26. What is a Cash Flow Statement

welcome to course 2 unit 5 lesson two

what

is a

cash

flow

statement

? In this lesson you will learn

what

a

cash

flow

statement

is and you will also learn how to use cash flow statements to identify strong companies versus risky companies, so let's get started if you remember to go back to the course, one unit one, you will remember a scenario where I was teaching people about income statements and balance sheets with an ice cream stand owned by one owner, Nancy, one of the things I briefly mentioned was the existence of a cash flow statement, but I didn't go into detail about how it was used. the cash flow statement and what its purpose was, and that's what we're going to do in this lesson: we're going to go back to the basic understanding of the income statement, the balance sheet, and now we're going to incorporate the cash flow statement into that, so which before 1987 a cash flow statement was not even necessary, but to provide more fidelity about what is happening within a publicly traded company.

Now the company's cash flow statement is required, so just a quick summary of the income statement which you'll find at the bottom left and what I'm going to use for this scenario is a basic candy store which we're going to say is called. Dan's Candy Store and we're going to use some real generic money to show how that money flows through Dan's Candy Store and we're going to show how each of these three statements does well, so the first What What you need to understand is the income statement and you should be basically familiar with this, and the income statement demonstrates the amount of money that is generated from the operating activities of the company, so this report will show you how much money is coming in or going out. of the. the company is based on that product, so this would be the sale of Dan's candy, so let's say Dan sells enough candy to generate enough revenue of $100, his net income would be $100 and that $100 would be reported outside of that income statement at the top of the income statement will be revenue and at the bottom will be net income or profit okay so $100 of profit flows into Dan's candy store that is the profit that got and that income statement would capture that now, once you're inside Dan's store, before we were showing how that money could be paid to the owner through a dividend or how the money could then be included as an asset on your balance sheet or that money could be used to pay debts which would reduce liabilities on the balance sheet, so if you were just looking at the income statement or balance sheet, which is how you would see it before 1987, you would have to look at the money coming in from the balance sheet. of results and where that money was going. would be if assets were becoming worth more or liabilities were decreasing, you would have to assume how that money was being spent based on how the balance sheet changed from month to month, so what the cash flow statement does is what it shows. you know where that money is generated and where it is spent and employed throughout the company, that is where the cash flow statement comes in and that will be its purpose, so let me give you another example, let's go back and say that $100 flows into the Dan's candy store, okay, and this is something you may not have thought about before, but now that we're getting into the advanced lessons, some of this will start to make sense to you, but let's say $100 comes into the store. of Dan's candy. through the sale of your product, okay, once that $100 hits your corporate bank account, your company's bank account, there are a lot of things you can do with that money, a lot more than I have.

You know, the basic things that As I described earlier, not only can you have money flowing out of the product that you've produced, candy is $100 of candy, but Dan let's say you have that this is a publicly traded company. Dan could actually increase income for his company through issuing shares, so let's say there are 100 shares outstanding in Dan's store, let's say Dan wanted to issue another hundred shares, there would be 200 shares outstanding and when he sells those shares, that will generate additional income, a lot of additional funds and bring cash into your business, so instead of just making a hundred on the candy that you sell, you could make another $100 just from selling your shares.

Another way Dan can raise money is by issuing FS bonds, um, I'm sure. You've already realized that, but that's not something you're going to capture on the income statement. You'll just see that he has more cash on hand or in any case it would be off the balance sheet and I really don't understand how it got there and the cash flow statement helps us identify it so let's say Dan issued $100 in bonds so he collects $100 from some investor in addition to the $100 you are already earning with your product, so there is an additional. $200 that will go to your balance.

Now here's another thing that many people may not consider: Let's say that Dan has been using money in his account to buy publicly traded companies just like he is doing within his company. Now count, this would make Dan's Candy Shop a holding company, but let's say he owns some shares of a company within his corporate account, and those companies he owns within Dan's Candy Shop's corporate account They are generating dividends. payments to it, so that would be additional revenue that wouldn't show up on the income statement and would only be captured from the cash flow statement, so those are just some of the different revenue streams that could come into the cash store.

Dan's candy and that won't It won't show up on that income statement, but it needs to be captured in some way and that's where you'll find the cash flow statement is very helpful in capturing those resources now, just like we described the funds coming into the Dan's corporate account. that were not captured on the income statement, there are also funds coming out of Dan's Candy Store that have not been properly accounted for. Let's go ahead and describe some of them. The first one that's pretty obvious is if Dan is paying a dividend to the owners of his company, um, what would he be if he paid himself a dividend that's not recorded on the income statement, so the payment of Dividends have to be recorded somewhere and that dividend payment is recorded in the cash flow statistic and you will see the funds. flow out of the company, let's say Dan is using the money, let's say, that $100 that flowed into his company, let's say he's taking a portion of that $100, let's say just 25 of those dollars and he's reinvesting it back into inventory or he's Using that $25 to improve your facilities or your equipment, all of that will be recorded in the investment portion of the cash flow statement.

Another thing he will find on the cash flow statement is the money he is using to pay. to pay off your debts or to make payments on your coupons on bonds you might have issued, when you were simply working with an income statement and a balance sheet, you would see that perhaps the liabilities would decrease, but you wouldn't know how much of your money was being allocated. cash to pay those debts, but with the cash flow statement you can now see how much money you are using to pay your debts and how much money you could be using to retire shares, say before raising money by selling. shares, let's say he's buying 100 shares, let's say there are 200 shares outstanding and he's using $100 to buy 100 shares of your business because that increases the value of the shares he has, so that would be the incentive for him to do something.

So, all of these things, all of these nuances that I'm describing are all captured in this very important document called a cash flow statement, so when we open up a cash flow statement and look at it, the cash flow statement is divided into three. categories, okay, the first category is operating activities, okay, and operating activities are all those funds that flow into the business, so if you were receiving dividend payments from companies that you own within your corporation, they would be included in the list of operations. activities if he, the net income is the first thing listed in the operating activities that comes directly from the income statement, so all the money that is generated for the business that you are doing and that you are producing is listed there in the operating activities now. the next is the second here is investment activities, so the money that you are using within your corporate account to buy more supplies to improve your facilities to buy new construction buildings to buy stocks and other companies to buy bonds, all of those investing type activities are the second item listed on the cash flow statement and then the third item listed on the cash flow statement is financing activities, so when you were talking about how maybe you were issuing more shares, That is one way to finance and raise money for your business, many people may not see it that way, but that is exactly what happens every time a company issues more shares.

The other way a company finances is by issuing bonds so it can OR take a loan, it could issue bonds and that will raise money and that's the third category listed on the cash flow statement and those are financing activities, okay. , so the important number to keep in mind of those three of those three categories in the cash. The flow statement is really that operating activity because this is where you should see the green on the sheet when you see a positive number under the operating activities, that is the actual number that provides the lifeblood of the company if you see a positive number. under investing activities that actually means that you sold some of your investments and that is the positive cash flow and the same goes for financing activities if you see a positive number in that third category in financing activities that actually means that You've sold bonds and you've incurred debt, so that's not a good thing, so when you look at the cash flow statement you'll want to see the operating activity as a positive number, hopefully a large positive number, and then the investing activities and financing as the negative number because he's buying investments or he's paying down debt, okay, that's important, the first one should be positive and the second two should be negative, so let's look at a generic example here and we'll call this company a and this one. is going to be the cash flow statement for company A, as you can see from right to left.

I have the years 2010 20 2011 and 2012, the first line is the operating activity, the next line is the investment activity and then the third line. is the financing activity and you will see that the fourth line is just the change, if you summarized the three categories, the sum is at the bottom, okay, so let's start with 2010 and move through the operating activities in 2010. You can see the company generated $1000 in operating activity, the next year it was $100 and the third year it was $1200, so you see nice steady growth and they are all positive numbers, like what we wanted to see because this is the money . what the business does is what produces the revenue, so if it is a candy store, the candy is the main thing that generates the income from the activities of the operating act now, as we move to the next line and look at the investment activities you will do.

Let's see that they are all negative and as I said before, this is a good thing because it means that you will take $500 in 2010, you will take $500 of the thousand that your company produced and you will take that $500 and you will invest it. turn it into a new Candy product, a new building for your candy company or maybe you're just going out and buying $500 worth of stock in another company, it could be any of those things or maybe you're buying $500 worth of bonds and you'll be collecting coupons. of that investment could be any of those things, but what you want to see is a negative number because that means he is investing now.

If you saw a positive number on that line, that would mean that you sold your stock or you sold your bonds or you sold half your plant to some other company that is now producing candy and now doesn't have the ability to generate that cash flow for the next period, so what you would expect if investing activities were a positive number depending on whether it was a good asset or a bad asset, maybe you could expect operating activities to decline the next quarter or the next year if those investment activities investment were a positive number, so you can see in this scenario that your investment also increased, you continue to invest a larger sum as you continued to earn more money in those operating activities.

Now when we look at the third line, which is financing activities, it is also a negative number, it is $400,500 and then 600 $0,000, this is also a good thing because this means that company A is paying off its debt in 2010, it paid $400 of his debt and had $100 left after that year; then if we look at the year 2011, they paid off another $500 of debt, that's good if this number was positive, that means that thecompany would be going into debt. Now they would have more cash in their bank account to do whatever they need to do, but in the long run that company is going to have to pay off that debt and you're going to see that get absorbed from the operational activities and you're not going to have that positive. cash flow potentially in the future depending on how they use the capital they borrowed, so this is what you're really looking for.

This is a good example of a cash flow statement. You want the first operational activities to be positive and you want. investing activities and financing activities are negative and then their net change should generally be a constant and consistent theme across the board. The fact that the net change in cash is zero in 2012 doesn't really mean much to Yo because at that time I don't know, the company has very positive operating activity, they are using that money to invest and they are paying down their debt, so to me everything has a good signal now if the company needed um.

Let's say they needed a lot of cash to carry out the acquisition of another business or something like that, you would see the company start to accumulate its cash and you would see that the net change in cash would be a positive number quarter after quarter as it prepares for that acquisition and That's usually a good sign, if you see a company raking in money, you probably know they're getting ready to make an acquisition of another company, so company A was showing them a good cash flow statement. now in Company B, I'm going to show you one that doesn't look so good, so let's start from right to left and look at the operating activities and you can see that the operating activity cash flow is slowly decreasing, it's going from 500 to 450 at 400 that's bad because it means that earnings, the lifeblood of this company, are slowly declining, since you know the capital growth of a company and the dividend payments that we are using, the value of the company in the long term, It has to be consistent. and it has to grow slowly so that they can continue to make those dividend payments and so that they continue to grow their book value in equity, so a company like this would have a difficult time meeting that given their earnings and their overall operating activities. they are decreasing over time so when we go down to the next line and look at the investment activities we can see that the investment activities are also slowly decreasing now since 2011 2012 went up $50 but overall it went from 600 to 300 to 350 and the reason those investment activities are declining is because because the operating activities are declining, they can't continue to invest at the same level that they were investing at when they don't have the funds to do so, so let's move on to the third line and Look at the financing activities and you can see that these are positive numbers, so instead of the company paying off debt, it is actually incurring another $500 of debt and by 2011 it is incurring another $300 of debt.

In 2012, it doesn't look good. everyone took out another $600 in debt, meaning they put money in their bank account that they're borrowing from somewhere or they're somehow making that money by issuing more stock or they're issuing bonds or they're getting loans um, but that's not what what you want to see, you want to see that first positive line and the next two negative lines and you can see that the net change in cash was zero in 2012, 450 and 400 in 2010, so the net change in cash was much higher here compared to company A but in my opinion this is a much worse cash flow statement because of the trends and the direction the money is flowing so just a quick summary here is company A and you can see .

I have the first line in green and the second two lines in red and this is what we are looking for, we are looking for that operating activity to actually generate that net change in cash flow, so I hope this lesson helped. I give you a general idea of ​​how a cash flow statement works. This is really general and basic, but in the next lesson we're going to go ahead and look at real companies and their cash flow statements so you can identify a good company versus a bad company with respect to how cash flows through the business. .

This concludes course 2, unit 5, lesson two, what is a cash flow statement and in this lesson we learned what a cash flow statement is and we also learned how to use a cash flow statement to identify solid companies versus companies risky, so I look forward to working with you in the next lesson, where we really apply the cash flow statement to real businesses.