Changes in Working Capital

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Accounting for Decision Making

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University of Michigan

Accounting for Decision Making

25 ratings

Through this course, you will start by addressing the two “big questions” of accounting: “What do I have?” and “How did I do over time?” You will see how the two key financial statements – the balance sheet and the income statement - are designed to answer these questions and then move on to consider how individual transactions aggregate to make up these financial statements. After developing a broad understanding of accounting and financial statements, you will begin to develop a more nuanced understanding of individual components of doing business, such as making a sale or building inventory. By considering many of the more common actions of a company, you will build your understanding of accounting, and explore these concepts by applying them across various types of transactions. Once you understand these individual concepts better, you will be ready to return to the overall financial statements and use them as informational tools, including building ratios. You can do this course standalone or to qualify for the residential component of the Finance for Strategic Decision-Making Executive Education program. For more information, see the FAQ below.

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Cash Flow Statements

We have been spending our time developing the concepts of accrual accounting. We started with the big picture, learned how to use bookkeeping to construct accrual statements and then spent the last three modules deep diving into various accrual accounting topics that help to create a useful set of financial statements. Throughout that time we have focused on capturing economics, not just cash flow. Of course, many of you still want to know about cash (so do I - it is important). But I have put off the cash flow statement for two reasons. First, I wanted you to really give accrual accounting a chance. If we mix cash in from the beginning, most students seem to drift back to cash every time things get a little complicated. But we have demonstrated that often leads to misinformed choices. Second, the cash flow statement effectively requires you to "undo" accrual accounting. That means you have to know accrual accounting pretty well to do a cash flow statement. I am going to be honest (I have all along, after all). The cash flow statement is tough. It seems like it should be really straight forward. Parts of it are. But a few choices were made when the cash flow statement rules were set. The choices make sense (well, somewhat), but they also make cash flow statements hard. We will break it down into pieces to make it approachable, but it is my experience that people need to see this multiple times. Lucky for you, the videos can be watched as often as you want. In this module I will systematically walk you through how cash flow statements are constructed. We will start with a cash T account and build statements from there. Our goal is to build an understanding of what information you can take from a cash flow statement. We are going to spend an entire week just on the cash flow statement. At the end of that week, I will expect you can understand an overall statement, but I will not expect you to be able to build one from scratch. Finally, I want to point out that this module is an inflection point in the course. We started looking at the idea of financial statements and creating broad statements in modules one and two. In modules three through five we began to look at the financial statements one item at a time. With this module we are moving back to the overall statement level, which is the perspective we will also take next module (which will be our last).

Changes in Working Capital13:42

Indirect with Changes in Working Capital Example4:15

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Greg Miller
Professor
Ross School of Business

Welcome, in this video, I'm going to talk about a little different approach to doing

an indirect cash flow statement.

It's called the Changes in Working Capital Approach.

Now, I'm going to be honest with you, I always hate this part of my course.

For some reason changes in working capital really throw students off.

In fact, it's not for some reason, it's kind of a mechanical idea that

you're just going to have to do some practice with pen and paper to get down.

But let me show you the concepts as we walk through it, just keep reminding

yourself, I can always go back and rewind if I want to take another look at this.

Okay, let's take a look at it then,

I'm going to start with something that you seen before.

The cash flow from operating activities in an indirect cash flow statement,

without using the changes in working capital approach.

I'm going to use it to explain to you why we have the changes in working capital

approach.

Now if you go back and look at the video where we used our Libra of Wisdom to

create this as an example to show you how to do an indirect cash flow statement.

You may recall that what we had to do was undo the accounting.

That's is we're reconciling from the account net income view of the world

to the cash and operations view of the world.

To do that we had to know things like this wages expense,

was a wage that we had recognised as an expense, but not yet paid.

And we had to know how much of the items that we've sold, we had not yet

paid our own suppliers for.

We also had to know things like,

how much rent had we prepaid that hadn't impacted our net income.

How much non-cash revenue we had, etc?

Now, it wasn't that hard in our example,

we only had eight transactions to begin with, not that many T accounts, etc.

But imagine that you're a real company, say you're Procter & Gamble.

Now you have to go through all of your sales and figure out,

which ones have we've not been paid for you in this period.

And what sales were we already paid for in this period, but

where in last period net income, so we can adjust that out.

How much of our wage expenses not yet been paid to our employees?

And even what sale that we make, but not paid our supplier for yet.

So you're going to have to match things up pretty closely there,

that's an awful lot of work.

When the standard setters decided that they wanted to have a cash flow statement

be a requirement.

A lot of companies pushed back and said, look that amount of work just isn't fair,

it's not reasonable.

We can give you useful information about cash without doing that.

In response, the standard setters came up with a shortcut that could be used.

And I have to admit this is used in most cash flow statements that you're

going to see.

It's called the networking capital shortcut, and

what it does is that it focuses on taking those networking capital items.

Items like accounts receivable, accounts payable, inventory.

And it implicitly assumes that any transaction in those sort

of items was a cash based transaction.

Following that assumption, it uses net changes in the working capital position

to determine the amount of reconciling items between cash and accruals.

What it's recognizing here is that if there's a change in one of those

networking capital items.

Like accounts receivable or inventory,

that hasn't impacted our income statement yet.

It will in future periods, but it has impacted our cash statement in some way.

Let me give you some simple ways to think about this.

An increase in a working capital asset is assumed to show the company used up cash.

For example, if inventory increases,

the assumption here is that the company spent cash to get that inventory.

What we're thinking here is that we never buy inventory on credit, but

instead only pay cash for the inventory.

I'll give you another example, if accounts receivable goes up, the assumption here is

that we gave somebody cash rather than that we gave them inventory for

the accounts receivable.

In most cases that assumption is probably not true.

We didn't really give people cash, we gave them inventory.

But we're going to make this assumption that an increase in any sort of networking

capital asset means that we've used up cash some how.

We've gave it to somebody else, so what's the flip side?

Well a decrease in a working capital asset is assumed to have given us cash.

For example, if inventory goes down,

the assumption is going to be we were paid cash for that inventory.

Even though maybe in reality that we received the promise for

future payment and we haven't gotten that future payment yet.

We're going to assume that every inventory sale is a cash based sale.

Similarly, we're going to assume that any decrease in accounts receivable

is because we collected cash.

Now that's probably true most of the time.

There could be other reasons though, write offs, etc.

But again we're going to make the assumption that all of them were cash

related.

Let's switch to the liability side, and you're going to see it's just the flip.

A decrease in a working capital liability is assumed to have been a use of cash.

So for example, if we see accounts payable go down,

the assumption's going to be that we used cash to fulfil that obligation.

It's probably a reasonable assumption, but

it's also possible our accounts payable went down.

Because we negotiated better terms or

we gave something else of value to the person that we owed money.

Maybe we provided a service to them or give them the good that we sell.

On the other hand, an increase in working capital liability,

is assumed to have been some way that we've received cash.

Going back to accounts payable, this would say that an increase in accounts payable

is because somebody handed us cash, that's probably not true actually.

Generally when our accounts payable go up,

it's because somebody has sold us an item we're going to resale.

They've provided a service to us, they've sold us equipment etc.

But still we're going to make the assumption in this case,

that if accounts payable went up, somebody provided us with cash.

Okay, let me give you an example of why this actually works when we make all of

these offsetting assumptions on our balance sheet.

For this example, let's imagine a firm purchases $100 of inventory.

And they promise to pay it off in 30 days,

which is after the end of accounting period.

So they haven't paid for it yet, and to keep this simple we're going to assume

they haven't sold the inventory yet either.

So what's the journal entry going to look like for this?

Inventory and assets goes up by $100 and accounts payable or

liability also goes up by $100 was there any impact on cash here?

No, was there any impact on net income?

No, nothing's happened on either of those statements here.

So there should be no reason to consider this on our cashflow statement.

However, if we're going to take this shortcut assumption and use our net change

in working capital items then we're going to treat this a little differently.

We're going to take the first part of that transaction, the increase in inventory.

And we're going to assume that we paid cash to get that inventory.

So what's the implied impact on cash then?

$100, we're acting as if this is the transaction that really did occur.

Now, we're going to have to look at the second half of that transaction,

which also impacted a working capital item.

Our accounts payable goes up by $100.

We're going to assume that somebody gave us cash of $100 here.

So what's the implied impact on our cash here?

$100 increase.

When we make these two assumptions and put them on our cash flow statement,

what's the net impact?

It's 0, the two assumptions cancel each other out, and so we're okay.

So what does this mean for

actually reporting these on our cash flow statement?

Well, an increase in a current asset

is subtracted from net income to reconcile to cash flows from operations.

It's treated as if it was a use of cash that wasn't reflected in net income.

And from the same idea, a decrease in some sort of a current liability is

subtracted from net income to reconcile to cash flows from operations.

And of course, the flip side of this is true.

Decreases in current assets are added to net income.

The idea there is that it's something that brought cash in, so

it impacted our cash account but didn't impact net income.

And an increase in a liability is also viewed as a source of cash which

would have increased our cash account.

But not impacted net income, so we're going to add that back as well.

Now is that really clear to you?

I have to admit it wasn't clear to me the first time I saw it, or the second or

the third or the fourth.

Really what I had to do was sit down and practise this a little bit myself.

Get out pen and paper, think of a couple of different scenarios,

do the journal entries.

Break it into the journal entries like I just did, look at the net impact on each.

And convince yourself that yeah, this really works out and makes sense.

Once you get that thought process down,

each time you get confused you can just go back to the basics.

And think okay, if an assets going up, they must think I used up my cash.

If an asset is going down, they must think somebody gave me cash for it.

If a liability is going up, they must think somebody gave me cash.

If a liability is going down,

they must think I've given somebody else cash to fulfil that liability.

It's really that simple, but it something you have to experience for yourself.

Now I wish I could stop here, but I want to give you one further caveat.

This approach works because we make an erroneous assumption about

cash in one entry.

And there's generally an offsetting erroneous assumption related to another

account.

The reason that there's usually an offsetting erroneous assumption

is generally,

when we do things with our working capital items, the entries move together.

So if we're doing something that's not cash related to accounts receivable,

it's often related to some other working capital item or to accounts payable or

inventory, etc.

But that's an assumption that's not always true, and

this is where we can run into trouble.

This approach is flawed if a current asset is financed by a long term liability.

A liability that's not part of our networking capital or

if a long term asset is financed by a current liability.

In that case, we've got an asset that's not part of our working capital, but

our liability is part of our working capital.

The way to think of this is one working capital item changes due to transactions

that involves a non working capital item.

Now we've got a problem, let me show you what journal entry is,

I think that'll make it clear.

We're back to our example from before, we have an increase in inventory and

we erroneously assume that we gave up cash there.

And we have an increase in accounts payable, and

we erroneously assume that we got cash there.

We've made two mistakes, and

if you put the two journal entries together, they cancel each other out.

This is really showing you the same thing I showed you before that the net impact on

the cash flow statement cancels out, and so we're okay.

However, what if there is only one working capital account involved?

Let's change our inventory example, let's assume now that the inventory was

purchased with a long term note payable that's due in two years.

Maybe we're opening up a whole bunch of new stores, and because we're opening up

the new stores, their supplier are willing to give us long-term financing.

They want to have more stores too,

because they think they're going to make more sales in the long run.

Well in that case, we have one working capital impacted, inventory.

But the long term note payable is not a working capital item.

Now let's think about how this would really impact out books.

Well inventory goes up and notes payable goes up, both by $100.

Is there an impact on cash?

Nope, it's 0.

This shouldn't show up on our cash flow statement at all.

But now what happens when we start to apply our

net working capital thought process?

Well in that case, we're going to do our journal entry with the inventory part.

Inventory went up by $100,

we're going to erroneously assume that there's a $100 in cash there.

What's the implied impact then?

The cast is going down by a $100.

Now we look at the second half of this transaction, and

there's no implied entry made for the notes payable.

We're not going to assume that there's a cash part of that,

because it's not a working capital item.

So the net impact on our cash flow statement, when we only think about half

of this transaction having a cash side to it, well we're down by a $100.

Our cash flow statement isn't going to work because of that.

What this means for companies is, even when they take that shortcut

of making changes in networking capital items.

They still have to go through look for

transactions like this where they had mismatches.

It's a lot less work in considering every transaction, but

it still does require work to find this sort of items.

What this means for you is that when you're looking at financial statements.

You'll often find that the numbers on the balance sheet say the change inventory,

are not the same as the numbers on the cash flow statement.

That's because there's been an adjustment to the numbers used on the cash

flow statement.

To come up with the change in networking capital,

to adjust out to where they've been transactions that

didn't involve working capital items on the other side of the transaction.

If you just sit down and practice a few of these on paper too,

you'll see that it's not that confusing and it's a useful caveat to know.

I can't tell you the number of times students have come to me and

said something is wrong with this companies financial statements.

The changes on their balance sheet don't match the changes on their cash

flow statement.

But it's always, because of a situation like this.

So it'll make it a lot more useful for you as think about what you're getting out of

the cash flow statement and what you're getting out of the balance sheet.

All right, I hope this has clarified the cash flow statement further.

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