As stated, we begin with Net Income which is taken directly from the Income Statement. We then adjust Net Income to arrive at the Cash Flow.
Depreciation and Amortization are expenses in the Income Statement that don’t have any impact on cash, known as a “non-cash transaction”.
When we account for the “wear and tear” of an asset, no cash leaves the business. It’s how we allocate the asset’s expense over its useful life.
The only time Cash is affected is when the asset is initially purchased. But depreciation and amortization reduce net income, and since Net Income is the starting point we need to add this expense back.
The same applies to the gain/loss when disposing of assets. An example of this would be the company’s sale of a forklift that it initially acquired for $10,000 two years ago.
Over the two years of use, the forklift’s value has depreciated by 50% to a value of $5,000.
At the end of a heated auction on “e-buy_my_unwanted_stuff-Bay”, the company sold the forklift for $8,000.
The Income Statement will reflect a gain of $3,000 on the disposal of the forklift.
However, the Cash Flow Statement needs to reflect the full cash impact, not the profit of the disposal.
We need to deduct the $3,000 gain as Net Income in the Cash Flow Operating section and show the full $8,000 cash in. But selling unneeded equipment is not an ongoing core operation of this business, so we record the $8,000 as a Sale of Asset in the Cash Flow Investing section.
Changes in Working Capital mainly consist of inventory, receivable, and payables.
To understand why we need to adjust for these Balance Sheet items we need to understand how these positions influence the amount of money the company has in the bank.
- Inventory – Suppose that your inventory for last year was 100 and this year the inventory is 150. Your inventory increased by 50 which means you are keeping more inventory in stock. This increase in inventory had to be paid for, so more cash has left the business.
It would be easy to think that the cash spent would be reflected in the Net Income of the Operating section, but Net Income only includes the expenses for Cost of Goods of sold products, not for additional inventory.
The increase in Inventory needs to be reflected on the “(Increase)/Reduction of Inventory” line of the Operating section.
- Receivables – These work similarly to Inventory. Suppose you sell a customer a product for 100 but you sell it to them on credit. The cash is yet to be received.
In the Income Statement we show the earned revenue which increases our Net Income, so our starting point includes the 100.
Because cash wasn’t received, if Accounts Receivable increases we adjust with a negative number. If they are lower, we adjust with a positive figure.
- Payables – Payables work the opposite way because they are liabilities. If we had 120 in Payables last year but have 140 in Payables this year, we payed out less to our suppliers. We’re working with their money, which is good for our cash balance.
A higher figure for Payables is a positive cash increase in change. If they decrease, it’s negative for our cash balance because we used more of our cash to pay the suppliers.