Hello, I'm Professor Brian Bushee, welcome back. This week we're going to spend the entire week talking about the statement of cash flows. And we're going to need the whole week to get through it. In this first video, we're going to talk about how to classify transactions into operating, investing and financing activities, which is the first step toward putting together, and then analyzing, the statement of cash flows. We've got a lot of work to do, so let's get to it. The statement of cash flows is going to report changes in cash due to operating, investing, and financing activities over a period of time. So a period like a fiscal quarter or a fiscal year, any period between two balance sheet dates. The statement has the following format. Kicks off with net cash from operating activities, net cash from investing activities and cash from financing activities. You add them all up and that should be the same as the net change in cash balance. If the company does any non-cash transactions, like they trade a piece of land for a building, those have to be disclosed at the bottom of the statement of cash flows. Two other required disclosures. Companies must tell you cash interest paid and cash income taxes paid for reasons that we'll talk about in later videos. But these disclosures either will appear at the bottom of the cash flow statement or somewhere else in the footnotes. >> Cash is cash. It is what it is. Why divide it into three categories? You professors have too much time on your hands. Do you always have to make everything so difficult? >> If you remember back to one of the first videos in the course, we looked of this example of Dave's Car Transport Service. In that example, we saw why it's important not to look at total cash flow. Because all Dave had to do to increase his total cash flow is either borrow more money or raise more equity. What we really want to know is how much cash flow is being generated by operating the business. How much cash flow is the business investing in the future? And how is the business financing, itself? That's why its important to look at these three buckets and separate the cash flows into operating, investing and financing. Let's talk about each of these three buckets of activities in more detail, starting with operating activities. These are transactions related to providing goods and services to customers and paying expenses related to generating revenue. The best way to think about this section is it's the analogy to the income statement. So transactions that appear on the income statement, we tend to see their cash impact in the cash from the operating activities section. So we'll see cash inflows like collections from customers. But other sources of revenue or positive income, like receiving interest or dividends on investment. And we'll see cash outflows like payments to suppliers, payments to employees, payments of interest and tax, other operating and disbursements like payments for advertising, legal fees and other things like that. >> I see the words interest and dividends on investments. Wouldn't that be an investing activity? Yeah, a case could certainly be made that dividends received, and interests received should be invested in cash flows because they're returns on your investment. But these items also appear on the income statement. And the Financial Accounting Standards Board, the FASB, decided that they wanted them as part of operating cash flow to provide comparability between the income statement and cash from operations. But I have the feeling we'll be talking about these items more as the video goes along. There are a few types of transactions that appear on the income statement that we need to make special adjustments for on the cash flow statement because, even though they're on the income statement, they will not be part of cash from operating activities. The first type of adjustment is for depreciation, amortization and other noncash items. These will affect income, but there's no cash flow involved, so we need to make an adjustment for them. Also, sometimes we get gains or losses on selling something like property, plant, equipment which affect our income statement. But we don't want to show the cashflow in the operating activities section, we want to show it in the investing activities section. So we need to adjust for that. We're going to make these adjustments later on in the week, but I just wanted to put them in the back of your mind right now. The next bucket is investing activities. These are transactions related to acquiring or disposing long-term assets. So cash inflows like selling property, plant and equipment, selling intangible assets, selling investments or selling a whole business, a business divestiture. Cash outflow examples would be acquiring a business, acquiring property, plant and equipment, acquiring intangible assets or purchasing investments. >> What if I buy stock as an investment, but I only intend to hold it for six months? Would that be a long-term asset? Would that be an investing activity? >> You bring up an excellent point. There is a rule of thumb that any asset that we intend to hold for more than a year would be an investing activity. Whereas any asset we intend to hold for less than a year would be an operating activity. But this is a rule of thumb, it's not an ironclad law. And there are going to be places where we see that this rule of thumb is violated. In the case of investments, there's a whole set of rules around whether the investment should be operating or investing activities. And we'll talk about those later in the course. And the last bucket is financing activities. These are transactions related to owners or creditors (except for interest payments). >> Except for interest payments! If ifs and buts were candy and nuts, every day would be Christmas. Interest is paid to creditors. Payments to creditors are financing activities. Ergo, interest payments are financing activities. QED! It's hard to argue with a QED. But this is a situation where the FASB wanted comparability between the income statement and cash operations. And so they decided to include interest payments as an operating activity to parallel the interest expense that's in that income. Having said that, a lot of investors and analysts disagree with this classification, and want to pull it out. And if you remember, earlier in the video, I mentioned that companies have to report cash paid for interest somewhere in the financial statements. That disclosure's there so if people don't want cash paid for interest in operating cash flows, they can just find this disclosure and take it out. So what financing activities will include are cash inflows such as the money you get from issuing new stock or reissuing treasury stock. That's when you take the stock that you previously bought back, which we call treasury stock, and then sell it back to the public. Or money that you get from borrowings from banks or other creditors. Cash outflows include paying dividends to your shareholders, purchasing your treasury stock, so repurchasing your own stock, and then payment of principal on debt. But, as we mentioned earlier, not the payment of interest. So putting it all together, the statement of cash flows is going to have these operating activities, investing activities and financing activities listed in this order, showing you the three different buckets where a company's cash flow comes from or goes to during a period. >> I believe your classification of interest and dividends is not correct. After you quashed my question earlier, I texted my sister who works in Hong Kong. She confirmed that interest and dividends received are investing activities. What do you have to say about that? >> Well, I'm certainly not going to argue with your sister from Hong Kong, especially since we're both right on this one. As it turns out, this is one of those situations where the treatment under US GAAP is different than the treatment under International Financial Reporting Standards, or IFRS. I've been giving you the US GAAP treatment, but the IFRS treatment does differ. Let me jump back to the slide to show you these IFRS differences. We're talking about transactions where a company receives interest and dividends on investments, or pays interest or pays dividends. Under IFRS, interest and dividends received and paid can be classified as operating, investing or financing, as long as the company is consistent. The ideas is as long as the company does the same thing year after year, investors and analysts will know where to find it, and can make adjustments if they think it's necessary. But under US GAAP, these four items all have to be in the buckets that we show on this slide, there's no discretion. So that's one of the differences that remain between US GAAP and IFRS. Now that we've defined operating, investing and financing activities, I'd like to do a simple example to show you what we can learn by dividing cash flow into these three buckets. So let's say we're a start up company. We're a pharmaceutical and we're trying to come up with a medicine that will prevent gray hair. Not that there's anything wrong with gray hair. So, anyway, all you would have to do is pop a pill, and you'd no longer have gray hair. As a startup company, we're likely going to have negative cash from operations. We may have an initial version of our drug that's working, for which we get some revenue. But we have a lot of negative cash flows, as we have a lot of operating costs from running the business, and we're also investing in R&D. Our investing cash flow is a big negative because we have to go out and create facilities, and buy equipment and invest in all these long-term assets to get the business up and running. And then we have a big, positive financing cash flow. We go out and raise money from the stock market or venture capital firms. We borrow money from banks or the public markets. We need all that money coming in to finance our investments and the negative cash from operations. The bottom line in this case is zero net cash flow. That doesn't necessarily need to be the case, but I would just carry that throughout. Now our company starts to have some breakthroughs. We move into the early growth stage. The drug seems to be working pretty well, people are taking the medication, their gray hair goes away. And we're starting to get positive operating cash flows. As more and more doctors prescribe our medicine, we get revenue that comes in and covers the operating costs. We still have big, negative investing cash flow because we're trying to grow the business. And we're trying to invest in new property, plant and equipment to meet demand for our drug. And maybe we decide to go out and acquire another company to diversify our product lines. So maybe we acquire a company that makes pro-blonde medication. So you can take the pill, and your hair will turn blond even if it was, say, dark brunette to begin with. Not that their's anything wrong with dark brunette hair, either. So, anyway, we have the big negative investing cash flow. We can not fund that investing cashflow just out of operations. So we have a positive financing cash flow, as we need to go out and raise money either from the stock market or from banks and other creditors. >> Hey, this is actually useful information! Can we get more of this? >> Hey, I'm glad you liked it. I've got two more examples so let's get back to it. Next, our company moves into the mature phase of its life cycle. We've got patents on our anti-gray hair drug, our pro-blonde hair drug. And we can just print money as a result. There's a lot of revenue coming in, covering all the expenses of running the business. So we have a high cash from operations. We still have a fairly high level of investing cash outflows because we're still growing. We have capital expenditures that we need to have to meet the demand for our product. Maybe we're doing a couple of other strategic acquisitions. But now we're able to pay back some of the financing, so we have negative financing cash flows. We use the excess cash from operating, after covering the investing cash flow, to go out and buy back stock, or pay back debt or maybe start to pay dividends to our shareholders. Then we move into the decline stage of our life cycle. All of our patents have expired, customers can now buy generic, anti-gray hair medication or generic pro-blonde medication. There' a few holdouts that still insist on buying our original name brand, but our cash from operations have gone down substantially. Our investing cash flows have also gone down substantially because we just don't have a lot of other ideas for new investments. And so what we end up doing is continue to have a negative financing cash outflow. We're taking our excess cash from operations and using it to buy back stock, repay debt or pay dividends which, at this point, is essentially just saying to our shareholders, we don't have any projects to invest in. So we're just going to give you the money, and maybe you can find something to do with it because we certainly can't. And then, I guess, the last stage would be we either go bankrupt or acquired, and our cash flow statement would disappear altogether. So I think this video showed that it's fairly straightforward to classify cash flow activities into the operating, investing and financing buckets. But it's not always straightforward. In the next video, we're going to apply these classifications to the Relic Spotter case. And there we'll see that there is judgment that does apply in some situations, which makes this a bit trickier than it first seems. I'll see you next video. >> See you next video!