hello I'm Professor Brian Bay welcome back in this video we're finally going to finish the Relic spotter Case by putting together its statement of cash flows using the direct and indirect methods let's get started last time we looked at the Relic spotter case we put all of the cash transactions into operating investing and financing buckets so now we're going to go ahead and use these classifications to put together the cash flow statement to do the indirect method we're going to need to pull some information off the income statement so here's a reminder of what the
income statement looked like for Relic Spotter and we're going to need to use the balance sheet so here's what the balance sheet looked like for Relic spotter where did all of the zeros come from I don't remember all of those zeros when we put together the balance sheet good memory in fact when we put together the Relic spotter balance sheet we didn't have all these zeros in there because we only put together the ending balance sheet but when we do a c statement we need the change in the balances the difference between the beginning balance
and the ending balance there was no beginning balance in any of these accounts because Relic spotter is a startup company so I went ahead and created a beginning balance sheet of all zeros to make it clear that we're taking the change in the balances for the statement of cash flows not just the ending balance first I'm going to do the direct method for investing and financing activities once we get that out of the way then we'll look at operating activities under both both the direct and indirect method for the investing activities we need to pull
up the column of cash flows that we classified as investing and then just list them in the cash flow from investing activity section so we have purchase of land for 103,000 purchase of buildings 85,000 we purchase Metal Detectors of $120,000 cash and purchase the software which is a long-term asset $2,100 add them all up we get net cash outflow from invest activities of 31,100 this section will go on the final cash flow statement how do you determine which line items to report on the statement often times don't companies simply report a line called Capital expenditures
there are generally no specific rules that govern how much or how little detail you break things into on the statement of cash flows it's the manager's choice but usually the manager makes the choice based on what investors and analysts want to see because if investors and analysts are looking for piece of information that's not there they'll just ask the company about it during a conference call or some other communication so what you're seeing on the cash flow statement is a joint agreement between managers and the users of the financial statement as to how much detail
they want to see in these various line items about the company NeXT we do the direct method for the financing activities so here is the column of cash transactions that we classified as financing now we just need to list them so we paid dividends of $2,500 proceeds of sale of stock that was $250,000 coming in and proceeds from the mortgage payable was $124,000 coming in that gives us a net cash inflow from financing activities of $371,500 and this section will go on the final cash flow statement now even though it's somewhat theoretical because companies never
really report these we're going to look at the operating activities under the direct method so let me pull in the operating cash flow transactions and under the direct method all we have to do is list them so first I'm going to take all the cash we collected from customers we received cash on the rental prepayment from the pen inti equities Club the revenues that came in cash from metal detector rentals and then the 35,000 of cash from the sundry sales you add that together and we have cash collected from customers totaling 156,00 wait we haven't
recognized Revenue yet on the rental prepayment amount how can we justify putting that on the cash flow statement well we can justify putting it on the cash flow statement because Relic spotter actually received cash but you rais a good point in that a lot of the examples we've seen so far companies are recording Revenue before they receive the cash and so we have a change in accounts receivable but you could have a company receive the cash before they earn the revenue the cash flow statement is is just giving you cash in and cash out during
the period and that's going to be different from revenue but it could be different in either direction either you can might get the cash first or you might get the cash later compared to when you book the revenue continuing on we paid $2,000 cash to our supplier and we bought an additional 38,000 of inventory with cash add that up cash paid to suppliers is 40,000 cash paid to employees for salaries and wages was 82,000 cash paid for short-term loans was 5,000 and then I'll combine legal fees and advertising into cash paid for miscellaneous expenses of
11,900 again whether you list those separately or combine them depends on what your financial statement users want to see in terms of the level of detail we add all this up and we get net cash from operations of 17,400 which is what we had in the operating bucket to begin with okay this direct method is simple clear straightforward and informative but you said that companies rarely use it so so why do we have to learn the indirect method why do companies prefer the indirect method and why does the Faz B require it even when the
direct method is chosen um yes that is what I was going to ask let's hear your answer I'm glad you asked that question here because this is the best place for me to show you why the direct method is not that useful for the operating section of the cash flow statement let me jump out to the slide to show you what I mean so Relic spotter's cash collected from customers was 156,00 is that good or bad Relic spotter's cash paid to suppliers was 40,000 is that good or bad well you can't tell without some kind
of Benchmark you could look at prior your numbers to see if there's a trend but we really want to know is what was the level of activity surrounding these cash collections during the year for example if Relic spotter had 157,000 of Revenue and collected 1563 in cash then the cash flow makes sense but if Relic spotter had 500,000 in Revenue but only collected 1563 then there may be a problem or let's say that Relic spotter sold 40,000 of inventory paid 40,000 of their suppliers again the cash flow makes sense but what if Relic spotter only
sold 10,000 of inventory then the question is why did they spend an extra 30,000 in cash to acquire inventory they didn't sell what the indirect method's going to do is start with net income as a benchmark for the expected level of activity or expected level of cash flows During the period and then highlight any discrepancies from that level this is the kind of thing we'll talk about when we do an analysis of an indirect cash flow statement after we finally put one together later in the video now we're going to do the indirect method which
will be what will show on the final cash flow statement for Relic spotter we're going to go step by step following the algorithm that I did before starting with net income so I've pulled up the income statement at the bottom line we can see net income was $2,370 so on our indirect method cash flow statement we start at the top with net income of 2370 notice I already have the answer at the bottom net cash operations of 17400 because whatever we do in this section we have to get the same answer that we got under
the direct method okay so far so good next step in our algorithm was to adjust for components of net income tied to non-cash items or investing activities we could ignore investing activities for Relic spotter because they didn't have any gains or losses on sale of PPE or Investments so it really involves adding back the depreciation amortization here is the income statement again we had metal detector depreciation of 3,000 software amortization expense of 350 and building depreciation expense of 1,500 I'm going to combine those into one line item called depreciation and amortization of 31,800 and we're
going to add that back to remove that non-cash expense from net income do we always combine all of the depreciation and amortization into one line again this is a choice by managers about how much or how little detail that want to provide on their statements one thing I will say here is that generally the only place you can find depreciation amortization expense in the statements is on the statement of cash flows yes it's part of the income statement but it's often combined with other items and not broken out separately but you'll always be able to
find it broken out separately in the operating section of the statement of cash flows the last step in our algorithm is to go through all the asset and liability accounts related to operating activities in other words the working capital accounts and add or subtract the change in the balance based on the balance sheet equation so start with accounts receivable accounts receivable went from 0 to 4200 so it went up by 4200 during the year that's a non-cash asset going up which means we need to subtract it on the cash flow statement to stay in Balance
notes receivable went from 0 to 5,000 non-cash asset going up to stay in Balance we need to subtract that on the cash flow statement so we subtract change in notes receivable of 5,000 interest receivable went from 0 to 250 non-cash asset going up so we subtracted on the cash flow statement inventory went from 0 to 12,000 non-cash asset going up so we subtracted on the cash flow statement prepaid advertising went from 0 to 4,000 and again non-cash asset going up we subtracted that on the cash flow statement I think I understand assets are always subtracted
when the indirect method is used no no no no no that's just a function of looking at a startup company which of course had a balance of zero in all the assets at the beginning of the year and so all the assets went up in a future video we'll look at examples where companies do add assets to their statement of cash flows because they've had assets go down during the year if we look at the rest of the assets out of the balance sheet we have land buildings metal detectors software we don't do anything with
those in the operating section because we've already taken care of those in the investing activities so we move on to the liability side of the balance sheet we have accounts payable went from 0 to 2,000 that's an increase in a liability of 200,000 note we're on the other side of the equal sign with the liability so liability going up means that we need to add it to the cash flow statement interest payable went from 0 to 4900 so that's an increase in a liability of 4,900 which we need to add to the cash flow statement
to keep the balance sheet equation in Balance income taxes payable went from 0 to 630 again an increase in a liability gets added to the cash flow statement and unearned Revenue went from 0 to 1100 that's an increase in liability that gets added to the cash flow statement and I think I am not wrong to assume that it is not necessarily the case that liabilities are always added under the indirect method wow there were a lot of negatives there I'm not really sure what the question was but you should not assume that liabilities are always
added on the cash flow statement again because we looking at a startup all the liabilities went up in value and so we added them we will see examples where liabilities go down during the year and we end up subtracting them on the cash flow statement going back to the balance sheet the next accounts we would have would be mortgage payable common stock additional paid in capital but we already took care of those with the cash flow from financing activities and retained earnings that's just net income and dividends which we've also taken care of so looks
like we're done which is a good thing because we're out of space on the indirect method cash flow statement here on the right and if you add everything up you'll find that we get the same answer 17,400 that we got under the direct method so putting it all together this is what Relic spotter's cash flow statement is going to look like cash flows from operating activities are going to be under the indirect method and then we'll have cash flow from investing and financing activity under the direct method in terms of analysis what this statement tells
us is that this company is still in the early growth stage of its life cycle we do have positive cash operations 17,00 400 but that's nowhere near enough to cover all the cash outflow for investing activities so Relic spot had to go out and raiseed a lot of cash through financing activities both through stock and mortgage payable so again just like we did in Prior videos we can look at these three buckets operating investing and financing to get a sense for where a company is in its gross stage and life cycle now I want to
focus just on the cash flow from operating activity section so we can talk about what we learn from this indirect method presentation first thing we learn is it gives us the two different pictures of the company's performance during the year so we see Relic spotter's net income which answers the question did Relic spotter price their rentals and sales high enough to cover all the cost of the running the business and thus post a profit and we can see they did they had a profit of 2370 then at the bottom we see net cash operations which
answers the question did Relic spotter have more cash coming in than cash going out in activities related to running the business and here we see that that was the case also between those two pictures of the business we see all the discrepancies all the reason why we got different answers and the biggest discrepancy is the depreciation and amortization and that makes sense because net income includes an expense or a charge for using up these fixed assets using the buildings and metal detector and softwares whereas there is is no cash implications of doing that and so
it doesn't affect cash from operations so anytime you look at companies that are very Capital intensive they have a lot of long-term assets you'll see this difference between net income and cash from operations is primarily driven by this depreciation amortization then we have all of the changes in working capital that have created discrepancies between net income and cash flow and from an analysis point of view I think these are the most interesting and important lines to focus on in the cash flow statement because what these lines are telling you is that some management activity is
creating a wedge between cash flows and revenue and expense recognition so what you want to do is focus on the really big numbers and try to understand what's going on so for instance the biggest number is the change in inventory is a negative - 12,000 what that represents is that Relic spotter purchased $122,000 more inventory in cash than they needed for their level of sales which were recognized in net income what you want to do now is dig in and try to find out what caused that so did Relic spotter management buy a bunch of
inventory that they couldn't sell because nobody wanted it then this would be bad news or were they getting some kind of volume discounts and so they were buying excess inventory in advance of future sales which would be good news I mean the cash flow statement is not going to tell you which one it is but it's going to tell you you need to dig into these further as another example a big uh discrepancy that you often see is changes in accounts receivable which in case of Relic spotter was - 4200 this indicates that they booked
more sales than they collected cash this could be good news if their sales are growing dramatically and they just haven't had a chance to collect them yet or it could be bad news if their sales on account to customers are not getting collected because the customers are not paying they're in financial difficulty again we don't know which scenario is going on just by looking at the cash flow statement what it does is it highlights we need to dig into these further so you want to look for the big numbers and these changes in working capital
and these are going to be a starting point for further information gathering to try to figure out what's going on at the company so that was our first trip through putting together an indirect method cash flow statement using the balance sheet and the income statement not clear yet don't worry there are more examples coming in the future videos I'll see you then see you next video
