hello I'm Professor Brian B welcome back in this video we're going to look at a couple of madeup companies purple and green which have very different net incomes but exactly the same cash flow it will give us some more practice at putting together cash flow statements under the indirect method but more importantly it'll allow us to talk more about the differences between net income and cash flow and it'll give us some practice in doing a complete analysis of a statement of cash flows let's get started to put together cash flow statements for purple Incorporated and
green company we of course have to start with net income so here are the income statements for both purple and green we can see that purple has 150,000 of net income green has 50,000 so when we start on the statement of cash flows that's going to be the Top Line the net income for purple and the net income for green now the next step in put together the cash flow statements for these two companies would be to look for non-cash charges like depreciation if we go back to the income statement you don't see depreciation anywhere
here that's because it's lumped in with cost of goods sold so what I'm going to do is give you some additional information that you'll need to solve this problem and the first piece of additional information is the depreciation for the two companies so purple had 50,000 of depreciation included in cost to get sold green had 100,000 of depreciation included and cost of good sold under the indirect method we add those two back they're non-cash expenses so to remove them we have to add them back now there's actually another non-cash expense for at least one of
these companies and that's an expense due to restructuring so purple had no restructuring activity in 2012 green recognized the 75,000 liability due to restructuring in 2012 but did not pay any cash on that liability during the year excuse me what is this restructuring liability why is an expense recognized before any cash is paid this is the conservatism principle in action so we talked about this in Prior videos but the conservatism principle says that when a company anticipates future losses they have to recognize an expense for them today so in this case green has decided to
restructure they have a restructuring plan which will involve laying off employees and incurring employ Severance costs closing facilities and incurring facility closing costs and they have to recognize an expense for the total amount of those estimated cash costs today and then create a liability that will represent the obligation to pay those cash costs in the future to reinforce this point let's take a look at the journal entry green would make when they record this restructuring liability they debit restructuring expense for 75,000 that represents presents the amount of expected future cash flows they're going to spend
on the restructuring which they're required to recognize an expense in the year they make the decision to restructure they credit the restructuring liability for 75,000 which of course is the obligation to pay that cash in the future notice there's no debit or credit to cash here so this is a transaction that has no cash impact so we treat the restructuring charge like depreciation it's a non-cash expense so to remove the non-cash expense we add it back to get from net income to cash from operations next both companies had proceeds from selling equipment during 2012 purple
sold equipment for $30,000 which included a $10,000 gain over the book value of the equipment green sold equipment for $50,000 which included a $20,000 loss over the book value of the equipment now I'm going to show you the journal entries here just to make clear how this works we're going to revisit this topic later in the course so what purple would have done is debit cash for 30,000 because that's how much cash they're receiving they have a gain on the sale which is a credit it's like a revenue it increases net income it increases stock
holders Equity so you credit gain on sale for 10,000 and then they would credit net property plan and equipment to take the PPN off the books at its current Book value what is a net PP and account do they even have these in the real world no they don't have net PPN accounts in the real world I'm just using this as a simplification for now in the real journal entry what you'd have to do is credit the building account for the original cost of the building and debit the accumulated depreciation account for all the depreciation
that's accumulated so far in the building we'll see that journal entry in a couple weeks but for now I'm trying to keep things simple so I created a net ppne account sorry now let's look at the journal entry for green they would debit cash for $50,000 because they're receiving $50,000 cash they debit loss on sale the loss is just like an expense it reduces net income reduces stockholders Equity so that leaves us with a credit to net property plant equipment the original book value of the equipment that was sold was 70,000 we only got 50,000
cash which is why we got a loss of 20,000 now going to the statement of cash flows what we want to do is take those two debits to cash the 30,000 and the 50,000 and show them under investing activities as proceeds from sale of equipment but then to avoid double counting we need to remove the gains and losses from the operating section so for purple they had a gain of 10,000 we subtract that gain to remove it from net income to get to cash from operations for green they had a loss we need to add
that loss back to remove it from net income to get to cash from operations by taking out the gains and the losses we avoid double counting the cash flow in operating we've already recognized that cash flow in investing I believe the viewers would be more entertained right now if you did the Okie pokei again I suppose here it goes for purple you put the gain in you take the gain out you put the gain in and you shake it all about you do the hokey pokey and you turn yourself around that's what it's all about
now for green you put the loss in you take the loss out you put the loss in and you shake it all about you do the Hoke Pokey and you turn yourself around that's what it's all about next item both purple and green spent cash flow on Capital expenditures buying things like property plant and Equipment purple had 220,000 of capex green had 70,000 of capex so we know that capex is an investing or is it capex are an fting activities capex is or capex are you Americans have no idea how to use the correct verb
tense you say England is eliminated from the World Cup when everyone knows the correct version is England are eliminated from the World Cup please move on uh okay anyway we put a line in the cash from investing activity section where we show the capital expenditures for both purple and green next we have a number of financing activities that two companies did during 2012 purple received $50,000 proceeds from issuing long-term debt they made 35,000 of payments on their long-term debt and they didn't pay any dividends green did not issue any new debt they paid back 95,000
of their existing long-term debt and they paid 60,000 of dividends to their shareholders these are all financing activities so in the state of cash flows we just put a line item for each activity to show the proceeds and payment of long-term debt and the dividends paid for the two companies so now we're done with the investing and financing sections of the statement of cash flow so we're going to go back and work on the rest of the operating section I'll give you the changes in the working capital accounts and we'll go ahead and put those
in the cash flow statement so for accounts re receivable purple had an increase of 100,000 during 2012 whereas green had a decrease in accounts receivable of 100,000 so to know whether to add or subtract these we need to use the balance sheet equation Cash Plus NCA equals liabilities plus stock holders Equity excuse me what is NCA sorry NCA stands for noncash assets starting with purple their accounts receival went up so that's an increase in a non-cash asset which means we have to subtract it on the cash flow statement the intuition here is that they made
more credit sales than they had cash collections so they're booked some Revenue that was non-cash and we have to subtract out the increase in accounts reable as the non-cash portion for green their accounts receivable went down by 100,000 it's a non-cash asset going down so we add that back on the cash flow statement the intuition here is that their cash collections were greater than their new sales which must mean that they were collecting based on prior sales in addition to whatever collected this period next purple had an increase in inventory of 50,000 green had a
decrease in inventory of 50,000 so starting with purple inventory goes up non-cash asset goes up we subtract that on the cash flow statement what must have happened here is purple bought more inventory than they sold with the amount of inventory they sold represented in net income for green their inventory went down so that's a non-cash asset going down we add that back on the cash flow statement to stay in balance and what this means is that green actually sold more inventory than they purchased so not only did they sell whatever they had this year but
they tapped into the inventory at the beginning of the year and sold some of that as well so that's an extra source of cash flow by selling the inventory from the prior period purple had prepaid expenses which decreased by 100,000 Green's prepaid expenses increased by 25,000 during 2012 so for purple prepaid expenses go down and non-cash asset goes down we add that on the cash flow statement for green non-cash asset goes up by 25 as prepaid expenses increase we subtract that on the cash flow statement for accounts payable purple had an increase of 75,000 in
2012 green had a decrease of 75,000 in 2012 now we're on the other side of the equal sign so for Purple account payable goes up that means liability goes up by 75,000 so we have to add that to the cash flow statement to stay in Balance intuition here is that if your accounts payable are going up that's money that you're not paying to your suppliers which is a source of cash for green their accounts payable went down their liabilities went down and so we have to subtract that on the cash statement to stay in Balance
what happened here is green actually paid more cash to their suppliers then they acquired new inventory on account and that actually makes sense because we actually saw their inventory reduce so those two often go together uh inventory as a source of cash is often accompanied by accounts receivable as a use of cash as you're paying off more creditors than you're adding in new accounts payable finally for interest payable purple had an increase of 10,000 in 2012 green had a decrease of 70,000 in 2012 so for purple we have an increase in interest payables and increase
in liabilities so we add that to the cash flow statement for green we had liabilities go down by 70,000 as interest payable dropped we subtract that on the cash flow statement and once all is said and done and we add everything up it turns out that purple and green have exactly the same cash from operations of $225,000 so these companies have the same cash flow but purple has three times the earnings as green what do we make of this does this happen in the real world yes in fact I think it happened in episode four
of the real world Honolulu but maybe I'm not remembering that correctly anyway I'm going to go through now and do a detailed analysis and we'll talk about why these two numbers can be so different now that we've put them together let's take a look at these two cash flow statements in detail to see what we can learn by analyzing them first for purple we see a nice big cash operations of 220,000 most of which they're reinvesting in long-term assets we see they have Capital expenditures of 220,000 their net cash from financing is slightly positive uh
because for some reason they decided to run up their cash balance by 50,000 but this profile overall looks sort of like a growth maybe into a mature stage where you've got healthy cash from operations but most most of it is being reinvested back into the business through cash for investing activities now let's take a look at green green had the same high cash from operations of 225,000 but they're investing almost nothing in long-term assets their Capital expenditures were only 70,000 and they sold $50,000 worth of equipment during the year so what are they doing with
all that cash that they're not investing they're actually paying off financing and paying dividends so we see a big negative cash from financing activities they're not borrowing anything new they're paying off a lot of long-term debt and they're paying dividends to their shareholders this is typical of a late mature and declin Stage Company where the Investments aren't there so they're taking the excess cash flow and paying off debt and returning it to shareholders through dividends next I want to take a look at the operating sections in more detail for these two companies starting on the
top line we have net and we see that purple has three times as much net income as green even though their cash operations are the same so is purple three times better than green or are they the same company well we can learn what's going on with this discrepancy by looking at everything between net income and cash operations so all the things that cause them to be different the first big difference is depreciation green has much more depreciation than purple now one way that we can try to understand what this means is to compare depreciation
and capital expenditures if you think of depreciation as using up old equipment whereas Capital expenditures is buying new equipment it's an interesting comparison to look at the relative magnitudes so for purple they have 50,000 of depreciation but 220,000 of capex indicating that they're growing dramatically they're investing a lot more in new equipment than they're using up old equipment when we look at green we see 100,000 of depreciation and only 70,000 of capex so green is not even investing enough to replace its existing use of equipment so that would indicate that green does not have a
lot of good growth prospects the next big discrepancy is the restructuring charge with green ended up taking during the year that's a non-cash charge so it caused net income to go down but did not affect cash operations and in fact it's one of the big reasons why green had much less net income but it's also an indication of bad news because the restructuring charge is an estimate of all of the future cash flows that green will have to pay to lay off employees pay employee severances close facilities and things like that so what net income
does is they pull all those future charges into the present within expense whereas the cash flow statement will only show those future cash payments as they happen down the road finally we can look at all of the changes in working capital so for purple we see negative effects of change in accounts receivable and inventory which means those two accounts are growing uh change in accounts payable is positive which also means it's growing so this indicates that purple's business is growing substantially in terms of their working capital when we look at green we see that accounts
reable and inventory was a source of cash because they've been liquidating or reducing their account tuent inventory their payables have also been going down and so this profile is again consistent with a company that doesn't have a lot of growth and may actually be reducing its size so putting it all together it turns out that these movements in working capital due to the different growth stages happen to make the cashm operations the same this period but purple looks like it's the much better bet long term because it's throwing off a lot more net income and
it doesn't have to do this restructuring down the road last I want to look at eah for these two companies remember iida is earnings before interest taxes and depreciation amortization and what we see from the ibida is that purple has much higher IAH than green which means that ibah is really not picking up cash flow because what we just saw in the cash flow statement was that the cash from operations was identical between these two companies now of course if you think back to the cash flow statement one of the things that green had was
a restructuring charge which is a non-cash charge like depreciation that needs to get added back so if we add back the restructuring charge so that we get ebit dah without the restructuring now the two numbers are closer also if we go back to the cash flow statement they had different losses and gains on sales of assets that's part of earnings but it should be an investing cash flow so we need to take that out as well so why don't we adjust for the gains and losses on asset sales and when we do that then we
get EIT da that's identical between the two companies although I guess since it's iida without the restructuring in the gains and losses we should call it IID darle I believe that you simply made up the term iidle does anyone use that term in the real world excuse me I am the real world guy so does anyone use the term bit tarle in the real world I believe we should stop asking you silly questions so you can tell us what is the best measure of cash flow yes I did make up the term eat Dargo probably
the only people that use that term in the real world are my former students and they probably only use it once get laughed at and then stop using it again but I want to raise the point with this Eva darkle term that people often say IA but they don't literally mean earnings before interest taxes depreciation ammonization because if there's other non-ash expenses or gains and losses from investing activities they'll take those out as well and still call it eada so before you use IAH you got to know what's in the measure so one more point
I want to make before we wrap up the video we see that the EA darle is identical between purple and green and we saw that the cash from operations was identical on the cash flow statement but the cash from operations was less than EA Dargo so there's two reasons for this discrepancy one is that EA dargle takes out interest in taxes whereas the cash flow statement number includes cash taxes and cash interest the second discrepancy is that of course the net cash from operations adjust for changes in working capital whereas EIT dargle doesn't so to
get a really good cash operations number I would suggest one of the two following approaches either calculate EIT dargle and then adjust for all the changes in working capital or take net cash from operations and then add back the cash interest and cash taxes to remove those two but you have to do one of those two approaches taking either EA darle on its own or net cash from operations on its own is not going to give you the number you want if you're going to take this and put it into a free cash flow model
I hope that gives you some sense of the things that you can learn by doing an anal analysis of the statement of cash flows and I hope it gives you some caution in using this EIT dah measure that everyone seems to like even though it has a lot of drawbacks and wow look at that we're already done with the week on cash flow statements where has the time gone I'll see you next time see you next video
