Module 1: Accounting

Session: Understanding Financial Statements

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Video 1:
I hope you also better realise the links that exist between these three statements
and the fact that the cashflow statement bottom line feeds the assets side of the
balance sheet. Whereas the income statement bottom line feeds the liability side of
the balance sheet.

And as our balance sheet is always balanced, actually the three financial statements
are always list together like the three angles of a triangle.

We often speak about the financial triangle. And definitely, I hope you are
convinced that if we want to have a comprehensive view of what happened in a
company during a period of time, we need to look at the three statements.

It's not enough to look at the income statement. We have key information
embedded in the cashflow statement and the balance sheet.

And also the other way around when we are managing a company, we can't manage
only against the income statements. You will come to look for profits only.

You need to pay attention to cash as well. You need to be aware of the resources
you're employing in the balance sheet to run your business.

So really, you know good Managers top performing Managers will be the ones that
are able to take into account the impact of the decisions on the three statements at
the same time.

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Video 2:
Now, I would like to take some time with you to recap a few important points we
saw on the income statements. So, the income statement, what is it?

We said it is here to measure whether the company has generated a profit or was
at a loss during your period of time. Profits arise when sales are more than costs.

So, the top line of our income statement will always be the sales revenue. And we
said the sales revenue, how do we compute it? Well, basically the sales revenue is
the sum of all the invoices we have issued during the period of time.

And when are we allowed to issue invoices? Well, we're allowed to issue invoices as
soon as a sale is realised.

That is as soon as our goods or services have become the property of our
customers, that's the very important principle of realisation of sales. So, some sales
can be included in the sales revenue, even if customers have not paid us.

Then what's next? Of course, we're going to subtract all the costs from the sales
revenue.

But there is a bit of structure in an income statement. The first big chunk that is the
upper part of your income statement will be dedicated all the times to what we call
the operations. What are the operations?

The day to day core business. So purchasing food, producing, cooking, selling pizzas,
doing advertising, doing R & D.

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If you do R & D for pizza business, whatever you do, but the core of the business,
the heart of the business. So, first we're going to subtract all the operating costs,
operating expenses that from time to time, we call opex, standing for operating
expenses.

What type of opex can you see here? Well, the second line of your income statement
will systematically be the cost of goods sold, from time to time we also call it the
cost of sales and two important principles are at work, when we compute the cost of
goods sold.

Third, the matching principle. So, what you recognise in this line cost of goods sold is
truly as per say, let's listen to the words, the cost of the goods we have truly sold.
That is the cost of the goods that we previously included in the upper line of the
sales revenue.

And the second principle that is at work is the consistency principle. Here, we do
have a bit of leeway to contribute to the cost of goods sold includes some fixed in
direct costs or not, make up your mind, decide on a principle, but then stick to it
throughout the entire company and over the different periods.

That's the key message the consistency principle gives us. If ever you're able to
include only the variable costs in the cost of goods sold. As we did in the pizza food
truck exercise, then you will be able to compute what we call the variable margin or
the margin on the variable costs.

It's interesting, you can compute it as a percentage of the sales revenue and you
can also benchmark it year on year.

See, how does it evolve over time? Of course, this variable margin must be sufficient
to cover all the costs, all the fixed costs that are going to be expensed further down
in your income statement.

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In the automotive sector, for example, in the early 2000, you could see that, you
know selling prices were moving down very much, raw material costs were going up
very much.

Therefore, the verbal margins were completely shrunk and everybody was
wondering, well, is this business going to last long? If variable costs go up so much
and prices go down that much, there will be no room left to generate a sufficient
variable margin to cover all the fixed costs to the expense later on.

So things have evolved and the automotive industry is doing better and better, but
it's interesting to monitor the variable margin. Then what's next. Well, what's next?
All the fixed costs from operations.

So, here I gave you an example with fixed production costs, marketing costs, R & D
costs. You could imagine other types of costs, linked to HR, linked to legal and so on
and so forth.

And as far as fixed operating costs are concerned, let's not forget about
depreciation. Most of the times, depreciation is a fixed cost.

And it is a cost that relates to the operations. It is part of your operating expenses
because you do need the property plant and equipment to run your business. So,
you must take into account the cost linked to utilising this property, plant and
equipment.

That is the depreciation. So, in the operating part, we start from sales revenue. We
subtract all the operating costs, and then we are done what we call the operating
income. Again, let's listen to the words.

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Operating income tells you what it is. It's the profits from the operations as per se,
that we also often call the EBIT. EBIT is an English acronym that stands for earnings
before interests and tax.

But operating income tells you probably a little better what it means. By the way,
you may see in my income statement that just above the EBIT, we had another
intermediate level of profitability, the

so-called EBITDA.

What is EBITDA? EBITDA stands for earnings before interest, tax, depreciation and
amortization.

Amortization what's that? Well, it's a very, it's a concept that is very close to
depreciation, but it applies to intangible assets.

Don't bother too much, I must say that in some languages like French, you may
have heard my French accent. In French, for example, we only have one word for
depreciation and amortization.

So, it's something a little bit subtle that we have in English. Why do we compute the
EBITDA? Why is EBITDA so important? I would say for two reasons.

The first one is assume you wants to benchmark the performance of two companies.
One running very old equipment, almost fully depreciated, and one running brand
new equipment with huge amounts of depreciation.

Well, of course the company running brand new equipment is likely to have a lower
EBIT than the one running fully depreciated old equipment. But does that mean that
running old the equipment is better?

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Well, not necessarily. It may create more problems to come in the future and these
very old equipment will suddenly have to be renewed in the future.

So, temporarily we have very low depreciation one. But don't worry, depreciation is
going to come back very quickly with high on numbers in that company.

So, it's only something very temporary that you can see a fairly high operating
income in that first company running all the equipment. So, benchmarking
companies against the EBITDA, before the depreciation expenses allows us to get
rid of this bias, linked to the age of the equipment.

Because if I look at the EBITDA, I'm just before the depreciation expenses. The
second reason why EBITDA is so closely looked at nowadays is that it's because
EBITDA closely relates to the generation of cash at operating level.

If you look at all the lines that are involved in the computation of EBITDA from sales
revenue down to research and development in my example, here, you will realise
that all these lines are 100 percent cash in or outflows.

Maybe not a 100 percent this period. Maybe some customers have not finished to
pay us yet. Maybe we've not finished to pay our bills to our different suppliers. But
sooner or later, all these lines will translate into cash.

Whereas depreciation will never, ever translate into cash. So, if you're interested in
how much cash was generated by the operations during the period, it's a much
better idea to start from EBITDA than EBIT.

Then, you will have to make some adjustments because profit is not cash, you saw
that in the pizza exercise. So, you will have to make some adjustments and we will
see that when we look at the cashflow statement in greater details in an upcoming
module.

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So, this is the first part of your income statement. The upper part of an income
statement always speaks about the operations and the operating part
systematically finishes with the operating income.

That is the most comprehensive measure of the profits made by the operations. Here,
we made

$3,600, for example, of operating income.

I don't know if it's a lot or not a lot. Usually you don't speak in dollars, but you speak
in percentage and you compute the operating income as a percentage of your sales
revenue.

And you say that's your operating income was 5 percent here in my case, or you say
the operating margin was 5 percent. Operating income as a percentage of the sales
revenue is often called the operating margin.

We'll go deeper in the analysis in the next module. These operating margin, of
course you know, it's very interesting to look at how it evolves over time. From a
year to the next and also benchmark it against competition.

I invite you to have a look at companies you're interested in.

Please go to the web and look at that corporate website, go through the investor
relations section and you should be able to locate that annual report or a summary
of the key numbers, and you should be able to compute very quickly their operating
margin and benchmark it against competition. A

nd see how it evolved over the last 2, 3, 5 years.

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It's a very interesting exercise and fun exercise to do.

Video 3:
Then we need to speak a bits about the lower part of the income statement. So what
do we have next? Well, we're left with expensing two different categories of costs.

First we have a finance section, so we need to look at the financial results. So, we're
going to subtract the interest expenses, linked to the loans we've previously
borrowed from that.

And maybe we had invested in a couple of financial securities, for example. So we're
going to have an interest income on those financial securities.

It isn't present in my example, but that could happen real life. So, we have a
financial result to take into account. Lastly, interest income minus the interest
expense.

And that will take us down to the earnings before tax. The earnings before tax is an
important level of profitability because that serves as a basis to compute the
income taxes due to the government.

And therefore we'll be able to expense the taxes next. So, taxes will be computed as
a percentage of the earnings before tax.

And after subtracting the taxes, you realise that we've paid everybody that was
involved in running the business this period.

So, we're done the net income or earnings after tax. You can call it one way or
another and this is the level of profits that goes back to shareholders.

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See above the net result, we had paid everybody involved in business, the suppliers,
the workforce, the consultants, the banks, interest expenses, the government to
taxes.

So, done the net income, only the shareholders are left to pay. So, net income is the one
that is going to be taken to the owner's equity in the balance sheet of the company.

Video 4:
We've seen two important questions so far, and that gave us an opportunity to look
at the profits generated by a company during a period of time and more broadly
speaking, all the cash movements that can happen in a company during a period of
time, again.

But from time to time, it is important in a company to take a snapshot of the situation.

For example, at the end of the year, well, sometimes at the end of the month or at
the end of the quarter, or just before the company is sold to another party.

There is now a third question I would like to raise, who are the main company fund
holders? You may have thought about the shareholders of course, you may have
thought about the bankers and maybe some of you spoke about the suppliers.

Those three parties, are yes, granting funds to the company so that it can run its
business over time.

I would make a slight distinction between shareholders and bankers on the one
hand side and suppliers on the other hand side.

Suppliers belong to the world of operations. Why do we take advantage of supplier

credit?

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Because our procurement people have negotiated good payment terms with
suppliers, and that's typically part of the operations, the day-to-day core business of
the company.

The shareholders, the bankers somehow they sit outside the company and their
preoccupation is whether they will get the expected return on their investment or
not.

They're not involved at all in the day-to-day core of business. So that's why
shareholders bankers on the one hand side, suppliers are on another hand side. But
however, all of them are helping fund the business.

And the key question of course is what does the company do with this good money?

So from time to time, it's good to take a snapshot of the situation of a company and
show where the money comes from?

And that statement that shows what the company owes versus what it owns is what
we call the balance sheets.

So, the balance sheet is really these snapshot that we take at the end of a year to
understand where the money comes from and how it has been used, who the
company owes money to and what it owns now, thanks to the funds it was rented by
shareholders, bankers and suppliers typically.

So, who invested funds in the company and how were these funds invested in the
operations?

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That's what you can see in a balance sheets. So, typically what the company owns is
what we call the assets.

And the money that the company owes is called liabilities and equity. Equity is
owed to shareholders.

Liabilities is owed to all other parties, mainly the bankers and the suppliers. And
there is one important thing to remember in accounting.

It is that your assets will always be equal to your liabilities and equity. Both sides of
a balance sheet must always match.

Besides the accounting rule, I mean, this say something really important about the
company.

It says that whatever company owns, it owes it to external parties. So, a company is
never rich or poor because whatever it owns, it owes it to external parties.

And therefore in the exercises, we'll have to ask ourselves what happens when a
company makes money generates a profit, who does it belong to?

I just said the company is never rich or poor. So, when a company creates wealth,
who does it belong to? More to come in our next exercise.

Video 5:
I think we should also do a wrap-up of the learning acquired so far regarding
balance sheets. So, what is a balance sheet?

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A balance sheet, we said, is a snapshot of a company's situation taken at one point
in time, maybe on December 31st or on March 31st, at the end of the fiscal year. A
balance sheet has two sides: assets versus liabilities and equity.

Assets represents what the company owns, liabilities and equity represents what
the company owes to external parties. Equity is owed to shareholders, liabilities to
other parties, so technically this is: where does the money come from and how it is
utilised, invested.

And by definition, the total of the assets must match the total of the liabilities and
equity. Whatever a company owns, it owes it to external parties. Let's do a quick
review of the main items that enter the assets and the liabilities and equity.

As far as assets are concerned, you can see a big chunk which relates here to
property, plant and equipment. Actually, it's part of a bigger category that we
usually call fixed assets. As far as fixed assets are concerned, you can have
property, plant and equipment.

These are tangible fixed assets. You could also think about intangible fixed assets,
and you could also think about financial assets when companies hold shares in other
companies. Besides the fixed assets, mainly the property, plant and equipment.

Usually what do we have? We have inventories. Inventories, this is the valuation of

the goods stored, kept in the company to be sold or utilised for production purpose
a little later. Of course, you have different categories of inventories.

You have raw material inventories, you have finished goods inventories and you have
work-in-progress inventories. These are goods in the process of being transformed
into finished goods.

Depending on the type of product you're dealing with, you will hold more or less
work-in-progress. If your production process is very long, you will hold

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work-in-progress for long periods of time and the majority of your inventories will
be work-in-progress.

Companies try to limit the finished goods inventories they hold, but sometimes
they still hold huge inventories because, by definition that production process
requires they always hold a big amount of work in progress.

A key principle when we value inventories is to be prudent. Remember, the prudence

principle we already discussed. This prudence principle states that assets should not
be overvalued and liabilities should not be undervalued, in particular that applies to
inventories.

Let's not overstate the value of our inventories. So, recognise the value of
inventories at the lowest value possible between the purchasing price, okay and the
possible market value that can be estimated.

Next to inventories, we can see, accounts receivable, so accounts receivable

represents the fraction of the sales revenue that we have not cashed in yet. This is
how much money customers still owe us and, lastly, you can see cash.

Cash is how much cash do we have on the bank account of the company or in on in
its wallet at the end of the period here at the end of the year.

This number comes straight from the cash flow statement, and you remember this
link, we saw a couple of times in the pizza exercise between the cash flow statement
and the balance sheets.

That's for the main items on the asset side. On the liability side, we have two
categories of items. If I start at the bottom, I have all the liabilities.

So, accounts payable, this is how much cash we still owe to our suppliers, because
we've not finished to pay our bills. Then we have long-term and short-term debt.

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This is the money we owe to banks. What's the difference between long-term and
short-term debt?

Well, financially speaking in accounting, we consider assets to be or liabilities to be

short-term when their maturity is less than one year. Anything with a longer maturity
than a year is considered long term.

So, here you can see that you know I will have to repay 2,600 of debt within the next
year, because it is short-term debt.

So, it's important to see how much of the debt is going to expire short term and
maybe needs to be renewed.

Okay and how much is more long term is going to stay there for a longer period of
time will not need any renewal for more than a year and will not necessitate any
cash outflow over the next year.

That's the first category. The second category is owner's equity, so owner's equity
represents all the money that belongs to shareholders in the company.

This is composed of the initial share capital invested plus maybe additional share
capital issued during the life of the company.

Okay, and they are valued here at their issue price. Then we have the
retained earnings, so accumulated profits and losses since the creation of
the company and not yet distributed in dividends and, lastly, the net income
of the year.

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You have one balance sheet on screen here and it's pretty difficult to interpret
anything from the performance of the company during the year looking only at one
balance sheet.

You seldom have access to only one balance sheet.

What is a lot more interesting is to be able to see two subsequent balance sheets,
end of last year end of this year, and then we can see the evolutions and we can
find entry points to challenge the performance achieved.

Video 6:
I also want to come back to the retained earnings. Some of you may, you know,
feel like, yeah, but how do we distribute dividends?

We say dividends will be taken out of retained earnings, but how does that come into
play?

So, here I'm putting on screen, two subsequent balance sheets of a fictitious
company, and I'm claiming that this company did distributes dividends during year
end.

Can you guess why? So, actually I know that this company did distribute dividends
during year end. If I compare evolution of retained earnings from last year, this
year, look at the end of year and minus one.

The total of the retained earnings were amounting to 1,400 and last year the
company made a profit of 400.

So, if no dividend was distributed, then the retained earnings at the end of year end
must be 1,800. Previous retained earnings plus profit of last year.

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But it's not the case. End of year end, the retained earnings are only 1,600, so 200
are missing. Where are they? Cash cannot disappear. Retained earnings cannot
disappear.

If 200 of retained earnings are missing, it means that 200 of dividends were
distributed during year end.

Therefore, my retained earnings only increased by $200 instead of 400. So,

dividends make the retained earnings account decrease on the balance sheet.

And of course on the other side of the balance sheet, dividends also make the
cash decrease by the same amount. And that way my balance sheet stays
balanced.

Video 7:
But is it enough to look at the profits generated from sales? Not really.

You see the income statement is a little bit narrow minded, sales are important, but
many other things happen in a company. You may have purchased or sold machines.

You may have acquired a company. You may have raised capital and that doesn't
show up in an income statement.

So, actually we need other statements to describe the rest of the company to get a
broader view of the company's situation.

The second question that is important to raise is what activities generate cash
movement? Cash inflows, you may think about you know, being able to sell goods
that generates a cash inflow.

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Well actually it generates a cash inflow, the day you are able to collect cash from
customers. You may get cash inflows because you've borrowed money from a bank
because shareholders just injected more capital in the company.

You may also think about plenty of cash outflows like purchasing raw material from
a supplier, paying your workforce, you know paying an advertising campaign,
distributing dividends, purchasing machines.

So, there are plenty of different cash outflows. So, we'll have an accounting
statement to describe all the cash movements.

That statement will be the cash flow statement. And in the cash flow statement, we
can sort out the cash movements into different categories.

If the business is relatively small, the easiest way is probably have a column with the
cash inflows and another column with the cash outflows.

But if the company gets larger and if you wanted to do some analysis of what
happened in the business, you may need a bit more structure in your cash flow
statement.

So, usually when you open the cash flow statement of the company, you find that
the items are sorted out into three categories. And these three categories
systematically come back when we are working in finance.

So, what are these three categories? Actually we have the operations, the
investments and the financing activities. The operations include everything that
relates to the day-to-day core business of the company.

So, this talks about selling goods, purchasing raw material, paying the workforce,
paying for this advertising campaign, taking care of HR, legal you know, after sales
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services, all these things you can think about that happen inside the day-to-day
business.

The investment activities relate to the purchase or sale of assets that you plan to
use over the long run. So, purchase new machines or sale of new, old machines,
acquisition of other companies.

These are all investing activities. And how about the financing activities? While the
financing activities are all the activities that relate to your relationships with
bankers and shareholders.

So, when you borrow money from a bank or you repay an existing loan, when you
distributed dividends, when you raise share capital from shareholders, all these are
the financing activities, and it's fairly natural at the end of the day, because why do
we make these financial statements public?

Well, because we wanted to give a view to outsiders on what happened inside the
company during a given period of time.

So, the financing parties, the ones that are sitting in the financing activities want to
know what is done inside the company with their money, you know, how was it
invested to buy machines, make acquisitions, and did that help generate cash from
the day-to-day business the operations?

So in a nutshell, when we look at the cash flow statement, we have two possible
types of structure. You don't sort out the items by cash inflows and cash outflows, or
sort them out into three categories, operations, investments, and financing
activities.

So, we can bridge the gap between how much cash the company was holding at the
beginning of the period on its bank account and how much it holds at the end of the
period, thanks to all the different categories of cash.

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So, the total cash flow generated by the company during the period will be the
difference between the cash left on the bank account at the end of the year. And the
cash that we had on the bank account at the beginning of the periods.

And it will also be the sum of all the cash inflows minus all the cash outflows, or it
can be the sum of the cash generated by the operations minus the cash spent in
investments plus the cash that came in or out, it depends from the financing
activities.

Video 8:
The cash flow profile of the company can already tell us a lot about its story. So, for
the sake of fun, let's have a look at different cash flow profiles and I will give you
my interpretation of what can

that reveal from a company. But, of course, it could mean plenty of different things
and I count on your imagination to envisage more and more scenarios.

Let's take a look at this fast cash flow profile. What can we see here? We can see
your company that’s generated a lot of cash from operations and reinvested very
little to prepare it for future growth. But the shareholders and the bankers took out
a great fraction of the cash out of the company.

So, I would feel like this company looks a bit like sweat your assets. Make the most
of the existing assets, swept them, so that the company's fund holders can get a
very liquid reward on their investment. That could be typical of a company being
under an LBO or leverage to buy out. When companies usually hold a lot of debt
and have to serve the debt heavily every period.

A second example we could look at is this one. The operations did generate some
cash, but not much. And really not enough to fund the necessary investments to
prepare the future growth of the company. So, how did the company managed to
keep a decent cash position?

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Well, thanks to shareholders, bankers who injected cash inside the company and we
can see that from the positive cash flow from financing activities. Of course, that
could be typical of a start-up company and the question is, how long can that last?
How patient will the company's fund holders be? Will they be likely to reinject cash
in the company year on year, not so sure.

So, we need to have a clearer understanding of how the business is going to develop
in the future. Of course, gradually, we expect operations to generate more and more
cash and the needs for investments to get lower when we manage to run the
existing assets.

This profile is again different. What could that be? What is striking as here is the
negative cash flow from operations. This company is really not in good shape.
Couldn't generate cash from
operations during the periods. However, they still kept on some investments, looking
like they still think the future will look nicer.

Last year wasn't good, but we trust the future. So, we keep on investing. So, we are
ready when the business is back on track. However, did you notice that had the
shareholders and bankers not reinjected cash inside the company, it would have
gone under. It would have gone bankrupt, because its cash position would have
gone below zero.

So, it's likely to be a company facing a big, big crisis. Unable to generate cash from
operations because they probably didn't sell much during the period; kept on
investing because they think the business is going to come back so do the company
fundholders, probably the shareholders because they were ready to put more money
inside the business and avoid it goes bankrupt.

What is striking us on that last cash flow profile? What is striking me on that cash
flow profile is the positive cash flow from investments that seldom happens, doesn't
it. How come the cash flow from investments can be positive? Well, cash flow from

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investment is positive, if and only if the company sells some assets, some fixed
assets that it previously had on its balance sheet.

So, what happened here is the company resold some existing assets, some
machines, or some shares it was holding in another company and so on and so
forth. And thanks to that positive cash flow from investments, the company holds a
temporarily high cash position at the end of the period.

That cash will be available to fund future investments next year or to reward the
shareholders and the bankers in the cash flow from financing activities. Looking at
these different cash flow profiles, I hope I could convince you that the cash flow
statement will tell us many, many stories regarding what happened in the company.

It's really a very comprehensive statement, a lot more comprehensive than the
income statement, actually. So, if I had to choose between looking at a cash flow
statement or looking at an income statement, I would probably choose to look at
the cash flow statement only.

Therefore, sure, all three statements are needed to get a comprehensive view of
what happened in the company. The cash flow statement, the income statement,
and the balance sheets. Also, the cash flow statement is interesting because you
don't want in an income statement some lies are subject to estimates or biases.

Typically, revenue recognition can be the source of many discussions and different
depreciation rules will lead to different profits achieved during the year. That's what
I mean by biases, estimates in an income statement. That doesn't happen in the
cash flow statement, because we are looking at real data here.

So, cash flows are a good gauge of how good the earnings are. When the profit is
good, I want to double check that it's truly good for the company in the cash flow
statements. And also, don't forget that some companies have gone bankrupt
despite showing very high profits. So, it's definitely not enough to show huge profits.

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Companies must be able to show that not only do they generate high profits, but
also they are able to translate them into very good cash flows.

Video 9:
We are now going to dive a little further into the cash flow statement. What do we
have in each and every of the three big categories of the cash flow statements. Let's
go bottom up, because the upper part is a little more tricky.

The third category of cash flow we have on screen is the cash flow from financing
activities. So, what would that include? Well, typically I said, everything that relates
to your shareholders and bankers. So, here you have the example of a company
that issued shares and that generated some cash inflow because some shareholders
bought these shares.

From time to time, you can also see companies buying back their own shares.
Companies using their own cash to buy back to their own shares, and therefore, that
would be some cash outflow and bank wise, you can see the repayment of existing
loans, cash outflow, or the borrowing of new loans, cash inflow. That's for the
financing activities.

The investing activities are also pretty straightforward. This is the purchase or the
sale of fixed assets, equipment, machines, buildings, trucks, cars, computers, shares
in other companies, such things would be investing activities.

What is a little more tricky but very much interesting is the content of the cash flow
from operations. And you may be a bit surprised because the computation of the
cash flow from operations starts with the EBIT or in the so called operating income.

We have already said a couple of times that profit is not cash; profit is not cash. So,
how come a cash flow computation starts from a profitability indicator. Well, profit
is not cash, I do confirm, but somehow and you feel it intuitively, profit and cash are
correlated.

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Luckily, the higher my profit, the higher the cash flow I am generating. So, the way
we are building the cash flow statement is the following. We start the cash flow
computation from a profitability measure and then all the lines that will come down
the EBIT will be here to emphasise the differences that do exist between the EBIT
and the cash flow from operations.

Let's look at it. Let's put on the screen at the same time the income statement of
that company. Let's locate together, the EBIT operating income roughly in the
middle of the income statement,

$3,600 or rupees, whatever the currency and let's have a look at how these EBIT was
computed.

Let's look at the lines above the EBIT and let's ask ourselves, was that cash or not?
If you look immediately above the EBIT, you can see depreciation. Depreciation
was an expense in the income statement. It made the operating income decrease
of course, but it's not a cash outflow.

No, we know depreciation is not a cash outflow. It's just an accounting artefact to
recognise the use of an equipment throughout its lifetime. So, depreciation should
not have an impact on my cash flow statements.

It is logic to have it in the income statement, but that should not influence the cash
flow statement. So, if it was an expense in the income statement, if it made the
profit from operations decrease.

Now, I am going to add it back, so as to neutralise its impact in the cash flow
statement and that's why you see the second line of the cash flow from operations
computation, plus depreciation, because we want to neutralise the impact
depreciation had on the profits of the company.

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Video 10:
What's next? Well, more things happen in the upper part of the income statement.
Let's give a thought to the sales revenue. Did we truly cash in $72,000 from sales
this period? Not so sure. It depends how fast customers paid us or didn't pay us yet.

The whole problem here relates to accounts receivable. Maybe customers owe me
some money now. So, I probably hold some accounts receivable in my balance
sheets and these accounts receivable represent the money I couldn't cash in from
sales yet.

You may tell me, but look, we probably collected some cash from the last period
accounts receivable, and that's right. And if accounts receivable are stable from a
yard to the next, then what am I missing from this year sales is fully compensated
by what I collect from last year sales.

Problems happened cash wise, when my accounts receivable increased. If accounts

receivable increase, it means customers owe me more money, and therefore, I am
lacking cash in my own wallet. So, cash wise, when I see accounts receivable
increasing, I should consider this impact, my cash flow from operations negatively
and that's why you see this slide minus increase in accounts receivable.

Could we see the balance sheet of that company, we would be able to check that
accounts receivable increased by $4,975 from last year till now and that was bad
for cash.

Conversely, of course, if we managed to make accounts receivable decrease, it's

good news for cash. Customers owe me money. I have collected more cash from
last year receivables. Then the new receivables, I have just generated. So, a
decrease in receivables would be a plus in my cash flow computation.

The same reasoning applies to changes, fluctuations, increases and decreases in my

inventories and payables. See in the income statement, when I considered cost of

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goods sold, I didn't take into account whether I had finished to pay my suppliers or
not.

I didn't take into account either where the goods sold were coming from. From
previously built inventories or from recent production. That had no impact in my
income statement, but that must have had an impact on my cash flow statement.
So, for the same reasons, increases, decreases

in inventories and payables must have an impact on my cash flow statements and
you see that on the next line.

When inventories increase, it makes my cash flow statements decrease by 400 in

that example. Symmetrically, when accounts payable increase, is that good or bad
for cash? Think about it.

When accounts payable increase, it means that I owe more money to my own suppliers.
I have not finished to pay them yet.

So, for the time being, there is more cash left in my own wallet. So, when accounts
payable increase, I owe more money to suppliers, but I have more cash with me, so
it's good news for the cash flow from operations computation. And that's why you
see on screen plus increase in accounts payable and symmetrically, it would be
minus decrease in accounts payable.

So, on these three lines here, what do we see? We see the variations, the changes in
the working capital items and we have seen already two big chunks in my cash flow
from operations computation.

The first chunk was linked to the margin made that was EBIT plus depreciation. The
second big chunk is the change in operating working capital. And there are two
more items left here that may sound a little weird, by the way.

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We have interest expenses and we have taxes that are also flowing into the cash
flow from operations computation. Why am I saying it's a little weird? It's a little
weird to see interest expenses taking in the cash flow from operations computation,
because interest expenses depend on the borrowings from the bank and that is
typically a financing activity.

So, shouldn't interest expenses be recorded inside the financing activities? Well,
they could be, but accounting wise, that’s not done that way. Accounting wise, we
usually consider that the interest expenses, because they are a recurring expense
should be kept inside the operations.

Also, accounting wise, 100% of my taxes are kept inside the cash flow from
operations computation, again because they are a recurring item. And you see now,
we have a better view on how did the company managed to generate cash from
operations.

The company generated $2,600 of cash from operations, but it generated a lot more
from the profitability of its business. However, the company has suffered a significant
increase in its working capital and that burned a lot of cash.

So, at the end of the day, the cash flow from operations isn't as good as we could
have expected while we were looking at the income statement only. Of course,
interest expenses and taxes make the cash flow from operations decrease a little
further, but that's more natural.

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