. You take the end number subtract the beginning
number and the difference has to be explained by
how much cash was paid for the new equipment. Now, let's say from the footnotes
you recognize that the gross cost of equipment sold was 50, then what
is the cash paid for new equipment? The answer
is as follows; you have an ending balance, let's say
of 500, so you will do 500 + 50.
The way you can think of this is if the equipment had
not being sold then the ending balance would have
been 550, and then you subtract the beginning balance
of 400, you have 550 - 400 which is equal to 150. Next, we
try to determine cash inflow from the sale of equipment.
This is a little more complicated and here we need
to understand the equipment amount, the accumulated
depreciation and the gain or loss on sale of equipment.
The cash from sale is equal to the historical cost of the equipment
sold, this is the same as the gross cost of the equipment
sold minus depreciation on equipment sold. When
you combine these two items, you have the net book
value of the equipment which is sold. Let's say
that the net book value is equal to 80 and let's say
that the gain on sale of equipment, you can easily
get from the income statement, is equal to 5. The cash
from sale of the equipment would then clearly be
80 + 5, which is 85, but these numbers however, are not
so easy to come up with, they're not given to you. They
have to be computed using the financial statements.
So, let's see how we compute these numbers. The historical
cost of equipment sold is equal to the beginning
balance of equipment. So this would be the gross
amount for equipment. If you are looking at a given
time period, let's say 2010, you will look at the beginning
balance of equipment, then you will add the equipment
purchased. This typically would be, this information
would be obtained from footnotes. So you add that
and then you subtract the ending balance, you subtract
the ending balance of equipment, and we look at example
on the slide. Depreciation on equipment sold
that is given by this formula, the beginning balance
of accumulated depreciation again, that would
be start of the period, plus depreciation expense minus ending
balance of accumulated depreciation. These two
items would come from the balance sheet, this would
come from the income statement, and then you add
the gain on sale of equipment, this is easy, this comes
straight from the income statement. Now, I want you to
memorize what you are looking at over here, or at
least make a note, and then attempt the question on
the next slide, which is given right here. So, here
is what you should be doing. This is simply reproducing
the information from the question, the correct
answer is 3.5. You first, compute historical cost
of equipment sold as 3 and to come up with 3 you
need to look at the beginning balance of equipment,
that's the gross amount, 80 + equipment purchased,
that's 14, minus ending balance, which is 91, and then you
subtract the depreciation on equipment sold that's
1, and you get that using this expression. Beginning
balance accumulated depreciation, which is 25
plus depreciation expense, 7, minus accumulated
depreciation at the end, 31, so that should give you
1, and then gain on sale of equipment from the income
statement is 1.5. Put these numbers together, and you should
get 3.5. Coming now to Financing Activities, and
as I mentioned before, both with investing activities
and financing activities, we only have the direct
method there is no indirect method. Financing activities
deals with cash flow between the firm and suppliers
of capital. The major suppliers of capital are either
lenders or bondholders and shareholders, either
the common shareholders or preferred shareholders. So,
all this cash flow needs to be shown on the financing segment
of the cash flow statement. It's referred to as
the CFF, Cash Flow from Financing. If you look at the
lender side, the net cash flow from creditors is equal
to the net borrowing, so in a given period, this would be
the net borrowing. This is how much money the firm
is getting from the lenders, minus the principal
amount repaid and these are the principal amount
repaid. In this particular scenario, we are assuming
that any interest paid is shown on the CFO part of
the cash flow statement. So, this clearly is U.S. GAAP
perspective, or it could also be IFRS where we are
assuming that interest is shown in the CFO segment.
In terms of interaction with shareholders, the net
cash flow from shareholders is equal to new equity
issued. When a firm issues new equity, it is going
to get cash from shareholders, so that's this
over here, minus shares repurchased. When the firm repurchases
shares, it is giving money to shareholders, and then
also minus any cash dividends. When cash dividends are
paid, the firm is giving cash to shareholders.
The combination of these two essentially form the
CFF part of the cash flow statement. Putting all
this together, you notice that we have operating
activities shown right up front and we have discussed
each of these elements, cash flow from customers,
and then various cash expenses are just cash paid
for rent, employees etc. Then, we have investing activities
where primarily we are dealing with the purchase
and sale of equipment even investment securities
would fall in this category. So, this is CFI, and
then financing activities are issues of stock increases
and notes payable, that means borrowing went up.
Repurchase of treasury stock, this is money going
out to the shareholders, cash flow from financing
activities, net amount is given right here. You add
all these together, and that's the total cash flow.
This then is a simple example of a overall cash flow statement
using the direct method. With the indirect method,
the only thing that would be different would be the
operating segment, where we would start with the net
income and reconcile down to CFO, the CFO number
would be the same. Let's briefly talk about the
indirect method now. Here, we begin with the net income
and this comes obviously straight from the income
statement. Then, we add back all non-cash charges
to income and subtract all non-cash components
of revenue. Classic example here would be depreciation
for non-cash charges, say, for a given company, the
net income is a 100, since, we are dealing with
cash flow, we need to add back depreciation, say, the
depreciation charge is 10. Remember, the depreciation
was subtracted, in order, to come up with net income.
So, if we are going to arrive at a CFO number, we need
to add back depreciation. We subtract gains or losses
that resulted from financing or investing activities.
So, actually, subtract gains or add the losses that
resulted from financing or investing activities.
The classic example would be, let's say that on the
income statement, we showed the gain of 5 from the
sale of equipment, now, the gain of 5 caused the
net income to be higher, but that wasn't a real cash
flow, the gain of 5 was not a operating cash flow. So, what
we are then doing is subtracting that gain, if this
had been a loss then we would be adding. When you add
or subtract changes to balance sheet operating
accounts, and we have discussed this before. Any increases
in operating asset accounts, such as accounts receivable
going up is a use of cash, so that would be a minus.
So, if accounts receivable is going up by 3, then we
would subtract 3, if inventory has gone up by 7 then
we would subtract 7. When we deal with increases in
operating liability account. So, if accounts payable
is going up by 6, we would add 6 over here. Once you
put all this together, you then have a reconciliation
between net income and the cash flow from operations.
In order to internalize what we are talking about,
over here, I would strongly encourage you to do example
7 from the curriculum. Coming down to the conversion
of cash flows from indirect to direct method. This
is a little bit complicated, but it is part of the learning
objectives. However, I think the probability of
you being tested on this material in detail is low.
Nevertheless, since it is part of the learning objectives,
we will go over the process. Step one, is to aggregate all
revenues and expenses. So, you come up with total
revenue subtract the total expenses, and you have
your net income, this is essentially, your income
statement. Then, you remove all non-cash items from
aggregate revenues and expenses and break out remaining
items into relevant cash flows. The major item here
would be to take your revenue and remove non-cash
revenue, such as gain on sale of equipment. This material,
by the way, is illustrated quite well in exhibit 11
in the curriculum. So, if you also follow along from
the curriculum, this discussion will be a little
bit easier. The cost of goods sold, salary and wages,
etc all this information, you can get from the
income statement, and then you convert accrual amounts,
these are the amount from the income statement
which are based on accrual accounting. So, you convert
these accrual amounts to cash flow amounts by adjusting
for working capital changes. The working capital
is your accounts receivable, accounts payable inventory,
etc, your current assets other than cash and
your current liability, such as accounts payable.
So, when we talk about cash from customers, you start
with the revenue number and make an adjustment based
on accounts receivable. To get cash to suppliers
you start with COGS and make an adjustment based
on changes in accounts payable, and inventory and
so on. This is exactly what we have talked about earlier.
So, you make the adjustments and come up with the various
cash payments, and then you have your final number
for CFO. Notice, we are only dealing with operating
cash flows, because for investing and financing
the material is always presented in the direct format
anyway.