Cash Flow Statement

[00:00:00.00] [MUSIC PLAYING]

[00:00:08.91] IAN SCHNOOR: Now that we have finished building up the income statement, it's
time to build up the cash flow statement in this model. The cash flow statement seems like a
simple statement, but I'm going to share with you some thoughts around it that you might not
have heard before. I'm going to encourage you to think about each of the sections in a different
way than you might have ever considered previously. So we're going to build it and talk about it
as we go. Let me share my screen, and let's get started here.

[00:00:34.45] So here, you can see the cash flow statement. We're going to build it up together.
The first comment that I want to make is very, very similar, the same comment that I made on
the income statement. If you remember, on the income statement, I told you there should be no
work on the financial statements. And that holds for the cash flow statement. It holds on the
balance sheet. But let me rewrite it because it's so important. No work on-- jot it this way. No
work on cash flow statement.

[00:01:00.96] No surprise. Everything should just be linked. Let me show you. Let me prove it to
you. The cash flow statement should be an incredibly simple statement to build if you have done
your model well. Let's look here. Now, I'm going to do this fast. So you don't have to worry
about what I'm actually linking up to because we are going to build up every row one step at a
time. But just take a look here. Every single line is a link, a link, a link, a link, and then a total.
And then down here in the investing activity, it's a link, a link, a total, and then a link, a link, a
link.

[00:01:31.14] Never needs to be different than that. Every cash flow statement you ever build
can simply be links with no work, and it makes them very easy to build and to check. Now,
what's the purpose again? You've all probably heard this before. This is a comment that people
know. What's the purpose of a cash flow statement? I like to think of a cash flow statement as a
statement that reconciles or shows-- let's just say it this way, shows the total change in cash in
the company's-- in the company's bank account during the period.

[00:02:05.68] That's it. That's the purpose of a cash flow statement. It's to say, how much cash
was in your bank account at the beginning of the period? In our model, it's years, so I'll say
years. We're trying to say, how much cash was in the bank at the beginning of the year? What
was the change in your bank account during the year, and how much cash did you end up with at
the end of the year? That's it. That's the purpose.

[00:02:26.14] And what accountants like companies to do is to build it with three sections, to
reconcile and to show all of those changes in cashes in three ways. There is the operating activity
section here. We often refer to this as the CFO, Cash Flow from Operations. There's the
investing activities section, which people usually refer to as the C-- so jot it this way, the CFI,
the Cash Flow from Investing activities. So we have CFO, CFI, and then Cash Flow from
Financing activities is the CFF.
[00:02:59.98] Those are very common acronyms that we use. And so what an accountant says is,
OK, we want to record and check, how did the cash change in your bank account? And let's
break up each of the changes in one of three ways. So every change, every inflow or outflow of
cash, had to fall into one of three groups or one of three buckets, what we call cash flow from
operations, from investing, or cash flow from financing.

[00:03:24.76] Now, by the way, you probably also know, and I get asked this question a lot, this
is what we refer to as an indirect cash flow statement. I'll jot it down here. This is an indirect
cash flow statement, which is much, much more common. Most financial statements report their
cash flow statement using an indirect method. And indirect method just means you're using these
three sections. You're starting with net income, and you're showing each of the three changes.
This is the most common methodology I've ever seen. So that's what we're going to do in this
model.

[00:03:58.63] Now, why is it then-- so we now know that there's three sections. I've told you
what you probably already know, that we're reconciling the total change in the cash during the
period in the company's bank account. So the question is, why the order? Why the flow? Well,
most people, most people like to build their income statement first. And then there's a-- then
there's a-- you can see people go in one of two different ways. In majority of models I've
encountered, the income statement is the first financial statement.

[00:04:32.52] I like to have the cash flow statement next and then the balance sheet underneath.
so the cash flow statement and then the balance sheet. Some people prefer to show the income
statement and then the balance sheet and then the cash flow statement. That is fine. You can do
that as well if you like. Let me tell you, though, why I like to do it this way, why I like to show
the cash flow statement underneath the income statement. It's because the income statement
starts with revenue. Every income statement starts with revenue. And every income statement
ends with net income. That's normal.

[00:05:04.26] Well, every cash flow statement, an indirect one, anyway, begins with net income,
which is right on top of me. So the cash flow statement begins with net income, and it comes all
the way down. And the very last item on a cash flow statement is ending cash. It shows the
ending cash in the company's bank account at the end of the period. In our case, it's the end of
the year. OK, that's the end of the cash flow statement. Well, where does the balance sheet
begin? Well, the balance sheet begins where the cash flow statement ends.

[00:05:34.88] The balance sheet begins with cash. Usually, the first line on a balance sheet is
cash. Where does that come from? Well, right on top of me. The cash on the balance sheet-- and
we're going to do this in the next lesson-- comes from the bottom of the cash flow statement. It
becomes like a giant waterfall. Everything nicely flows down the page if you organize it this
way. And so that's why I find it helpful to do the income statement, then the cash flow statement,
and then the balance sheet. And again, we'll do this one next.

[00:06:02.43] So let's continue on with the cash flow statement. The next question that I like to
ask people usually is in terms of why. So then people sometimes say, that makes sense. But why
else? What is another reason? I like to talk about another reason why I like to show the cash flow
statement next. And this is something that people often haven't thought about. When I talk about
this, people find that they haven't heard this in this way. Let's come back to the income
statement.

[00:06:28.49] What's the purpose of an income statement? I mean, you all know this. The
purpose of an income statement, of course-- I'll put a new note here on the screen. But the
purpose of an income statement is to show economic activity. The purpose of an income
statement is to show economic activity at the company. We're trying to show the revenues, all the
sales they made, and all the costs they had. But there's a critical, critical concept that accountants
use on an income statement, and that's the idea of accrual accounting.

[00:07:02.60] An income statement always uses the idea of accrual accounting. And what that
means is we're not reflecting items based on when the cash comes in but rather when economic
activity occurred. You know that. So revenue, of course. This doesn't mean-- when we look at
revenue on an income statement, of course, the revenue does not reflect how much cash we
collected. It represents how much sales the company made.

[00:07:28.43] But some of those customers might not have paid us yet cash. But if there was a
transaction, if we delivered a product or we signed a contract, there's different ways accountants
measure this, we will record a revenue even though it wasn't collected in cash. And that's the
same all the way down. We show costs as what we incurred as an expense, even though we may
not have paid all of it as cash yet, et cetera. Every single line item on the income statement
reflects the economic activity, not cash inflow and outflow.

[00:07:59.51] You've heard that before. Why am I telling you that? Because what's the best way
to think of the items on a cash flow statement? Well, I encourage people to think of the CFO.
People wonder what-- people sometimes wonder, what exactly is the CFO mean? Well, what's
happening in the CFO section is this. All we are doing is unwinding. We are unwinding,
unwinding the accruals on the income statement.

[00:08:30.27] I'm trying to get the spelling right here. All that's happening on a cash flow
statement is we are unwinding the accruals on the income statement. In fact, you could go as far
as to say-- some people like to say this-- is that the CFO section is really a cash income
statement. If you were trying to build an income statement using cash accounting instead of
accrual accounting, it might look like this. This is more like the income statement using cash
accounting.

[00:09:02.93] So all we're doing is unwinding all of the items that were non-cash to try and
reconcile what happened in my bank account. What really happened with the cash in and out in
my bank account? So let's take a look at this. I'll make this row this blue. So of course, I just
showed you that the net income comes off the income statement, the bottom of the income
statement. But remember, that net income-- this net income is the starting point on the cash flow
statement.

[00:09:28.76] But the net income is after adding in all of these various line items that were not
necessarily reflective of cash in and cash out. So what we do is if we're starting with net income,
we next have to say, well, let's add back the depreciation. Let's add back all of the non-cash
expenses. And depreciation is always the first one. And I'm going to grab that right off the
income statement because we're going to say that reduced-- this depreciation reduced my net
income. It caused net income to go down.

[00:09:59.51] But it didn't cause my bank account-- it didn't cause my cash balance to go down. I
didn't pay this $16.2 as cash. So I'm going to add it back. If I start the cash flow statement with
the net income, that net income is after the depreciation, which is a non-cash expense. So we add
it back. Same thing with the deferred income tax. The deferred income tax was expensed on the
income statement because it reflects the economic idea that there was a tax expense. But that
amount didn't get paid as cash. That comes from our tax unit.

[00:10:31.40] And so because that was not paid as cash, I add that one back as well. So simple.
Just links. And then change the working capital. Also, it's just a link. Let me jot some notes
down here. So of course, the net income, if you want to put some notes in column F with me, is
going to come off of the income statement. It's a link. Same thing with the depreciation. Same
thing with the deferred tax. Sometimes people say to me, oh, depreciation. Couldn't you also link
that to the depreciation schedule? Yes, you could. Yes, you could.

[00:11:00.08] I like to link it to the income statement because it's a little closer. It's easier to
check and audit. But if you wanted, if you wanted to link this directly to your depreciation
schedule-- now, remember, I've renamed it a PP&E schedule. But if you wanted to link it to the
depreciation here, that's also fine. I have no problem with that. That is fine. Some people prefer
that approach. No problem. I just find that it flows nicely to think about each of these as being
add backs off the income statement. So I tend to get them off the income statement. Either option
is fine.

[00:11:34.78] Same thing with the deferred tax. This comes off the income statement or from
your tax schedule. Now, the change in working capital has to come from the working capital
schedule. I'll jot this in. It's going to come from the working capital schedule. First of all, most
importantly, it's just a link. It's just a simple straight link to the working capital schedule. No
work. No big deal. I'll show you. I'll go down there and take a look at it. Of course, it's just
linking to the very bottom.

[00:12:01.44] Remember, I put a note. Said, build it. And then it goes to the cash flow statement.
So there it is, and then it links in, negative $2.1, to the cash flow statement. Good. But one more
time, let me explain what that means in the context of this, of unwinding the accruals. Well, now
you know that I started the CFO section with net income. And I've added back any individual
line items. I've added back any individual line items that were not paid out as cash, like
depreciation and like deferred tax.

[00:12:31.88] The change in working capital captures everything else, basically, all of the other
operating items on the income statement that were not truly reflective of cash. Now, you can see,
in the first year, it says negative 2.1. Let's pretend, let's pretend that that was entirely because of
revenue. What we're really saying then is because I've showed-- let's see. I've showed a net
revenue of $252, $252.5 on the income statement.
[00:12:58.59] So what the change in working capital is saying is, well, hang on a second. That
$252, that did not all come in as cash. There was a couple million around-- what is it? There was
$2.1 million. So if the change in working capital was entirely because of revenue not coming in,
what we're saying is, hang on a second. Not all of that revenue was collected as cash. So because
you showed the revenue as $252 at the top, I need to deduct. I need to make-- I need to show the
bank account as having gone down because I didn't actually collect all of that as cash.

[00:13:32.20] Now, in reality, this negative $2.1 does not simply reflect the revenue line, but it's
the revenues and the costs and any other items on the income statement that showed up as
accrual items on the income statement but were not truly reflective of cash. So that is what the
change in working capital represents. And then the calculation, the total, is just a calculation
here, of course. Very, very simple. No big deal.

[00:13:57.60] So I wanted you to understand and think about, what does the CFO really mean?
We're building a cash income statement. What about the CFI section, the cash flow from
investing activities? Well, what this is, and people typically know this represents capital
expenditures. And of course, as a starting point, this is linked to the assumption I also mentioned
in an earlier lesson. So you now have seen, this is coming from-- I'll jot this down. This is
coming from my assumption page. This is coming from the assumption page.

[00:14:29.12] And I have this still noted as this cash outflow. This row, of course, is a cash. Let
me move this note over. This is a cash outflow. It's coming from the assumption page. But I will
remind you one more time, it must be negative. You must flip the sign and make it negative
because on the assumption page, we're talking about the new assets we're going to purchase. And
here, we're saying, well, what's the opposite? What's the other side? How much cash did we
spend to acquire those assets? So it's negative.

[00:14:57.92] Same thing here, any other items I've also captured from the assumption page. And
it's a link to the assumptions if there were other investing activities. And the total is just the total.
But and then the total, of course, is the total. I'll put a note here that says calculation. But what's
the best way to think of a CFI section? Here's something people have often not thought of before.
I'm going to encourage you to think of the CFI section this way.

[00:15:21.21] The CFI section, the cash flow from investing activities, reflects changes in the
asset-- in the assets on the balance sheet that were not included on the income statement. So if I
say it another way, what these lines reflect or what the CapEx reflects specifically is changes to
assets, cash that I spent to change or cash that I received as a result of changes in assets. But that
change was not picked up on the income statement.

[00:15:59.61] And because it was not picked up on the income statement, it did not hit the net
income line. So of course, you know, when a company spends-- in our first year, the company is
spending $16 million of cash to purchase new asset. That's not an income statement item. That's
not an expense. We capitalized it. It went right to the balance sheet. But because it did not hit the
income statement, you need to reflect it directly on the cash flow statement. So one more time,
the CFI represents changes in assets.
[00:16:29.71] We sometimes call that the left side. The left side of a balance sheet is the asset
side. So this is changes in the asset side of the balance sheet that were not captured on the
income statement. And as a result, they must hit-- we have to show that they're hitting our bank
account, our cash account, but they didn't come through the income statement. So they picked
them up right here. And that's a very simple section. The CFI is the simplest section to do.

[00:16:53.62] The last section on the cash flow statement is the CFF, the cash flow from
financing activities. And let me just put this note. I'll start with this note this time. What does this
reflect? Well, I just told you that the CFI, the investing activities, reflects changes in assets that
were not captured on the income statement. Very, very similar note for CFF. And you might not
have heard this before. The CFF section, the cash flow from financing, reflects changes in the
liabilities. Liabilities, I'll put LIAB, liabilities and equity.

[00:17:30.10] This reflects changes in liabilities and equity or debt and equity. Primarily, it's
debt. It's really debt and equity. I'll actually jot it this way, just so that's super clear. The
financing activities reflects changes in debt and equity that were not included on the income
statement. And I also told you to build this section last. The financing activities we do last. So
you had this note already. We do this at the very end. Your section should look like this. All of
your sections should look blank. We have not built it yet.

[00:18:01.40] You can't do it until you have built your debt and equity. But the point is, the
purpose is to capture all changes in debt and equity accounts that did not flow through the
income statement. And I say that because of course you know interest expense. Think of debt.
Debt has interest. Well, interest expense hits the income statement. Interest expense hits the
income statement. And it reduces net income, which means it's captured within operating
activities.

[00:18:31.19] So we do not, of course-- we never would include interest expense on the CFF
section, even though it is a debt-related item. The financing activities reflects any changes, any
changes to the debt and equity accounts that did not get reflected on the company's income
statement. And so that's the purpose. And you can see, of course, no surprise there, just links.
Look, a link, a link, a link, a link, and then a total. Very, very simple.

[00:18:58.66] But the question is, where? Where do they come from? Well, no surprise. All of
these, the revolver items and-- the revolver and the term debt should come from the debt
schedule, the debt schedule, debt schedule. And then common shares and-- common shares and
dividends should come from the equity schedule. But there's a big, big, big important note that I
need to share right now, and that's this. So of course, these are just going to be straight links to
the debt schedule and the equity schedule. And I will add another note here.

[00:19:29.88] I'll put another note off to the side here that simply says-- I'll put it up top here--
that each piece of debt and equity should have its own line on the cash flow statement. So if you
are building a cash flow statement for your own company, your own model, you need to know
that the way to do this nicely so you don't miss anything is every piece of debt and every piece of
equity should have its own line on the cash flow statement in the CFF section.
[00:19:59.94] You know that we have a revolver, and we have a piece of long-term debt. So they
each have their own line. We have common dividends, and we have-- we have common shares
and common dividends. They each have their own line as well. If the company had preferred
shares, if this company had preferred shares, well, then you know I would have a section for
preferred shares on the equity schedule. And then I would have to have a row here for preferred
shares. Any changes in cash from the preferred shares would need to be its own row.

[00:20:29.41] So I'll take that out. Every line item, every piece of debt and equity gets its own
line on the cash flow statement. But the very final line and the most important note is this. You
now have seen that every one of these is a link, a link, a link. But where to? Where exactly on the
debt and equity schedule should I link to? Well, you remember, you remember I told you that
every piece of debt has a beginning, change, ending. You've heard me say that many times.

[00:20:58.35] I'm just going to keep this note for a second. Every piece of debt has a beginning,
change, ending. The revolver had a beginning, change, ending. The long-term debt had the
beginning, change, ending. Which row should your cash flow statement link to? When you link
to the revolver section, should you link to the beginning, the change, or the ending? I hope you
are thinking the change, the change, the change. The cash flow statement must link to the
change. Every line on the cash flow statement must link to the change rows, the change rows.

[00:21:32.53] I'll put this in. Every line on the cash flow statement. So let's take a look at this.
The revolver, I'm linking it to K305. Let's go to K305. It's linked to the change row. Remember,
this is the row that-- the change row that has my negative min function. This is the negative min
on the debt schedule. It's the change. Beginning, change, ending. I link the cash flow to the
change row.

[00:21:56.71] How about for the long-term debt? My cash flow statement will have to link to--
this is the change row. In my model, it's 314. It'll be a little different in your model. But in my
model, it's row 314. So I will be linking my cash flow statement to this row here, row 314. Let's
check and see if I did that correctly. Sure enough, when I go into the second row, it is linking to
equals K314, the change row. I can't tell you how many times, hundreds of times, thousands of
times, I've seen people's models not work. Their balance sheets don't balance. And it's because of
this.

[00:22:31.29] They have linked the CFF rows to the wrong line items on the debt and equity.
They've linked it to the beginning balance on the debt schedule or the ending balance. That will
never work. It must link to the change row. Same thing here. Common shares. Where is that
coming from? The equity schedule. And of course, it's linking to the change row, the change
row.

[00:22:55.20] As for the dividend on the cash flow statement, you can either link it to the
common dividend row on the equity schedule, which is fine, that's what I did, or directly to the
retained earnings. That's also fine. But of course, you know what I'm going to say next. Either
way, whichever one you link it to, you must make sure it's negative. And in my case, it's
negative. I linked it directly to the common shares section, so I put a negative in. I flipped it, and
I made it negative.
[00:23:23.66] If you linked it to the retained earnings section, to the dividends in the retained
earnings, it's already negative. It doesn't matter. Either one is fine. The point is, they are all links,
links, links, links. And the total is just a sum. So simple. By the way, we're just about done. The
last thing to do-- there's a lot of notes here. The last thing to-- because there's a lot going on.
There's a lot more than meets the eye, a lot more to think about on a cash flow statement than
people sometimes realize. We're just about there.

[00:23:48.41] What's happening now? Well, the very last things on a cash flow statement is to
look at the total change in cash. This is always going to be equals CFO. Jot it down this way.
CFO plus CFI plus CFF should never, ever be anything else. It should only ever be adding up all
three. And that is what I am doing there. I'm adding up the operating, investing, and financing.
Let's take a look here. It's simply a straight sum. Operating, investing, financing. That's it. So
that's all we are doing in the change in cash.

[00:24:22.47] Beginning is very simple. Beginning balance is just equal the end of the last
period. And then the ending is just a sum. Let me jot that down for you. So the beginning is just
the end of the previous. And then the ending cash is just a sum one more time. No surprise. Very,
very simple. I already showed you then that once you have the ending cash, it simply comes
down to the balance sheet. And the balance sheet pulls from the bottom of the cash flow
statement. So simple. So effective.

[00:24:53.10] But yet an area where people make so many mistakes. People make so many
mistakes on their cash flow statements. But if you do it this way, I promise you, you'll never
have problems. You'll always get it working and be able to build a best-in-class cash flow
statement. And I hope from this lesson that you come away not only with the understanding of
how to link and construct it, but I also hope you have a better understanding of what we are
trying to reflect in each of the three sections, CFO, CFI, and CFF.

[00:25:24.45] That wraps up this lesson on the cash flow statement. In our next lesson, which is
the last one in this unit, we will get into the balance sheet. I'll see you then.

[00:25:35.28] [MUSIC PLAYING]