 Last class I gave a very brief introduction on the need for a cash flow statement and why that certain users of the cash flow statement would be interested in knowing the behavior of cash. And to understand the behavior of cash I had told that the activities of a firm gets broadly classified under three categories namely the investing activities, the financing activities and operating activities. Broadly these are the types of activities that have a direct impact on cash and if we are able to analyze the behavior of cash in these three activities then we will be able to understand how cash is getting consumed and how cash is getting generated. Normally investing activities means those activities where you find that the firm is investing its money or it will use money for buying a constructing plant, purchasing equipment or it can even lend money to other entities these are all the investing activities of the firm or even if it sells its assets and gets money, disposal of assets and it gets money that is also an investing activity for the firm. The financing activities broadly are those activities that are related to the source of the capital for the firm it can be from the loans or shares so this can either bring in cash or consume cash same thing here consume or generate. So if I get a loan I get cash for the firm if I repay the loan cash goes outside the firm but still it is a financing activity. If I pay dividends to my shareholders it is a financing activity for the purpose of understanding a cash flow payment of dividends to shareholders is classified as a financing activity and broadly any activities that do not come under this investing or financing will come under operating activities like your accounts payable, your accounts receivable, inventory all of these comes under your operating activities. So these are broadly the three types of activities which will change the behavior of cash and by studying the behavior of cash under these three type of activities we will be able to generate a cash flow statement. Now how do we do that? Your income statement as I told you gives the net income for the entity the net earnings that is available to the firm the free cash that is available to the firm. So your net income is one that would have taken into account all the operating expenses the interest expenses the depreciation the income tax everything and finally is the net income from the income statement you will be able to calculate that. Now let us for example say that I want to understand the behavior of cash. And I have already told you that this net income is not cash. So by saying that I have 10 million rupees as net income it does not mean that in the balance sheet cash is 10 million I have repeatedly told to the class that both are totally different. Then how is that from this net income I can relate with the opening cash and see what has happened to the activities that have either consumed cash or generated cash. And then see whether from the opening cash the net income and understanding these activities that have generated or consumed cash can I arrive at the closing cash that I see in the balance sheet. Then let us for example say the accounting period is the first of April 2011 to 31 3 2012 which means I have a balance sheet I have an income statement. Now the net income as on 31 3 2012 and I have a balance sheet for 31 3 2012 which has a closing cash both are not same. Now is it possible for me to start with the net income for this year and understand what has happened to activities that have either consumed or generated cash during this period first April 2011 to 31 3 2012. And then add that with the opening cash that is cash at the end of 31 3 2011 plus all these activities that have influence the behavior of cash plus the net income during this accounting period and when I do this I will find that the summation of all this is the cash at the end of 31 3 2012. And if you are able to do that in the process you have created a cash flow statement. It is not as easy as I explained for you to understand what it is so let me just give you an example and then take you through that example so that you will understand this better. Now look at this you look at the balance sheet between two successive periods as I told you before 31 3 2011 and 31 3 2012 look at this figure cash 230 326 96 which means the end of accounting period 2011 the cash was 230 the end of 2012 it was 326. So the change is 96 what am I going to do by creating a cash flow statement it is to understand how this change of 96 has happened and it could have happened in a variety of ways as simple as just cash 230 a bank gave me a loan of 96 and let us say this is in lakhs of rupees so 96 lakh of rupees and nothing happened to cash during the entire accounting period so 230 plus 96 326 as simple as that we could have explained the cash flow. But reality in an accounting period of one year it is not a simple loan that has brought in 96 lakh of rupees that explains this difference of 96 no a host of some activities would have happened which would have changed the different accounts and the resultant of that change is this difference of 96 what accounts it could have changed it could have changed the accounts receivable it could have changed the inventories it could have changed the equipment purchase it could have changed in investments or even in my liabilities side it could have changed my accounts payable it could have changed my debt profile all this could have changed. So we are going to understand how these have changed if at all they have changed and because they have changed change could be either it could have consumed the cash or could have brought in cash and because of this change we need to understand whether cash has gotten inside the entity or left the entity. Now let us for example say plant an equipment end of 2011 it was 2000 end of 2012 it is 2003 the difference is 350 now the question is very simple how do you explain difference the explanation can be in a variety of ways again as simple as saying I just purchased equipment worth 350,000 and that explains the difference this could be one explanation acceptable a different explanation could be that I purchased equipment worth 800,000 and it was during this accounting period I also disposed of another equipment that was worth let us say 400 450 or 500,000. So I purchased a new equipment worth 850,000 I disposed an existing equipment worth 500,000 now that difference also explains the difference between these two activities explains this difference of 350 or it could be you know I purchased something worth 500,000 I disposed of an existing equipment worth 150,000 that difference also explains this difference 350. So how do we know actually what happened then we will go to our account from the ledger we will go to the account title this plant in equipment and see what has happened during this accounting period and then we will see that an equipment new equipment worth 500,000 was purchased and existing equipment whose cost of acquisition was 150,000 has been disposed of and it is because of this that there is this difference of 350 and we are not stopping with that we also find that the equipment whose cost of acquisition 150,000 was disposed was not disposed at its book value of 0 but was disposed for let us say a value of 20,000 that also gets captured somewhere and sits somewhere in this valence sheet in cash we will have to call out that and understand what has actually happened and when we do that calling out we are trying to extract cash transactions in all these balance sheet items between 2011 and 2012 or in effect I am trying to understand this change that has happened between 2011 to 2012 how that change has affected the behavior of cash. So let us say I start with the opening cash of 230 and see how the behavior of cash has been affected because of all these transactions and the summation of this with the opening cash should give me this 326 that is the purpose of today's class to understand how we do this and then in the process understand that this is actually the cash flow statement that we are creating just as I gave an example for the equipment let us say for example I see this long term debt 500 end of 2012 it is 835 to a layman who does not know cash flow statement I look at the balance sheet the immediate interpretation that I make from the balance sheet is that my long term debt at the end of 2011 was 500,000 the long term debt now is 835,000 so the difference is 335 in the absence of any other information I would safely assume that I have borrowed 335,000 more and that is an acceptable interpretation but then if I again go deep into the ledger the account copy of long term debt I find this 5385 the difference of 335 is not because I got in a fresh loan of 335 it could be because I got a fresh loan of 375,000 and that I already repaid to the extent of 40,000 of an existing loan and this difference is this 335,000 so proceeds from new loan is 375,000 payments on existing long term debt to the extent of 40,000 explains this difference of 335 likewise every change will have an explanation for it and that explanation will explain the behavior of cash associated in each of this change and that could happen in accounts receivable inventory accounts payable long term debt short term debt disposal of assets so in all this there is some behavior in cash that gets changed and if you are able to track that behavior and match it with the opening cash to understand the change then you will be able to track the entire cash flow information in that accounting period and it is that tracking of information related to cash that I am interested in knowing in the form of a cash flow statement in the absence of which just looking at the balance sheet I cannot know what has happened let us say I wanted to know financing activities I look at the balance sheet as I told you before I just know that the difference is 335,000 that is it I do not know how I got this 335,000 suppose I want to know operating activities I just know that the accounts receivable has changed this much the accounts payable has changed this much but I do not know what has happened that has caused this change and it is that very specific information on what has happened is that I am interested in and that is why I create a cash flow statement. Now let us begin to understand this by starting to prepare a cash flow statement of cash flow for 31,3 let us say 2012 right now the net cash flow from operating activities I told you there are 3 sets of activities operating activities financing activities investing activities and we are going to see how cash has behaved in all of these 3 activities and let us begin with operating activities. Now I begin by first writing in net income which is not available because I have just given you the balance sheet figures let us say the corresponding net income at the end of 31,3 2012 was 200 okay 200 is the net income. Now what I am going to do is from the net income I would be adding or subtracting the cash value of those activities that have either generated or consumed cash from this net income and then after I do this add it with the opening cash as on 31,3 2011 and when I do that if we have done that correctly the answer will be the closing cash that you see in your balance sheet as of 31,3 2012 and this statement that we did to do this is your statement of cash flow. Now when we begin with the net income for that particular year we always start the cash flow by first adding back the depreciation for that particular year. Now let us say the depreciation for that particular year was 120 that again I have not given you the balance sheet but the example that I have taken is a real example and in that the income statement I find that the depreciation is 120 depreciation added back. Now this is an important thing that you will have to understand for the purpose of an income statement I have recorded depreciation as an expense why because when I record depreciation as an expense in the income statement it reduces the taxable income to that extent I am treating it as an expense contrast that with other expenses let us say wage or salary or utility that also reduces the taxable income then what is the difference between these two why is that I am adding back depreciation for the purpose of cash flow statement while I am not going to add back wage or utility the wage or utility is all this have consumed cash it has been a real cash going outside the entity and that I have already factored in my income statement and it is only from that that I started with this net income of 200 that is already been factored and those are real cash outflows. Now this cash flow statement I am interested in understanding only about the real cash outflows and real cash inflows because I need to know only those activities that have really consumed or really generated cash has depreciation expense created a real physical outflow of cash no it has not then is it a cash outflow for the purpose of creating the cash flow statement no it is not and that is why I am adding it back to the net income because a depreciation expense is a non-cash expense and all non-cash expenses which have been treated as expense for the purpose of income statement to reduce taxable income gets added back to the net income when we calculate the cash flow statement and the first classic example of a non-cash expense is depreciation and that gets immediately added back to the net income when we actually calculate the cash flow statement. So I add back depreciation now come to accounts receivable so what is your accounts receivable in your balance sheet 6 10, 6 57 the accounts receivable is 6 10, 6 57 what is it changed sorry accounts receivable is 5 86, 6 73 inventories is 6 10, 6 57, 5 86, 6 73 changes 87 so have this in your mind the change is 87 the question here is accounts receivables is an activity that has changed the behavior of cash how has it changed it has changed by 87 that is very evident from the balance sheet the previous year closing accounts receivable was 5 86 now it is 673 87 is the change now is this change a cash inflow or a cash outflow that is the question for the purpose of cash flow statement and increase in accounts receivable is it a cash inflow or a cash outflow remember accounts receivable is something that the firm has to get now if there is an increase in the value of an account an account of accounts receivable type where I have to get money today I have to get 50 tomorrow the change happens in such a way that I have to get 100 there is increase in the amount that I am supposed to get so is that a cash outflow or cash inflow that is a cash outflow why because I have not got certain amount and that amount that I am yet to receive has increased during this accounting period it has changed to x plus delta x x I have not received x plus delta x I have not received so delta x is a cash outflow or cash inflow it is a cash outflow because I have not received that amount so this 87 is a cash outflow so you must understand what I am trying to do here is take each of this account categories see the difference and then analyzing difference whether it is a cash inflow or a cash outflow if it is a cash inflow positive cash outflow is negative that is all accounts receivable has increased and if it is an increase in an accounts receivable then it is a cash outflow why because it is an amount that I have not received that has increased next is inventories look at the difference in inventories if you go to your balance sheet that I gave you as an example 6 10 6 57 47 this is a straight forward explanation 6 10 end of previous accounting period 6 57 end of this accounting period difference is 47 and the difference is in inventories the value of the inventory has increased no doubt now why has it increased because you paid cash it has increased cash has gone out that is why you got in worth inventory an incremental inventory worth 47 or you would have created an accounts payable that has resulted in an incremental inventory of 47 that still explains that there is either a physical outflow of cash or an increase in liability is also treated as an expense that has cost this change so inventory has changed by an extent of 47 it has increased which means there has been a cash outflow to that extent 47 next is accounts payable again go to your balance sheet accounts payable is in your liability side 332 388 the difference is 56 what was applicable to accounts receivable is exactly applicable in the opposite sense to accounts payable in this case we find that the difference is 56 accounts payable has increased y plus delta y delta y is 56 if your accounts payable has increased between two successive accounting periods the amount that you have to pay to some vendor that you owe to a particular vendor has increased the fact that the amount that you owe or you are supposed to pay to a vendor if that has increased it means that there is an internal cash generation the fact that you have not paid and the amount that you have not paid is increased between two successive accounting periods is an internal cash generation and that is why increase in accounts payable is a cash inflow and hence this difference of 56 is recorded as a cash inflow same as the case with tax payable if you look the difference is 1 so it is a payable account so increase in tax payable is 1 and deferred taxes also the difference is 5 increase in deferred tax now what is the net cash flow from operating activities net cash flow from operating activities 320 376 377 382 minus 134 so this is your net cash flow from operating activities to 48 positive means the operating activities have generated cash worth 248000 now let us come to investing activities cash flow from investing activities let us begin with the first example I gave you that you know buying plant equipment disposing plant equipment is an investing activity so go to your balance sheet and see the difference in the plant and equipment that we have created during this accounting period so it is in your asset 2000, 2350, 350 is the difference so 2000, 2350 so acquisition of plant and equipment can I write 350 here as a cash outflow no why because I qualified that difference when I went back to my account ledger pick this account plant and equipment I found that during this accounting period 150,000 worth of existing assets was disposed for 20,000 rupees and new assets worth 500,000 was purchased and it is that difference is this 350 that I came to know only when I saw the account so now for the purpose of cash flow that particular account category plant and equipment now explains that I have purchased new equipment worth 500,000 and proceeds from disposal of existing asset that is your 150,000 worth asset gave me 20,000 worth cash cash inflow of 20,000 next investment activities let us say I also invested some money in outside investment securities so investment securities you go to your balance sheet you find that the investment securities difference is 50 now what does this mean the difference is 50 it means that the value of the investment securities that I hold today 450 is 400 the value that I held one year back was 450 which means I have sold some of the securities that I have to generate cash of 50 do not get confused by this negative 50 this explains this this 50 is a reduction in the value of the investment securities that does not mean that cash has actually gone out in fact in this case it means the opposite reduction in value of investment securities means suppose you had a deposit and then you the deposits get retired and you do not renew it you surrender the deposit you get cash for them so in your balance sheet the next year the value of the deposit gets reduced to that extent but you have got cash so it is a cash inflow now but what has happened when I went into the account from the ledger to see what has happened to investment securities I found that the explanation for this difference of 50 is not because I retired 50,000 worth investment securities and got 50,000 because of that it is because I purchase new investments I purchase new investment securities worth 25,000 so I have purchased new investment securities cash outflow and proceeds from sale of investment securities was 75 now you see that explains the difference 75-2550 in your balance sheet the net cash inflow of 50 so what is the net cash from investing activities net cash from investing activities is 525, 95, 430 what does this mean that when I did the quick analysis of all investing activities during this period I find that the investing activities have consumed the cash the net conception of cash because of investing activities is 430,000 so you have this in mind again in your operating activities it generated 248 in investing it has consumed 430 the next thing cash from financing activities again I go to my balance sheet what are my financing activities could be short-term debt long-term debt or I issue stocks pay dividends these are all financing activities so let us say I go to short-term debt so what is my short-term borrowings the change is 21 now if the change is 21 does it mean that I have repaid 21,000 worth existing short-term borrowing because you see it is 147 and it is 126 which means my short-term borrowings have reduced which means I have repaid in the absence of any extra information it is correct to assume that I have repaid 21,000 worth existing short-term debt but I say no you go into your ledger and pull out the account short-term debt and see whether something more than this 21,000 it is not just that 21,000 something more has happened and the resultant of all that has happened is this 21,000 so I go to that account and I find that I actually borrowed new short-term loans proceeds from short-term debt I borrowed 15,000 and then payment for existing short-term debt I paid 36,000 worth existing short-term debt and it is this difference 36 minus 15 is that 21 that we saw just a few minutes back in the balance sheet that is the difference of 21 so a short-term debt in this you find that there is a cash generating activity there is a cash conception activity both related to short-term debt and the resultant of that is a cash conception of 21,000 likewise long-term debt I purchase proceeds from new long-term debt is 375 payment for existing long-term debt is 40 so 375 minus 40 is what 335 now this 335 should be in your balance sheet let us see whether it is correct 500, 835, 335 is in your balance sheet now without looking at the balance sheet itself I went to the account category long-term debt I found that there were lot of activities in this case two activities one that actually brought in fresh loan worth 375 another long-term activity where an existing long-term debt worth 40,000 was paid 375 minus 40 is 335 and it is this 335 there appears as the difference in your balance sheet now let us say I also raised capital through stocks this how did I know I went to the accounts stocks and found that proceeds from new stock issuing new stock is 44 which means I raised a capital by selling shares 44 then when I go to the account statement I mean balance sheet I will find in the shareholders equity there is this difference 44 I issued new stocks worth 44,000 10,000 of which was at par and 34,000 was the additional paid in capital that brought in 44,000 to the firm it is a cash inflow did I pay dividends yes in an income statement from the 200 net income that was available let us assume that dividends worth 60,000 was paid so dividends paid is cash outflow 60 is the dividend that is paid this information is available to you so what will be the net cash from financing activities 1536 375 34 298 298 so what is the cash from net cash from all these 3 activities that is net cash from operating plus investing plus financing so it will be 298 plus 248 298 plus 248 546 minus 430 that is your investing activities is consumed cash so 6116 so the net cash is 116 so what does this mean it means that in this period between 1st April 2011 and 31 3 2012 a lot of things have happened to various accounts and because of that cash has moved out or cash has come in and we have captured all those activities and understood how much cash left or how much cash got into the entity and the summation of all that is your 116 which tells that the net increase in cash and cash equivalence because of all these activities during this accounting period is 116 now let us for a moment assume that I did not give you the balance sheet for 31 3 ending 31 3 2012 I gave you a balance sheet for 31 3 2011 and I told you that during the period 1st April 2011 to 31 3 2012 a lot of things have happened and finally the cash available end of 31 3 2012 is 116 can you tell me the total cash balance end of 31 3 2012 the answer is very simple I just add the opening balance which is the closing balance of 31 3 2011 in this case it is cash at beginning of year is how much you go to your balance sheet it is 230 right your cash at the beginning of the year is 230 add it with the cash that has been generated during this year alone it is 346 technically it should be equal to the closing balance or the cash that you see in the balance sheet end of 2012 it is 326 but what do we get here 346 how do we account for this 20000 is the question I leave this class with this question in your mind go back and revisit this exercise and tell me how do we account for this 20000 that is the assignment for you for this class because strictly in a cash flow statement when we calculate the net effect of cash whether it is cash consumption or cash generation during an accounting period that net result plus the opening cash at the beginning of this accounting period must be equal to the cash ending that accounting period it must and I have not done anything wrong whatever we have done now there is absolutely no mistake we have done everything meticulously but then our summation here shows that the closing cash must be 346 well the balance sheet shows it is 326 and I am telling you that the balance sheet is correct now how do we account for this difference of 20000 is a question that I would like to leave the class the answer for which you will get when we meet next thank you.