In this video, we're going to talk about the indirect method of putting together a cash flow statement. This is probably by far the hardest video that we're going to do, so make sure you spend enough time going back over it so that you get it. Most real world financial statements use the indirect method. So you're going to have to master this topic to be able to read and interpret a real cash flow statement. Another advantage of the indirect method is that it's going to link more explicitly the cash flow statement, the balance sheet and the income statement. So, if you can master the indirect method of the cash flow statement, your understanding of how all of those three statements link together will be much enhanced as well. The indirect method is only different than the direct method when it comes to the Operating Section of the cash flow statement. The investing and the financing sections, of the cash flow statements, are exactly the same. Under the indirect method, in the operating section, what we do is we start with net income, we know income's not the same as cash. So what we're going to do is make a series of adjustments to convert or back into cash. Understanding these adjustments is the key to understanding the cash flow statement under the indirect method. Now we're going to get the exact same bottom line. The same total for cash from operations, we're just going to see it in a much more complicated looking way. So, to illustrate where we're headed, this is an example of an Indirect Method Cash Flow statement in the operating section. It starts with income, it ends with cash from operations and it makes a series of adjustments. Some of them are positive, some of them are negative. Many of them are related to changes in balance sheet accounts. So our goal is to try to figure out, where do those come from and how do we interpret them? So if we compare what's in the income statement to what's on the cash flow statement, there's a lot of differences. Here are some of them. On the income statement, we got sales revenue. But on the cash flow statement what we really want is the cash collected from customers Income statements got cost of goods sold, cash from operations want amounts purchased from suppliers. Income statement has wage expense. Cash flow statements wants, what did we actually pay this period to employees? Income statement has depreciation expense. Cash flow statements says, that's not a cash flow, so I don't want it on my cash flow statement. So all of these differences exist on a cash flow statement versus an income statement. If the cash flow statement is going to start with net income, all of those things implicit in the calculation of income that aren't cash, have to get adjusted out. So for example, are there revenues recognized this period that weren't received in the form of cash? If that's so, we need an adjustment. Where do we come up with that adjustment? Well, that's the trick. Did we get cash that we didn't recognize as a revenue? That could happen, too. We could be collecting from a prior year sale or putting down a deposit on a future year sale. So again, cash and revenue would be different. We need an adjustment on the cash flow saying they can handled that. Same issues on the expense side. Are there expenses we recognized in the income statement that aren't actual cash out flows this period? If so, we need an adjustment and we need to figure out where that's going to come from. In addition, there could be gains and losses on the income statement that are cash flows, but they're not operational in nature. If that's the case, we need an adjustment for those too, because income is the starting point for cash from operations. If this income is not operational in nature, we need to somehow move it down to the investing or the financing section, okay, as the case may be. How do we know where to come up with these adjustments? Here we're going to go back once again to the balance sheet equation. That governs everything in accounting. The balance sheet balances at the beginning of the year, the balance sheet balances at the end of the year. The income statement is about the change in the balance sheet account retained earnings. Whereas the cash flow statement is about the change in the balance sheet cash. If there was a change in retained earnings, because of income, that's not reflected in the balance sheet cash, it's gotta be reflected in some other balance sheet account. So if we systematically go through all the other balance sheets' accounts, we can figure out what that difference is related to. By the same token, if there's something in cash that's not in the change in retained earnings caused by income, it's in some other balance sheet account. And if we systematically go through all those, we can reconcile the difference between cash and income. So that's really what we're going to do. If we think about our comparison of income and cash, and try to think about, well, what balance sheet accounts might the differences relate to, okay? It's not that hard to figure it out. On the income statement we have revenue, on the cashflow statement we have cash collected from customers, what's the difference between those two? Well, it's related to the receivables. If on the income statement we have cost of goods sold, but the cash flow statement we want the purchases paid to suppliers, there's actually two reasons those could be different. One is, cost of goods purchased was different than cost of goods sold because we bought more than we sold. If that is true, we would see the inventory account on the balance sheet go up. Similarly, some of the purchases might not have been paid in cash. If that was true, we would see the liability accounts payable go up. So again, changes in the balance sheet are going to reconcile differences between what's in the cash flow statement and what's on the income statement. Wage expense is on the income statement, but we want wages paid on the cash flow statement. The difference is going to manifest in a wages payable liability account on the balance sheet. And then, as we discussed, depreciation expense is on the income statement. That's related to the change in the long term asset account, specifically the accumulated depreciation account on the balance sheet and is in a cash flow. So that's going to adjust it out, so that we don't see anything on the cash flow statement related to depreciation. Let's be more specific. Revenues verses cash collected from customers. If something is a revenue, but we didn't collect it this year, what is it? Well it must have been a credit sale and we would have to see that on the ballence sheet. Accounts recievable would go up. If on the other hand we got cash from a customer, and it's related to a prior sale, we would see nothing on the income statement this year, but we would see cash collected from a customer. And the way we would see that on the balance sheet is, the accounts receivable would actually come down. So the change in receivables is going to link the revenue recognized on the income statement, and the cash collected that we want on the cash flow statement. Specifically, if we look at what happens on the balance sheet, the ending balance for accounts receivable is the beginning balance, plus the new sales made this year, minus the cash collected this year. That's the link between balance sheet changes, income statement effects and cash flow effects. Rearranging that a little bit, cash collected, which is what we want on the cash flow statement, is the sales revenue, which is what's in the income statement minus the change in accounts receivable. Sales revenue is on the income statement, that's the starting point for the cash flow statement. And this change in receivables is the adjustment that we need to make. If sales was bigger than cash collected, receivables would have gone up. If on the other hand, sales were less than cash collected, we collected more than we sold, then receivables are coming down. Saying that same thing but in a slightly different way. If we see on the balance sheet that receivables go up, we must have sold more than we collected. This means sales is too big as far as the cash flow statement is concerned, and we need to adjust that down to get cash collected. If on the other hand, receivables go down, we must have collected more than we sold. This means the sales number, in the income statement, which is the starting point for the cash flow statement, isn't big enough and we would need to add to it, okay? So in this case we would see a positive adjustment on the cash flow statement. How about the depreciation adjustment? Depreciation is not an outflow of cash. Depreciation is the allocation of the original purchase price of the property plant and equipment. When we bought the property plant and equipment, that was when it went on the cash flow statement and in particular in the investing section of the cash flow statement. As we're using it up, that's not an additional cash flow, okay? So we need to have nothing on the cash flow statement, but the income statement has the subtraction for its depreciation. How do we undo that? We just add it back, so the implicit subtraction as part of net income, plus the add back of the exact same amount on the cash flow statement. Result in an overall number of zero. Which is what we want on the cash flow statement. Wage expense, that's subtracted on the income statement. But what we want is wages paid on the cash flow statement. Those are going to be different if we see the wages payable account go up, okay. If wages payable go up, that means we didn't pay as much as we expensed, and we would adjust on the cash flow statement, accordingly. And then similarly for the cost of goods sold. On the income statement, it's the cost of goods sold, that's not necessarily the same as the cost of goods purchased. Those are going to be different if purchases are different than sales. We would see that on the balance sheet by inventory going up, or inventory going down. If inventory goes up, we must have bought more than we sold. And then the second step is even if we bought more than we sold, did we actually pay cash for that? We can figure that out by looking at the account's payable account. If accounts payable goes up, that means we must have bought more than we actually paid, and we would make an adjustment accordingly. So all of our adjustments then on the cash flow statement, start with net income and the first adjustment is for the increase in receivables. That's saying, some of the sales up in the net income number weren't collected this year, so we need to adjust downward, okay? Some of the adjustments are downward like that one. Some of the adjustments are upwards. How do we keep track of, is the adjustment positive or is the adjustment negative? Use the balance sheet equation again. Assets equals liabilities, plus owner's equity. Decompose assets into cash and noncash. Move everything that's not cash to the other side and express it in changes. The change in cash is minus the change in the non-cash assets, plus the change in the liabilities, plus the change in owner's equity. If non-cash assets go up, that's a subtraction on the cash flow statement. When non-cash assets go up, that's like you're buying more assets, that's in outflow, a negative on the cash flow statement. But if liabilities or owner's equity go up, you're saving cash, and so that's an inflow on the cash flow statement. A couple of complications. It's not simply the change in the balance sheet account that shows up as the adjustment on the cash flow statement. because changes in balance sheet accounts net together things that increase that account with things that decrease that account. So for example, in the property plant and equipment account, we're netting together and looking at the beginning balance and the ending balance, any purchases with any sales. If we bought the same amount as we sold, we'd see no net difference on the property plant and equipment account on the balance sheet. But the cash flow statement wants to show the two separately, so the cash flow statement needs to go in and get the increases separately than the decreases and show both of those. Another complication is the cash flow statement, because it's the cash flow statement does not show investing and financing activities that didn't involve cash. So for example, if you buy a company and use stock to buy the company, it doesn't show up on the cash flow statement. If you buy a company and use cash, it does show up on the cash flow statement in the investing section. Okay, so non-cash investing and financing activities aren't going to balance between what you see in the cash flow statement and what you see on the balance sheet. And the notes will provide more information, so that you can find out about those kinds of activities. So let's compare what the indirect method looks like with what the direct method looks like. The direct method is far simpler. Many users struggle to interpret cash flow statements put together under the indirect method. For this reason, standard setting bodies, both the FASB in the US and the IASB, are trying to encourage companies to use the Direct Method more often than they do now, but you still don't see it that often. There are some benefits though to doing the work to learn how the Indirect Method works. And in particular, if you can figure out how the Indirect Method works, you can see the links between Cash Flow, Income and changes in Balance Sheet much more clearly. Understanding how they all fit together gives you a much greater depth of appreciation of what's going on than if you just look at them as if they're separate from each other. In addition, this is also a useful skill in doing valuation. When we value companies, what we often do is try to forecast out future cash flows. But those are hard to forecast and so what we typically do instead is start by trying to forecast out future revenues and expenses. We then need to convert revenues and expenses to cash in flows and out flows. How do we do that? Using the forecasted Balance Sheet Equations. Exactly like what we're doing with the indirect method of the cash flow statement, the income number and the change in the balance sheet numbers are going to tell us the implied change in the cash flows. So the indirect method, much more complicated, but very useful if you take the trouble to learn it.