10. Cash Flows from Operations

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Indian School of Business

Trading Basics

413 classificações

Curso 1 de 5 em Specialization Trading Strategies in Emerging Markets

The purpose of this course is to equip you with the knowledge required to comprehend the financial statements of a company and understand the various transactions that take place in the stock market so that you can replicate the strategies discovered by the extant academic literature. The first part of the course provides a brief introduction to financial statements and various common filings of firms. You will learn how to obtain information regarding a company's performance from them and use the information to build trading strategies. Next, you are taught basic asset pricing theories so that you will be able to calculate the expected returns of a stock or a portfolio. Finally, you will be introduced to the actual functioning of asset markets, type of players in the market, different types of orders and the efficient ways and opportune time to execute them, trading costs and ways of minimizing them, the concept of liquidity .etc. This knowledge is required to develop efficient algorithm to execute various trading strategies.

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Basics of Financial Statements

This module provides a brief introduction to financial statements and various common filings. These are the most important sources for obtaining information regarding a company's performance. Most strategies are indeed based on financial statements. After completing this module you will be able to get the important details from the balance sheets.

1. Introduction to accounting5:28

2. The balance sheet3:37

4. Liabilities5:04

5. Shareholders’ Equity4:56

6. Income Statement4:46

7. Expenses 17:31

8. Expenses 26:42

9. Statement of Cash Flows4:31

10. Cash Flows from Operations9:51

11. Cash Flows from Investments and Financing6:35

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Ramabhadran Thirumalai
Assistant Professor
Indian School of Business

[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]

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