HARVARD @ BUSINESS How Cash Connects with Everything Else Understanding a Cash Flow Statement EXCERPTED FROM Financial Intelligence A Manager's Guide to Knowing What the Numbers Really Mean By Karen Berman, Joe Knight, John Case Harvard Basness Pees Boson, Mosh “sa7acopi 2008 Harvard Basins Soa Tabshing Companion Allighisesered Pate inte Und Snes Amare ‘Teche wa cll pied ws cape 1 of hinge “2 Mans eo og ha oe Nuns Ril Ma copyeigit 206 Hana Basin School testing Cpr, No par ii pbenon may be epidural o, rear nym oy any means laces mecanit plocPNE ‘searing oho) hou the por pein the publshr Regus fc rman sate ected to pemsnsnnttareebne ec ae Pesos, Haar Busnes SchalPubting 6D Hanan Wg Bestn sche 216 Yes onpurtase Haar Busines Fes boat teksten were You cn cde aval Bies Pes bok nd bok chaperone hardens oe, or calling 885005016 0¢ ose the US ard Canady 17 7S-H,How Cash Connects with Everything Else Qrecyse ae wt te Retymen tq restate tyre meee charts ohn Wl ome Rice arena carers aaa Tosh nln ey esc yng1 Sow Eas onece wth Everio Ese jst the resol of ertin rules, essumptions, estimates, and aul tons. They understand tha assets as reported on the balance set arent “ell” worfh what the balance set says, again because of the rules assumptions and estimates that go fnto valuing ther. Bot scountants also understand thatthe at of finance 5 we have called i, docs exist in the abstract. Ulimately al hose rules, assumptions, and estimates have to provide us with usfl infor mation about the resl worl. And since in finance the ral world is represented by cas, the balance shet and the income statement ‘must have some logical relationship tothe eth flow statement. ‘You can see the connections in common transactions. For exam pl remember that credit sle worth S100 shows up Boh as ans ‘rease of $10 in accounts ecivable onthe balance sheet and as an, Incest in sles of $100 onthe income statement. When the cus tomer pays the bill acountsreaavable decreases by $100 and cash Increases by $100 on thebulance set. And because cass involved, itaffce the cah owe statement a wel, Remember, 00, that when the company buys $100 worth of inventory, the balance sheet records two changes accounts payable ‘ses by $100 and inventory sists by $100. When the company pays ‘the bil, accounts payable decreases by $100 and cash decreases by '100—agnin, both on the balance sheet. When tat iavestoryissald (ciher intact at by retro incorporated into a product bya ‘manufacturer, $100 worth of cos of goods sold willbe recorded on the income statement. pain, the cash part ofthe tansscton wil show upon the cash low statement ‘So al dhese transactions ukimatly have an efit on the income statement, the Balance shet, and the cath flow statement. In fic, moet transactions eventually ind their way onto all thee To show ‘yo more of the specifi connections let us walk you though how accountants we the income statement and the balance hee 10 cal- ‘ulate cath ow.3 nse 1s Ke ‘RECONCILING PROFIT AND CASH “theft xen hs proces isto recone ptt csh The tuetion young anower hs is pei snp gien thet we ave Sin net rot, wit eft doe tata on ora fw? "West with et profi for then: every anton were done inch and ifthre wena noneath expen sche depec son, prof and peting cash fw wold be iti. since vingit ach ensctin, weneeo tere which Une tan onthe income tent andthe blanc soe hd hee fet ofincenng or dseasng cabin tec words, making. oe ing ah Bow diferent om et prof xan pat ie ned finden tnt ofthat when theyre added, evar athe chngsin cash fo. (ne sch ssmen tin account sable, Welt tht in any given te period wee gong baking in ome es fom re bly, hich wl hve the effet of decrensing the AMR ine We vel be makingmore crit ale which wi ad tthe AR le. Vican"retoat theca rom shee woKindofranactons ‘by looking at the change in receivables from one balance sheet to the no Remember, th blanc he fr pectic chang canbe ten when you compare te bain! hess) Imago fo tpl we str wih 10 in eels he ace set the sarofthe month Weta in $75in cash doing thermo and we tna $100 worth of credit se. The now AR neo the end ofthe Reconciliation 2 ce in Gi cnn el sts i ‘compans blancs sso mateh th actual cash the compay has in thanks ean yack i aS.4 ow as ooeas wth Everstiog Ee month willbe ($100-875-+ $100) o° $125. The changein receivables fiom the beginning ofthe period to the end is $25 ($100~8125). 1. fsalo equal tone sales ($100) minas ash received ($75)-Orto put 5 dfnetly cash received is equal to new sles minus the change in recxirables. Another adjustment is depreciation, Depreciation is deducted from operating proton the way to calulting net profit But de preition sa noncash expense, 2s we have earned it has no eect ‘on cash flow. So you have to adit backin, [ASTART-UP COMPANY ‘Ghar? Probably not S let imagine 2 simple stax-up company, with les of $100 in the fst month, The cost of goods olde $50, ‘other expenses are $15, nd depreciation is $10 You know that the Jncome statement for the month wll look ike his Ineome Sttement Sates $100) o0as a css prot 0 Expenses 5 Depreciation a0 Net raft 828 ‘Lets assume thatthe sles are all esivables—no cash has et ‘come in—and COGS is alin payables. Using this information, we ‘an construct two parti balance sees sets ont Pcoounisecehaie 0 slo $100 Lauies Acoownis payable $50 0case is [Naw we can tke the firs step constructing cash ow statement “The key rule here that fan asset increases, cash deraser—s0 We aba the nerd rom net income: With lab, the opposite it true. ibis increase cash increases too—s0 we ad the increase Here are the calculations Sart wth net profit $5 Subtactineeasein wR (100) 2d irereasein AP 50 1d in depreciation ag qu: net chengein cash § (15) ‘You cam se that this isto becaube he only ean eapeise decom any had daring dhe period was $15 in expenses With real basi ‘ness howeves, you cnt confinm our ests byeyebaling them, 0 you need to calcu the cash low statement scrupulously 2c- cording the same res [AREALISTIC COMPANY Lets try it with a more complex example. Het (for easy reference) arethe income sstement and balance sheets for the imaginary com ‘pany whose financial ppearin the appendix: {come Stotment i milons)__ ‘eco 32085 Sales $3629 Casto rods 6.565 tess pet $1933 Sain, general and ain. (SGA) $1,061 Depreciation 238 Oterineome 12 en $ oz Interest expense 191 Toes 28 etre sie5 wan omeats wth Eryn Ee alone Seat niin) e108 bes. 2008 en) Ccasn and cash equivalents Recounts eceable Invertoy (the cent assls an accruals “al curentassels Proper, pant, and equipment (the lngtei assets Tota sas tes Accounts poybie Crest ine Current prion offongerm dot “Toa urentabities Longe debt (hanger bites Totnes ‘Shree Common stock, $1 parvalue 109.000,000 autre, 74 000,000 cutstaring in 2008 and 2008) ‘cctona pain cata Retained earings ‘otal startles ey Tota ats and saree ay 2005 tnt Deprecion Numer oeammen shes ni) aie erste ase pe sare sos 1312 1270 2750 2230 $5,188 1022 109 aire 11037 310 1273 5.199 m4 238 sn 1.208 sia 8 2asT 2268 a sa sis 150 1330 1188 aio ais sane1 ‘asi 1s KIN ‘The same loge spplies ain the simple example we gave eats: Look t every gpnge fom one balance set othe net + Determine whether the change ested in an increase or Aecreas in esh + Then add or subtract she amount tor fom nt income, Here are the steps bservaton Acton ‘Sar wth nt pot, $218 eperiion was $239 Ad that noncash expense to re rt ecaunts receivable nereased Subract ht ees frame by $108 nt prt Inventory dectned by $244 Ad that decreas one pro (ther eurentessesrose —Subract hat increase rm bySi8 net pro PPE ose by $205 (ter Subict ates fr ‘adjusting fox depreciation rt prott 1 $236se0 ree 1) Other ongterm asses ‘Ad hat crease to net prot ‘ecreased by $20 Acute payable decreased Suvacthat dovease tom ‘wy sio7 re rth ‘reine decreased by $50 Subtract hat decrease fom net pr Current parton ofjongtem Ade that increas ot rit ‘seco by $1 Longte debt decreases by Subtract hat decrease rom Sit net prot ther longterm abies Add thatnceasa ono prt Incraead by $34 Dividends pd—$165 ‘Subtract that payment rom net (ovate) prot8 ow ash voc wt Ereting Ee [Note 1: Why do we need to adjust for depreciation when looking the change in PPE? Remember that every year FPE onthe balance ‘sheets lowered bf the amount of depreciation charged to the sets, in the account. Soi you had 2 leet of tuck that were acquired for 100,00, the balance sheet immediatly after the acquistion would inlude $100,00 for trucks on the FPE lin. If deprecntion onthe ‘tracks was $10,00 forthe year then atthe end of twelve months, ‘the Hine in PPE for tocks would be $90,000. But depreciation is a noncash expense, ad since wee ty wo arrive ata cash number, ‘wehave to “factor out” depreciation by adding backin ‘Note 2: Notice the dividends footnoted onthe bance sheet! Mi tipy the dividend times te mamber of shares outstanding and you ‘et xouphly $166 malion (wich we're epresentng aust 166). Net Income of $248 minus the dividend of $165 equals $82—the precise amount by which shareholders equity increased. This ihe amount ‘of profit that stayed inthe company as retained earings. I there Jno dividend paid ou or new stock sold then the cash provided or sed by equity financing would be zo. Equity would simply i- rene ordecreateby the amount of profit orlossin the period. "Now we can construct a cash low statement based on all these stops (se fllowing page). Of couse, with fll balance sheet ike this one youve to put the change in cas nthe right categories as ‘well The word athe right-hand column show where each number ‘comes fos The “cash ten” ofcourse equals the cash lance on the ending balance sheet ‘Thisis a complicated exercise! But youcan se that there's good eal of beauty and suber in llth connections (maybe only ifyoa ae an accountant). Go beneath the surface a ite—or, mit ‘metaphors, read between th Hiner-and you ean sce how all dhe numbers relate to one anther Your financial inteigence i on the ‘way up, asisyour appreciation ofthe at of finance.8 case 1s KING Cech Flow Staten! ( millon) ac ane 12089 ash om para actiir Nat rt $248 vel ott on income tatent Depreciation 239, erect fam income ‘ttenert ‘ecountsreedeble (108) change in fom 2008 82005 tentony 246 charg in imeony Cer curertasets (1) change nether cuentas Aocuntspmatie COZ) change in MP atom persons $488 ash om restig itis Proper pant and $205) PPE change adjusted for unmet ‘depreciation (thar n-torm assots 20 change rom balance sheet ‘as Lom estig sites) ‘ash ron ang ates Crane (60) change in short-term cet current portion of 1 change incurest "eng em debt Tenge aot Long tm debt (121) change om balance shost (ther ng-tarm lables 34 change fom balance sheet Dividends paid (08) dvdonds poi tw srarnoiders ‘ashram racing sean ‘crargein cash 116d the tee sections togeter ‘cash at beginning 72 tom 200A taorce sheet ahat nd $83 change incash + egnning ash——I00LB0X _ [FREE CASH FLOW "EBITDA, ac we noted ea, isno longer Wall Street’ fvorite"mea- _ureto watch Now thet merci free cash lo Some companies Ihave looked at free eath flow for years. Warren Buffett's Berkire “Hathaway isthe best-known example, though Bullet calls it owner earings How o caleulate free cash ow? Fst et the company’cash fow statement. Nay, take net cath ffom operations end subtract the amount invested in capital equipment. Tht all there is to it—ftee ‘ath flw is simply the cash generated by operating the business ‘ims the money invested to Jee it running, Once yo think about {it it makes perfect sense as a peefocmance measure. you¥e tying, ‘twevalastethe cash generate bythe company what yu reaiy want to know isthe eat from the business itl minus the cash requited to ep ithelthy over the longer term Publicly taded companies are not required to disclose fice cash ‘low, but many do report especially withthe new Wall Street focus ‘on cast might have helped us all bak nthe decom craze, when so many new companies had negetive operating cash and huge cap- tal investments Theis ee cash flow was big negative umber and ther cash needs were covered only because investors were throwing [ots of dollars nto the pt. Bit, who was ner alone back then 0{in relyng on free cash on neverinvested in anyof those companies, ‘What surprise! ‘At any rate, iByour companys fe cash flow is healthy an in- creasing, you know et east te fllowing: + Your company has options. can us fee cash flow o pay down, eb, by compests or pay dividends to ones. + You and your olleagues can focus on the business, not on mak {ng peyroll or on rising additonal funds + Wal Stet key 0 lok favorably onthe company's stock,