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.