In this video, we're going to come back and take another look at our case study, where we're following a startup firm up through its initial set of financial statements. We're going to do the cash flow statement again, but this time, under the indirect method. Remember that the indirect method is the way that most real world companies present their cash flow statement. So, where we're headed is start with net income. We know that net income isn't the same as cash. So we need to make a bunch of adjustments to get the cash from operations bottom line number. Our goal is to figure out where do these adjustments come from and then how do we interpret this. So, because this example is simple enough, we can actually lay out what a real cash flow statement under the direct method and what the income statement actually look like and see the differences. This will help us see the nature of the adjustments that we have to make as well. So, income has sales revenue in it, but cash from operations needs to have cash collected from customers. So, there are 17,000 more of sales than cash collected from customers. And if we look on the balance sheet, we would see that receivables went up by 17. So, that's the adjustment that we're going to need to make. Cost of goods sold, it's what's on the income statement, but we what cash paid to suppliers on the cash flow statement. We'll see that there's two adjustments that we're going to need to make there. One is for the fact that we actually bought more than we sold and the other is for the fact that we didn't pay in cash for everything that we bought yet. Wage expense is on the income statement, but we want wages paid on the cash flow statement. The difference is going to be related to, are there any wages payable accounts that went up or down. And then depreciation expense is subtracted on the income statement, but it's not a cash outflow. So, we're going to need an adjustment for that as well. So, let's start with the revenue adjustment. Revenue of 33 is in the income statement, and we could see in the balance sheet that receivables went up by 17. If receivables went up by 17, that means you sold 17 more than you collected. That means that the sales number is too high as far as the cash flow statement is concerned. So, we need to adjust the sales number downward by 17, and that will take it to the 16 that we implicitly needed to be. Depreciation expense on the cash flow statement, we see it as an addition. Does that actually mean that depreciation is a source of cash? Many people see it as a plus on a cash flow statement and say, depreciation gives you cash. Well, that's not right. We see the addition explicitly on the cash flow statement, but implicitly in the net income number calculation, there's a similar subtraction. So, the subtraction in the income statement and the addition on the cash flow statement exactly cancel each other out, and we get an overall zero, which is the right answer for how much cash does depreciation provide or use up. What about the wage expense? We know that there is a subtraction for wage expense as part of the calculation of the income number, but was it a cash outflow? In fact, we know the answer is no because we can see on the balance sheet that wages payable went up by 4,000 as well. So this means that none of it was actually paid in the form of cash, and the 4,000 subtraction as part of the income statement, and the 4,000 adjustment related to the fact that wages payable went up are going to cancel each other out. Lastly, the cost of goods sold, as we mentioned, that's a little bit more complicated because it's going to require two adjustments. In the income statement, is cost of goods sold, but we actually bought more than we sold. And we can see that because inventory went up. So, we need an adjustment for the fact that we bought more than we sold. When inventory goes up and asset goes up, that's going to be a negative adjustment on the cash flow statement. But we also know we didn't pay for all of the inventory that we bought yet because we can see that accounts payable went up. That's going to be another adjustment on the cash flow statement. A payable or a liability going up is going to be a positive adjustment on the cash flow statement. So we're going to see both of those on the cash flow statement. In principle, we would go through all the other balance sheet accounts as well to see if they went up or down and make adjustments corresponding to those, but that's all we've got for our case study company. So, that gives us our cash flow statement under the indirect method. And while this is how you would see it, I'll show it again with the income statement calculation implicit up in that top line. So, what we're saying is, income started at 8,700, and part of that is because of sales revenue of 33. But we're going to knock that down by 17 because we didn't collect all that sales revenue, and we know that because accounts receivable went up. A receivable going up is a negative adjustment on the cash flow statement. Part of the calculation of net income is the cost of goods sold of 20, but that's not what we actually paid, and we use the adjustment to inventory and the adjustment for payables to get that. Wage expense is subtracted in the calculation of income, but because wages payable went up by the same amount, those two canceled, and similarly for depreciation. There's an implicit subtraction in the calculation in net income. The addition in the adjusting entries here offsets that. And overall, this is why income started at 8,700, but cash from operations is only minus 1,000. So, interpretation. Income was 8,700 but we didn't get all that in cash. Why not? Well, partly, it's because there is a subtraction for depreciation in income that wasn't cash outflow. So that's actually going to add to the cash relative to income. So, that sort of gives us 9,000 of cash so far. But we don't have 9,000 of cash because we invested 10,000 in what we call working capital, working capital or the other short-term assets and liabilities other than cash. And we've invested 10,000 in those. Receivables went up by 17. We've got a $19,000 investment in inventory. Those hopefully will generate future benefits in cash but not yet. So, they're not really on the cash flow statement as positives yet. In addition, we delayed paying some people. That saves cash. Delayed 22,000 of payments to the supplier, 4,000 of payables to the employees, overall, those four things net to an investment of 10,000 in working capital, and that's what brought our net income number down to the cash from operations number that we see. So, the cash flow statement, much more complicated looking, but if you spend a little time trying to figure it out, you can also understand a lot more about how income, cash flow, and the changes in balance sheets are linked together.
