hello I'm Professor Brian B welcome back in this video we're going to 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 dispersements by the source or use of funds so where are all the places that the cash came from from where are all the places that you paid cash out to this method is
always used for investing in financing activities but it's 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 non-cash items from net income and including any additional cash flows that were not in net income so we're going to see a statement that starts with net income ends with cash 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 whereas 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 going to 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 is 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 that 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 non-cash 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 get the cash flow so for example net income includes depreciation expense and amortization expense which are both non-cash
expenses to remove those non-cash 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 could also have gains or losses on sale of property PL equipment or Investments now there are cash flows associated with those those but we want to count those cash flows in the investing section so we need to remove these 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 the payables what we need to do here is add or subtract the change in the asset or liability account balance and we're going to use the balance sheet equation to determine whether we should add or subtract for example counts receivable is a non-cash asset if a accountable went up we would need to subtract it on the cash flow statement to stay in Balance inventory is
a non-cash 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 counts 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 or maybe four or 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 um adding a little bit more complexity each example in the simplest case we have a company that had $100 of sales which are all in cash their cost of good sold were $60 again all in cash so they they bought $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 opper cash flow of 40 and in this case the operating cash flow is exactly the same of 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 non-cash 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 of 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 non-cash expense depreciation which gives the company a net income of 30 under the direct method we have cash collections to 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 non-cash 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 a 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 to show you how this works okay let's say we have another $10 of depreciation that means we would have $20 appreciation expense total and we would add back 20 but our net income
would be lower because more expense means less than net 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 + 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 is a non-cash expense it can't create more cash flow now one thing I should note is that you can use different depreciation for tax ta purposes
than you see here in the financial statements and changes in depreciation for tax purposes actually can save on taxes and can affect 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 let's assume that only $80 is received in cash the other $20 of sales were made on account so that we end the period with accounts receivable we still have 6 $ of cogs which is all in cash and our $10 of 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 we 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 non-cash 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 reable started the period at zero Ed the period at 20 so that's a $20 increase in a non-cash 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 depre iation expenses 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 despite the face actually I think throwing the baby out with the bathwater would be a better analogy here but anyway let's think through the intuition behind the indirect method we want to start with net income make adjustments to get to cash from operations net income includes $100 of 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 non-cash sales because anytime 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 non-cash sales we're left with $80 of cash sales and cash operations making the nose the face the baby and the
bathwater 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 going to make the inventory part a lot more complicated so we'll keep $60 of cost to get 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 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 zero and ended the year at 15 it went up by 15 because we purchased 75 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 zero ended the year at 25 so this Li 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 balanced 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 your Buy 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 going to go go through a lot more examples of like this in remaining videos to help you get down this intuition okay 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 uh sorry to be a little peevish there I guess that's what the cash flow statement will do to us I 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 what we're going to 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 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 indirect method cash flow statement anyway I'll see you next video see you next video
