2. Operating Cash Flows

Let's talk about cash flow from operations. Operations is the first section on the cash flow statement. So we've got operations, investment, and then finally financing. This one we're gonna talk about just operations. Like I said in the overview video, the operating activities are the day-to-day activities. They're also the activities tied to revenue and expense accounts on the income statement because the revenues and expenses are your day-to-day accounts also. When you make a sale, it goes into revenue. When you pay your employees, it goes into expenses. So the cash flow from operations is very closely related with the revenue and expenses on your income statement. So what we're gonna do is we're gonna use net income as our starting point.

So when you're doing the cash flow from operations, your starting point should be net income. And then we're gonna add and subtract a couple of things, and then you get to your cash flow from operations. This is called the indirect method, and it's called indirect because you're starting with net income. Now, there is such a thing as the direct method, where you just add in all the cash received, and you subtract all the cash out, and that gives you your cash flow.

We're not gonna talk about that in this video. We're just gonna talk about indirect. The thing that makes the indirect method a little bit tricky is trying to remember what all of these adjustments are. And I say adjustments because the net income number has a lot of things that flow into it, right? You've got sales revenue. You've got wages expense, salary expense. You've got gains from sale of equipment, loss from sale of equipment. You've got a lot of things coming into this net income number, but not all of them include cash. Not all of them are cash from operations activities. So while revenues less expenses gives you net income, and this is kind of close to cash from operations, it's not exact.

So once we get down to net income, we're gonna take out some of the things we added up here, and we may add back some of the things we subtracted. So if you can keep that in mind, it becomes a lot easier to logic your way into what are those adjustments, what are we adding back, and why? Let's start with what I think is the easiest one to remember. The first thing that you're gonna add back is you're gonna add back any depreciation expense, any depreciation or amortization.

And why is that? Well, if you remember, depreciation expense, the journal entry is actually a non-cash journal entry, right? We don't have cash over here, where when you have wage expense, if you pay it immediately, your cash goes down. Or insurance expense, when you pay it immediately and you don't put it into a payable, your cash goes down. However, when you're dealing with depreciation expense, you're putting it into this depreciation expense bucket. You're not actually affecting cash at all. So since we're looking for cash, and we decided, let's start with revenues minus expenses, well, this E right here contains this depreciation expense, but this depreciation expense is not linked to a cash transaction.

So if our depreciation expense was 1,000, we included that. We said all the revenues minus all the expenses, including this 1,000 of depreciation expense. Well, we didn't pay cash for that expense. We paid cash for all these expenses, but we didn't pay cash for this depreciation expense. So when you're going from net income down to cash from operations, you need to add back any depreciation because it's a non-cash expense. It's an expense you aren't paying for. Same goes for amortization, just on intangibles. Let's look at one that is slightly related but not exactly the same.

What about gains and losses on the sale of plant, property, and equipment? Well, right away, you should look at plant, property, and equipment and think, "Well, that's not operations." Plant, property, and equipment goes in the investment category, doesn't it? This isn't day to day. We sold a warehouse. We sold a machine. We sold or bought something really big. These aren't the widgets that we actually produce. This is some sort of investment activity. So we know that we're gonna have to back those out. But let's take a look at that. Let's say you got 1,200 cash for a piece of equipment that was worth 1,000, so you're missing 200 is a gain.

This gain right here ended up in net income. In the same way, if you had sold it for 800, your missing 200 would be a loss. And in the same way, this $200 loss would have ended up in your net income. So you either have the $200 gain or the $200 loss end up in your net income, but they shouldn't be there. They're paper gains, and they're paper losses. Your cash was properly recorded at 1,200. The cash change on this transaction is up 1,200 or up 800, depending on which one you're doing. This loss has nothing to do with cash at all.

This gain has nothing to do with cash at all. That's just a revenue or expense recognition entry. We right now only care about cash. For net income, absolutely, put the loss in there, put the gain in there. You'd be totally right to do that. But for cash, we only care about the cash part of the transaction, and that's accounted for in the cash entry. And these two entries, the 1,200 or the 800, depending on what you sold it for, you'll find those down in the investing, and it's gonna be cash proceeds. And so there you would just plop in your 1,200.

The cash proceeds from the sale of PP&E, 1,200. And again, you'll notice we don't care about the gain. The gain is just a net income. It's just a recognition procedure. The cash we actually got was 1,200. So on a cash flow statement, you just write down the cash that you actually got.

So since this net income includes that gain as a positive and includes that loss as a negative, we do the opposite. We took out the loss to get to net income, and so to get to cash flow, we add the loss back. We added the gain to get to net income, so to get to cash flow, you take the gain out. And that's one of the adjustments to get to your change in cash or your cash flow. All we're really doing is reversing what we did to get to net income. So you'll see losses are always subtracted, but we wanna reverse that process, and so to reverse it, we add it back.

Now we're getting to the fun stuff. Those three are pretty straightforward. Now we're getting to the ones that are a little bit more tricky. So now we have four more, and they all go together. You're gonna add any decreases in current assets. You're going to add any increases in current liabilities. You're gonna subtract any increases in current assets, and you're gonna subtract any decreases in current liabilities. Did you catch all that? The good news about this is if you can manage to remember even one of these four right here, you can remember all four of them. Let me show you. You've got current assets, two of those, up and down.

We'll just pick down, up. And then you've got current liabilities, same arrows. You've got down, up. Let's say you remember that a decrease in current assets, you're supposed to add it. Great. You remember one and you think, "I can't remember any of the others." Well, these are the same accounts, but they have opposite arrows, so pick the opposite. These are opposite accounts, but they have the same direction. They're both going down. So since the accounts are opposite, well, it must be opposite because if current assets go down and it's a positive, you can't say that current liabilities go down and it'd be a positive too.

It's gotta be the opposite. And then for the last one, same account, opposite arrows, and also opposite account, same arrows. So you see how all four of them kinda work together? If you can remember one, you know that opposite arrows on the same account must be opposite directions. And likewise, the same arrow on opposite accounts, assets versus liabilities, those have to be opposites because there's nothing more opposite than asset and liability. So if you want to brute force it, just memorize one and then use your brain and figure out the other three. But the real question is why? Why is, for example, a decrease in current assets, why do we even add that back?

How does that make sense? Let's take that as an example and see if we can figure out why. A decrease in current assets. My first question is: what's a current asset? Well, accounts receivable is the one we deal with the most as our current asset. Okay, so now we've got current asset. Let's address the decrease. Let's say we start with 5,000 and end with 2,000. That is a decrease in a current asset. That is a $3,000 decrease in accounts receivable. Now, according to what I just told you, that should be added back to net income to arrive at cash flow from operations.

That's it, by the way. These are the only adjustments you have to make. We're done with the adjustments. Now we just gotta figure out why do we make these four. So if you trust me, then you know that this $3,000 should be added back right here because that is the decrease in the accounts receivable account. And it's good for you to trust me, but it's better for you to know why. Let's make up some more numbers. Let's put 4,000 here.

And I'm just making these up as a way to prove something to you. Let's put 4,000 there. So 5 plus 4 is 9, so we need to have 7 over here. So we have 5 plus 4 is 9, less 7 gives us our 2,000. Okay, now let's think about this 4,000 and this 7,000. Under what circumstances could these numbers end up here? Well, we already have half the journal entry, AR 4,000 left side and something 4,000 right side. And then we have something 7,000 left side and accounts receivable 7,000 right side. So what I did was I just took this 4,000 and made it into part of a journal entry.

And I took this 7,000 and I made it into part of a journal entry. Because that's how we know that that's how these numbers ended up here. They ended up here through a journal entry of increasing accounts receivable by 4 and decreasing accounts receivable by 7. When do you increase accounts receivable? Well, you increase accounts receivable when you have a sale. You made a sale, they didn't pay you right away, so you put it into accounts receivable. You decrease accounts receivable when you get paid. So when you get paid, your cash goes up and your accounts receivable go down 'cause it's no longer receivable.

It has been received. Just very loosely, we can call the left side of accounts receivable, we can say this is kind of the revenue side because the other half of the journal entry that corresponds with a debit to accounts receivable is a credit to sales revenue. So just as a little shorthand, we can say, well, this is typically the revenue side, and the other half of a credit to accounts receivable is a debit to cash. So we can say, well, this is typically the cash side.

Now, why is this important? Well, it's important because this sales revenue number, that went into calculating our net income, didn't it? Didn't we say that 4,000 was our revenue, and that trickled down into our net income? Well, that's good. 4,000 was our revenue, but look, our cash was actually 7,000. And what's the difference between 4,000 and 7,000? 3,000. So we collected 3,000 more in cash than we recognized in revenue. So this net income number contains 4,000, but really, it should contain 7 because we collected 7,000 in cash. And that is why when you have a decrease in a current asset, you add it back.

You're adding back this additional amount that you got paid that wasn't recognized as revenue. That's one. Maybe that one doesn't make a lot of sense. Let's look at an increase in a current liability. Why is an increase in a current liability an addition? What is a current liability? Well, let's pick accounts payable. If we chose accounts receivable for current asset, accounts payable makes enough sense. An increase in a current liability is an addition. Let's say that any one of our accounts payable went from 1,000 to 5,000. So we have an increase in a current liability, and that increase is a $4,000 increase, right?

'Cause we have 5 less 1, gives us the $4,000 increase in a current liability. Now we wanna figure out why do we add that to net income to get to cash flow. Let me make up some more numbers to prove it to you. 6,000, 2,000. 1 plus 6 is 7, less 2 is 5. Okay, so we know we're on the right track. Now, how did these numbers get there?

How do we get things into accounts payable? Well, we typically have some sort of, let's say this account payable is for wages, wages payable. We have a wage expense of 6,000, and we toss that into the wage payable at 6,000. Then how do you get stuff out of accounts payable? Well, we decrease wage payable by the 2,000, and we decrease our cash by 2,000. So again, it's the same exact situation. We've got revenues less expenses is net income. That was the starting number we decided. This 6,000 was included in this expense number. But look, over the course of the year, we didn't actually pay 6,000, we only paid 2,000.

So we took our net income down by 6,000 as was appropriate, but we're trying to get to cash flow, so we should have only taken it down by 2,000 because the cash outlay was only 2,000. So to correct for that, we have to add back the 4,000. You can think of it as for net income purposes, 6,000 was our expense. But for cash flow purposes, 2,000 is how much we actually paid out. So the difference between the two, the 6,000 less the 2,000, is the 4,000 that we add back. This is the cash side. This is the expense side.

So you wanna know how much did I include to get to net income? What was the expense? How much did I actually pay? What was the cash payment? What is the difference? And I need to go add that difference back. We'll go over several examples of these, but little mental proofs like these help me remember why. Why am I adding back an increase in a current liability? Oh, I'm adding it back because I expensed more than I actually paid. Or why am I adding back a decrease in a current asset? I'm adding a decrease in a current asset because I recognized revenue of 4,000, but I actually got cash of 7,000, so I need to add the additional 3,000 'cause what I'm looking for now is cash, not net income.

That's the why behind all of this. And of course, you can just memorize one and then figure out the rest on the test.