In this video, we're going to talk about the cash flow statement. As its name implies, the cash flow statement is going to provide information about the inflows and outflows of cash. A very useful feature of the cash flow statement, is that it's going to classify business activities into different categories in particular operating, investing and financing activities. This is extremely valuable, because it helps us try to get more information about what the implications of this period's business activities are, for a future period cash flows. For example, if you earned a dollar by selling some of your product versus you earned a dollar by selling off some of your plant, it's a dollar either way. But clearly the implications for future cash flows are very different. You've got a lot more ability to repeat the sale of the dollar of your product than selling off more of your plan. Similarly, if cash flow is down and it's because, you're not selling product versus cash flow is down because you invested a lot that's very different in terms of future period cash flow implications as well. So, the cash flow statement classification, is an important part of the cash flow statement organization. Before we get more into that, let's talk a little bit about why we have a cash flow statement and how it differs from the income statement. The cash flow statement is really about liquidity. Income, is about profitability. Those are both important, but there are different things, especially in the short run. You can generate profits, but not have those profits be in the form of cash. Similarly, you could generate cash, but not in a profitable way. So, there are two different things, that are both important. Liquidity is clearly important because if you run out of cash or if you default on payments, that's obviously bad. Cash provides a resource, that allows you to absorb unexpected shocks and get you through some temporary bad times. Many people over exaggerate the importance of cash though, when you sometimes see some extreme statements, like well you can only pay your bills in cash, so cash is the most important asset. Well, even if it was true that cash is the only way you could pay your bills, clearly there are other non-cash assets that you could sell off, to generate cash if you needed to. You often also hear statements like, Cash is king. Well, that could mean a lot of different things. I think maybe the most charitable interpretation is, that cash is the most flexible asset that you can have. It's the speediest in enabling you to generate investments in other kinds of resources and activities. But it's the other activities that actually generate the profit, holding cash doesn't generate any return in and of itself. If cash was that important, why would you spend any of it? You also hear a lot of discussions about, the importance of cash versus earnings. Which one should you pay more attention to? Well, that's not really even a relevant question. It's never the case that you have to choose one or the other, you always have both available and they both provide useful information. One of the things that you see people talk about, is that cash is a harder number. It's more reliable. It's more objective, whereas earnings is a softer number, it's based on more assumptions and things like that. Now, that's absolutely true. But the reason that cash flow is more objective, is because it's not forward looking at all. Cash flow only looks at things that actually resulted in cash this period, something either did or didn't. Whereas earnings is by definition a fuzzier concept. But think about looking at sales. Suppose you had a choice of a dollar of sales, that were cash or a million dollars of sales that were on credit. Which one would you rather have. Well, probably the right answer is, It depends on how much of the million dollars of credit you actually expect to collect. But a cash flow statement doesn't look at that at all, cash flow statement says," the dollar of cash is cash, regardless of the probability of collecting on the million dollars, it's not cash now, so I don't count it". So, a cash flow statement is less forward looking than an income statement it will add an income statement by definition, if it's going to look forward, is going to be a little bit less reliable, a little bit less credible than cash is. But that doesn't mean that it's not credible at all, you just want to count the cash part and the non-cash part of earnings a little bit differently. Now, let's go more to the format and the classification. There's actually two allowable formats for cash flow statements. And the difference mostly applies to the operating section of the cash flow statement. There is an easy way to do it, which unfortunately you'll hardly ever see. And then there's a more complicated way to do it, which is how most companies do it. These are referred to as the direct method, the easier one and the indirect method, the more complicated one. The other two sections of the cash flow statement are relatively standard. The Investing section in the financing section, are just going to list the different kinds of receipts and disbursements of cash. But in the operating section, the direct method, follows that same format. Here are the receipts and disbursements of cash that are operating in nature, whereas the indirect method starts with net income and then backs its way into cash. That's much more complicated and we're going to have to spend more time trying to figure out how that works. What's the difference between operating investing and financing activities. Well, it's fairly intuitive, operating activities or transactions associated with providing goods and services to customers. So, the cash we get from customers and then what we're spending in order to be able to generate those revenue activities. Many of the things that show up on an income statement, are in the operating section of the cash flow statement. Analysts spend a lot of time looking at the operating section and the cash flow statement, to try to gauge the health of the underlying operations. Investing activities on the other hand, are ones that are going to be associated with future operating cash flows. Analysts like to look at the investing section to see, is the company investing for the future. Many of the activities in the investing section involve the long term assets, section of the balance sheet. Investing activities can be outflows, which is the usual thing, we're spending money to acquire, long term assets, but they can also be inflow, if we sell long term assets, those cash flows show up in the investing section, not the operating section. And then finally the financing section of the cash flow statement. This is the inflows and outflows of cash associated with acquiring financing or paying back financing. So this is usually transactions associated with debt holders or equity holders, issuing stock, buying back stock, paying dividends, issuing debt, buying back to debt. So, let's take a look at some examples and see if we can classify them appropriately. How about if we pay off some accounts payable. Well, this would be an operating activity. This is a usual type of activity for many companies. If we get money by issuing stock, that on the other hand, is a financing activity. We're getting money from investors. If we collect money from receivables, this is an operating activity just like the accounts payable would be. If we pay interest on debt though. So, that's going to be you might think a financing activity but actually accountants classify this in the operating section. Many analysts don't think this makes sense, because it does seem like it should be a financing activity. And so when people do an analysis of financial statements, they'll often on their own, move this down into the financing section. How about if we buy some land? Well, for most companies that would be an investing activity, but it depends on what your business is. If you're actually a home builder, and your business is to buy land, put houses on it and then sell it, buying the land is actually an operating activity for you. Issuing common stock to buy land. Well, this is kind of a tricky one, because it doesn't show up on the cash flow statement at all because it's not a cash transaction. If on the other hand, we issued common stock for cash, and then use the cash to buy land, both of those transactions would show upon the cash flow statement. When they're done together, neither show up on the cash flow statement. To help out investors with respect to these kinds of trickier transactions, the footnotes have to describe them. Couple more, if we buy a patent, this would be an investing activity. If we develop a patent on our own, the money that we're spending is probably going to be shown in the operating section instead. Because remember internally developed intangibles, aren't shown as assets under generally accepted accounting principles. If we pay dividends that's going to be a financing activity. If we buy back shares, that's also a financing activity. If we buy shares of somebody else though, that's an investing activity. So, an important part of the cash flow statement is to look at the underlying transactions and figure out which category that they belong in. Cash flow operations, is a measure that analysts spend a lot of time looking at. Profitable companies, generally have positive cash from operations and this is a sign of of health and good performance. But just because you have positive cash from operations, doesn't necessarily go the other way, it doesn't necessarily mean you're profitable. And the reason is, cash from operations doesn't have all the important costs in it. It only has operating costs in it. So, in particular it does not have the costs associated with acquiring long term assets. When you spend money to acquire long term assets, that shows up in the investing section of the cash flow statement, not the operating section. When you use those long term assets to generate benefits the revenues that come in the cash that gets collected, that does show up in the operating section. So the benefits are in the operating section but not the costs. So, this really isn't a measure of profitability. Profitability needs to cover the costs of the long term assets as well. So, cash from operations is an important measure of health but it's not the same thing as profitability. Okay. Both of them are important but they're different things.