PROFESSOR: Welcome back.

Now what we're going to talk about is a cash flow statement.

In the previous sections, we talked about the balance sheet,
kind of a snapshot of where you are at one point in time.
The income statement or the profit and loss statement,
which is the flow over time, those two statements
are very important, and there's a third statement
that you're required to disclose to construct and disclose
if you're a public company so that people
can see your financial health.
And that is called the cash flow statement,
or the statement of cash flows, whatever you'd like.
Why do we need that?
Well, because cash is king.
You can look good from an income statement,
and you can be running out of cash.
Your balance sheet can show that you have cash,
but it doesn't show how much you're burning.
So those two together are very, very important,
and this will add another dimension to look at it,
so you can quickly see the health of the company.
And it gets to something that's very important called free cash
flow that's going to be part of things as we go forward.
So let's just talk briefly about what's the difference?
So when we think about income, there
were some corrections that were made that were very important.
First of all, you don't want to penalize people
for making investments.
So if they're making long term investments that
will make the business more efficient
and bear fruit over time, then we
want to take that into consideration
and be able to show that the profit loss looks
like this over time, rather than get hit when you do that.
So what this involved here is depreciation or amortization,
but this encourages you to make those investments.
So if I buy a million machine and it lasts for 10 years,
if it's flat line depreciation, which
means the same every year, then I
will only get hit for an expense of $100,000
because $100,000 a year for 10 years will add up to that.
And if it has a useful life of 10 years,
then I should be able to depreciate that.
Now you might not have a straight line depreciation.
You might have-- often with cars, when they go off
the lot they decrease a lot, and that's
another type of depreciation.
But in any case, you're spreading out
the impact of making these long term investments over the time
that they're going to be useful that's the first one that's
called depreciation.
The second part of this is when you're making commitments
when you're making commitments or obligations,
you're making them or people are making them to you.
This generates something called working capital, and working
capital needs--
I need this capital to be able to meet
the needs of my business to keep it functional or not.
So what does commitments mean?
Commitments mean if I sell something on the positive side,
and someone gives me a commitment
that they're going to buy that, a purchase order, then
what I can do is I can recognize that revenue now.
And so I can then put it into my income statement
saying I have got a commitment for this.
I'm getting revenue.
It's just a matter of when we collect it.
But I have earned that at this point.
The second part that related to this and that's
called accounts receivables as we talked about before.
The other side of this is if I take on an obligation
where I take someone else's services
or I accept their materials, then
I have a commitment that I owe them money.
Whether I paid them or not, I now have an obligation.
So that will come in and be recognized as an expense,
and it will hit my income statement,
and appropriately so by the way.
Both these things are helpful to give you
a better view of the business.
And this will create working capital.
If my receivables exceed my payables,
then I have a negative working capital.
My income statement says that I have
more profit than I have cash because I've
recognized the revenue, yet I haven't received the cash,
and you can offset that by saying I've recognized expense,
but I haven't paid them yet.
So your payables if they're equal, then it's the same.
But usually the accounts receivables
are higher than your payables, and then what you have
is what's called working capital requirements.
That means our income statement is
overstating our profitability in terms of cash generation
right now.
If our payables are higher than our working capital,
then we have negative working capital
or positive impact on our cash position relative to the income
statement.
So these are the two things that are
going to distinguish the income statement, profit loss
statement relative to cash flow.
Now the third part of this is, when we look at investments
as well, another big one is inventory
and we're going to be looking at changes in inventory.

Let me try to explain that because if I take in inventory,

I buy inventory, I'm not going to see that on my income
statement until I sell the product that's
associated with it.
At that point, that is when that expense would be recognized.
So you can see an increase in inventory,
which will decrease my cash and then that will not
be visible on the income statement, profit loss
statement.
So the one other one that's common here is financing.
If on my income statement, I will have to pay off--
that me just get that correct--
financing.
By financing, I might have some debt or something
that I need to pay off.
That's the fourth area that we think about.
So what's the difference between our cash flow and our income
statement?
Both of them are showing flows, but the income statement
is one view that shows you depreciation
in it, that spreads out the expense,
so you don't get penalized for making investments.
It shows you when you take on these commitments
to show that this is really where you stand
now, whether you've actually paid out the cash or not,
you really need to pay that out or you're really due this cash.
So they take that in consideration.
It does not show your inventory.
If you add it to your inventory because you see a surge coming
on, your cash position will go down as you buy inventory
and that inventory is not cash remember.
It'll be some work to convert that into cash.
And the last thing you don't see here
is how do we pay off debt that's coming due,
debt, interest payments on financing, and the like.
Money that people have given to us,
and we're going to have to pay interest on that.
So now we're going to take a look at that
and I want to give you a concrete example
as to how this is implemented in the real world.
We're going to take the results of an income statement
and then convert it into a cash flow statement.