[MUSIC] Last time we started looking at the statement of cash flows, and briefly about its cash flows from operating activity section. In this video we will look at all the adjustments that need to be made to compute a company's cash flows from operating activities. These include adjusting for non-cash expenses, expenses related to investing and financing activities, as well as cash flows related to current assets and current liabilities. Let's start looking at Amazon's cash flow from operating activities for 2015. While there are a number of items on its statement of cash flows, we will only discuss the most common and important of these adjustments. The first item is Amazon's net income of $0.60 billion. To this we make adjustments for various items. The first set of adjustments are for non-cash expenditures, as well as expenditures related to investing and financing activities. These adjustments eliminate the impact of these items on the company's cash balance. Cash-based investing and financing expenses will be adjusted for later in the cash flow from investing and financing activity sections respectively off the statement of cash flows. The first major adjustment is for depreciation and amortization expenses which are non-cash expenses. This means that while they are deducted from revenues when calculating profits, this expense is not paid or owed to anyone. To this extent, the net income understates the amount of cash a company has. So the depreciation and amortization expense will have to be added back in full to the net income while making adjustments. These non cash expenses were $6.28 billion for Amazon. The next adjustment is for non-cash base salaries. All executive and employee salaries are recorded under SG and E and deducted from revenues. However, not all salaries will be paid in cash. Part of it may include stock-based compensation. While this compensation is recognized as an expense on the income statement, this, again, is cash not paid to employees. The net income again understates the cash on hand. In 2015, Amazon had stock-based compensation worth $2.12 billion, which is added back in full. Some of a company's operating expenses may not have been in cash and so, again, the net income understates how much cash a company has. This amount must also be added back in full to the net income. Amazon's statement of cash flows reports this number to be $0.16 billion. A company may earn income from interest and other sources, and may also incur other types of costs, none of which are related to its operations. The impact of these non-cash items must be removed from the net income. Amazon had $0.25 billion in such expenses, net of any income. This figure should be added back to net income as they are not related to operations. Had any non-operating income been greater than any non-operating expenses, the number would have to be subtracted from net income as the income net of expenses are not related to operations. The other major adjustment to net income for non-cash expenses is any deferred income taxes. The income statement reports how much tax a company should pay. However, at times, depending on tax laws, not all taxes may be paid off. Some of it may be deferred to the future. So deducting the entire tax due from revenues underreports how much cash a company has. Any deferred taxes will have to be added to net income. Amazon had 0.08 billion in deferred taxes, which is added back to net income. There are a few more non-operations related adjustments to Amazon's net income. These include an additional 0.01 billion in losses incurred by Amazon during the sale of marketable securities, and the deduction of $0.12 billion for excess tax benefits from stock-based compensation. We will not discuss these in detail. So the total adjustments to net income are $6.28 billion for depreciation and amortization, $2.12 billion for stock based compensation, $160 million for net operating expenses, $250 million for non-operating expenses, $80 million for deferred taxes, 0.01 billion for losses during the sale of marketable securities. And finally a -0.12 billion for excess tax benefits from stock-based compensations. These adjustments add up to a positive $8.78 billion. The next set of adjustments is operations related. These largely include adjustments due to changes to the firm's operations related current assets and current liabilities. Amazon's inventories increased by $2.19 billion between 2014 and 2015. This tells us how much the company has spent on purchasing raw materials and supplies but this is not recorded on the income statement until the inventory is sold. In other words it tells us how much cash the company has tied up in inventory. Consequently the net income overstates how much cash a company has at the end of the year and any increase must be deducted from net income. If inventory had not changed between the consecutive years then no inventory related adjustment is necessary because the company has not invested more cash in inventory. On the other hand, if inventory had decreased, the company would have converted inventory to cash and the cash on hand would have increased by the amount of inventory sold. Decreases in inventory must be added to the net income. The same argument holds for all other types of operations related current assets. For example if accounts receivable increases, it denotes that company has not received cash for at least some of its sales. So the revenue and the net income overstate how much cash the company has. Amazon saw an increase of $1.76 billion in its accounts receivables between 2014 and 2015. This increase is subtracted from net income on the statement of cash flows. The reverse is true for changes to operations related current liabilities. That is increases in current liabilities must be added to net income and decreases must be subtracted from net income. For example, an increase in accounts payable tells us that the company still has not paid some of its suppliers for products and services that the suppliers have already provided. However, the cost of these products and services are subtracted from revenues while calculating net income. So the net income understates how much cash a company has when accounts payable increases. Amazon's accounts payable increased by $2.49 billion between 2014 and 2015 and this is added to net income. Similarly accrued expenses also increased between 2014 and 2015. These are expenses deducted from revenues on the income statement, but still not paid. So these also need to be added to net income on the statement of cash flows. Amazon's accrued expenses increased by $0.91 billion between 2014 and 2015. Some clients and customers may also pay a company in advance for its products and services. These are recorded as unearned revenues on the balance sheet but are reported on the income statement only when the company delivers its products and services. But this is additional cash in hand, and hence any increases in unearned revenue should also be added to net income. Amazon's annual revenue increase by $7.40 billion between 2014 and 2015 and this added to net income. Amazon has an additional cash adjustment of negative $6.11 billion to its net income in 2015. To summarize, Amazon had the following operations-related current assets and current liabilities. A deduction of $2.19 billion for increase in inventories, a deduction of $1.76 billion for increase in accounts receivable, an addition of $4.29 billion for increase in accounts payable, an additional $0.91 billion for increase in accrued expenses, an additional $7.40 billion for increase in unearned revenues, and finally a deduction of $6.11 billion for amortization of previously unearned revenues. This adds up to a total of $2.54 billion. Adding this to the net income $0.60 billion and the earlier adjustments for non-cash operations and non-operating related expenses of $8.78 million gives Amazon a net cash flow from operating activities of $11.92 billion during 2015. Next time we will look at the remaining parts of the statement of cash flows and reconcile the changes in cash from it with the changes and cash and cash equivalence on the balance sheet. [MUSIC]