Compute cash flows by analyzing other financial statements

Before we get to our consideration of Home Depot, let's see how we can use forecasted balance sheet and income statement data to deduce the associated forecasted cash flow data. I have a friend who's been a loan officer at a bank for many years. He tells me that the first thing he has his staff do when a small to medium-sized business comes in for a loan is to use the company's balance sheet and income statement create a statement of cash flows? Well, let's learn how to do that. This skill is useful in and of itself, but this is also a useful exercise in that we learn how all three financial statements relate to one another. Now, by the way, if after this quick overview you feel a little shaky with your cash flow computations, feel free to work through the cash flow analysis course that my brother Jim and I have created for the LinkedIn Learning Library. Okay, so here are some simple income statement data for EV company. Sales, $300,000. Wage expense, $30,000. Cost of goods sold, $180,000. That gives net income of $90,000. Now, are these cashflow numbers? Not necessarily. These are income statement numbers and income statement numbers are meant to reflect economic value. We need more information to determine whether these income statement numbers reflect cash flows. So here are some balance sheet data for an EV company for the beginning of the year and for the end of the year. We see beginning and ending accounts receivable, beginning and ending inventory, and beginning and ending accounts payable, and finally, beginning and ending wages payable. So let's first consider how much cash was collected from customers. Now look in the balance sheet data. Is there any evidence that EV company has non-cash credit sales? Well, absolutely. We see some accounts receivable, which are evidence of credit sales. And we also see that accounts receivable increased by $20,000 during the year. When accounts receivable increases, I didn't get the cash. The cash is still in my customer's pocket. The $20,000 accounts receivable increase represents cash that EV did not collect. The $280,000 cash collected from customers is computed as follows. Sales, $300,000, less the increase in accounts receivable, $20,000, that's the cash we didn't collect. So the cash collected from customers, $280,000. Hey, that wasn't too bad. Now let's do how much cash did we pay to employees for wages? Well, sometimes our employees work now and we pay them later, hopefully not too much later. Look in the balance sheet data. We see some wages payable, evidence of a delay in paying wages. Wage expense represents the wages earned by the employees during this year. Wages payable at the end of the year is the amount of wages earned that have not yet been paid to the employees. We also see that wages payable increased by $12,000 during the year. When wages payable increases, EV company has retained some of its cash by not paying it to the employees this year. This $12,000 wages payable increase represents a cash savings this year, cash that EV did not pay to employees this year. The $18,000 cash paid for wages is computed as follows. We start with wage expense, $30,000, that's a minus, plus the increase in wages payable, that represents a cash savings, 12,000. So the total cash paid for wages, $18,000. All right, how much cash did we pay to our suppliers for inventory purchases? Look in the balance sheet data, we see that inventory increased by $40,000 during the year. This represents additional inventory purchased. Evie purchased the $180,000 in inventory that she sold plus an additional 40,000 in inventory increases. When inventory increases, you paid extra cash. We also see that accounts payable decreased by 25,000 during the year. When accounts payable decreases, you paid extra cash. The only way to get your accounts payable to go down is to pay extra. The $245,000 cash paid to suppliers for inventory purchases is computed as follows. We start with cost of goods sold, $180,000. We had to buy that so we could sell it to our customers. Less the increase in inventory, $40,000, that's more cash that had to be paid. Less the decrease in accounts payable, that's also more cash that had to be paid. So the total amount of cash paid to suppliers, $245,000. Now, the point of this exercise has been to demonstrate how we can use income statement and balance sheet data to deduce the amount of operating cash flows. We can use exactly these same techniques to use forecasted balance sheet and forecasted income statement data to estimate forecasted cash flow data.