hello I'm Professor Brian B welcome back in this video we're going 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 ebit DA 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 we $70 on the books for $75 cash how are we able to sell PP and 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 going to 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 going to end up selling it for more or less than it's on the books so they give it this way if we 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 going to 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 net income just like
Revenue would we're not going to consider a Topline 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 going to 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 going to 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 going to bring back one of the basic examples we did early on where we have all of our sales in cash all of our cost of goods sold in cash and then depreciation of $10 we're going to add to that the gain on sale of property plant equipment which goes in the income statement which would make our net income 35 under the direct method cash flow all of our sales were cash so we have collections from customers
of 100 all of our cost of good 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 PPN 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 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 ah 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 pokei 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 Hoke pokei and you turn yourself around that's what it's all about next I want to talk about some of the complications that you may run into when looking at a statement of cash flows uh these are not things that we're going to 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 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 divestures of businesses all the cash that companies pay when they acquire another company is considered an investing cash flow but part of the things that 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 an investing cash flow and we don't want to 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 rate movement would affect 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 what's 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 seconde elective so we're not going to go into this in detail in this course I just want you to be aware of the fact that all 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 affect what is considered operating
versus investing activities so let's think back to our company before that made the pills to cure gray hair not that gray hair needs to be cured let's say this company goes out and buys a real estate subsidiary well what happened 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 because 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 want to talk about disagreements that anals and investors have over the fby classification a couple items I I know it's hard to believe that people would disagree with the fby but there are a couple disagreements out there the first many investors in 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
under us Gap you're required to call those operating so one thing the fby did is they required a disclosure of cash paid for interest so if investors or analysts want to take it out of operating they can easily subtract it because that disclosure is 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 fby requires that all cash taxes paid must be dis closed 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 eitaa which is defined as earnings before interest taxes depreciation and amortization IA 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 ebit 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 inre IA but there's no cash that's collected the customers haven't paid us yet
instead accounts receivable go up so IA would consider this channel stuffing as a cash flow but it's not a cash flow now if we took IA and adjusted for this increase in accounts receivable then we would have a good measure of cash flow and I'm going to talk about this more in the next video I believe this is not correct everyone knows that Eid is the best measure of cash no I feel pretty strongly that EA is not a good measure of cash flow Because unless youjust for these changes in working capital then IA is
just as easy to manipulate as earnings is what we're going to do in the next video is a case where we'll highlight some of these drawbacks of IA 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 talk about cash is King implying that you should only look at cash from operations or IAH as a proxy for cash from 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 a 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 flow from operations and academic research is very clear that if you put both measures in together you get the best predictions of how a company is going to do in the future in terms of its future cash flows I bet that accounting professors did the research to show that turnings is better than cash flow is that truly the case in the real
world uh 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 longtime series of data from 1962 to the present and it's a very robust result that earnings are a better predictor of future F 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 want to 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 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 text books 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 fby number and then adjusting for interest expense another defines it as no plat which is net operating profits less adjusted taxes which would be ebah minus cash taxes on ebah
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 noat minus increases in working capital is a better measure noad 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 in taxes and add depreciation and a lot of them just say eada without defining what is and on top of this another problem you'll encounter is companies will offer 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 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 fby 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
iida 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 cach operations so I know that was a lot to throw at you in one video what we're going to 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
some practice on handling gains and losses on sale of property planted equipment in the cash flow statement and it will allow us to continue our discussion of earnings versus Cash Flow versus I I'll see you then I believe that we will see you next video
