CF 1-1A – Calculating Operating Cash Flows – Corporate Finance

Welcome to module one of our class in corporate finance. And this is the very first problem, problem one, one, a, you can click the link in the description to download a copy of this workbook for yourself. This problem has us looking at operating cash flows. Now I want to explain why we're going to look at operating cash flows. If you just want to solve the problem, probably skip ahead four or five minutes, we'll work through the problem. It's a, it's a very quick problem. But I feel like at the very start of the class, we should explain like, why, why are we doing this? So I want to discuss just the concept of cashflow and why it's so important in finance and that'll sort of set the table for the rest of this chapter. So if you take a finance course, you're going to find your instructor very obsessed with cash flows. Just about every problem we look at in a finance course in some form or another is going to discuss the cash flows of an investment or of a company or something like this. Uh, and it's a really important concept in finance. And the idea is to value a company, to value an asset, to value an investment value, its cash flows. Now I come at this from the perspective of an account, I'm an accountant. I'm a CPA. I'm not a CFA. So I do want to let you know that I am not a finance professional. I'm an accounting professional and accounting educator. I'm making these videos, uh, because students have requested that I make them. And so I've had to work closely with a friend and colleague who helped me develop the material. Uh, but he's the expert, not me in any of it. Um, in finance, cashflow is a crucial concept because it's very real. In accounting, a lot of things are based on estimates and projections. Oh, how many debts do I think are going to go bad next year? Or how many years do I think I'm going to use this building? They're all guesses and finance folks say, well, the realist thing you can have is money, right? The company generates money. They pay it to you, the shareholder and the dividend that's real. And that's something of value. That's what we want to base all of our work around is the cash flow that the company is generating. Not some accountants estimates that are ingrained in the profits. So, uh, what our first chapter has us doing in this course is just going from those accounting numbers, which are definitely useful in accounting to cashflow numbers, which are much more useful in finance. So you'll find in most finance classes, you'll be doing calculations like this early on taking accounting, income statements, and balance sheets, and moving them over into cashflow information, not cashflow statements. That's another accounting financial statement, but cashflow information, converting accounting information into finance information. So, um, a few more concepts and then we'll jump into the problem. Uh, the first thing is just this concept of, okay, a company uses its assets to generate money, right? It uses its assets to generate money. And what can it do with the excess money it generates? Well, it can use it to buy more assets and to sort of satisfy its own assets. So it can use it all on the left side of the equation. But if it has extra money, it will often pay money out to creditors or pay money out to shareholders or likely both. Well, from finance perspective, we're often playing the role of creditor or stockholder, right? We buy bonds in a company that's, that's we're creditors, or we can buy stocks in a company, then we're investors. So we're very interested in how good the company is at using its assets to generate cashflow, because that's money that's going to come to us. Potentially. So we're very interested in the cashflow of the company because. You know, it's, it's important to us as investors or potential investors or lenders or potential lenders. So how do I figure out the cashflow from assets? Well, this can get further broken down. And this is question one of our class has us looking at operating cashflow. We'll get to that in just a minute. Uh, question two, we'll look at capital spending three change in networking capital and question. And these are one dash one, one dash two, one dash three question. One dash four has us looking at all three of them. So let's focus in on operating cashflow. This is the cashflow the company generates from its day-to-day business. So Walmart sells stuff to us. That's their cashflow, uh, you know, from their day-to-day business, they pay their employees money. Maybe they buy goods from their suppliers and they sell stuff to us, right? Those are the operating cash flows, the main operating cash flows of a big retailer like Walmart or home Depot. So operating cashflow is just the company basically doing what it does to make money. Capital spending is them buying capital assets, like buying a new store, or buying a new equipment to go in the store. And obviously that's one way they could use, uh, their cash flows. And lastly, change in networking capital is a little more technical, but it's, uh, basically the short-term assets and short-term liabilities, current assets and current liabilities, how much money they have flowing in and out of those accounts. Uh, but this video is focused on, or this problem one, one is focused on operating cashflow. So with the preamble out of the way, let's get down to business. So we're using, we're figuring out how much money the company's day-to-day business is generated, generating. And the starting point here is an accounting income statement. So let's read the question CO2. Stranger company has sales revenues of $30,000. The operating expenses are 21, including depreciation of three. Company has interest of a thousand dollars and the tax rate is 25%. What's the operating cash flow. Okay. To figure this out, basically they've given us an accounting income statement, let's prepare that. Income statement. So we have sales of $30,000. And the income statement is the summary of revenues and expenses and take your revenues, your amount, your company earned minus your expenses, your costs, and that tells you how profitable it's a company was. So let's figure out the accounting profits of this company. Sales are 30 K operating expense. What is it? 21,000, but it says, including depreciation of three, I want to split out the depreciation. It's going to become relevant later. So our operating expenses, excluding depreciation 21 minus three are 18,000. Our depreciation expense. I'm being very shorthanded here because we're just asked to calculate something, calculate operating cashflow. We're not asked to prepare in good form and income statement or something like that. If it asked me for good format, I would spend more time on dollar signs and underlines and things like this. But in any event, sales minus operating expenses, minus depreciation is 30 minus 18 minus three 30 minus 21. That's $9,000. And that is our EBIT. Now EBIT stands for earnings before interest in tax in accounting. I mean, accounting guys, I would call this operating income, but in a finance class, we're going to call it EBIT, but we're essentially referring to the same thing. There's maybe some small differences here or there, but for all intents and purposes, we're talking about the same thing. Uh, so earnings before interest in tax. Well, then let's take away interest, which was a thousand to get us down to eight, which is our earnings before tax, take away the I cause we, we did take away the interest. And that brings us down to our taxes. Our taxes were 25%, 25% of 8,000. I can do in my head, it's 2000, a quarter of eight. Is two. And that brings us to our bottom line, our net income, our earnings, our profits. This company made $6,000. Okay. So there we have a beautiful sort of. Uh, income statement, but we haven't answered the question. What are the operating cash flows? There are so many ways a person could calculate this. I'm going to show you the one that I've seen most commonly in finance textbooks, and it says, start with EBIT and work from there. So that's what we'll do. We'll start from EBIT and we'll work from there. Um, so if I have my EBIT, which was $9,000, now I need to look above EBIT and below it. I'm going to look above EBIT and I'm going to say, is there anything up there that should have been excluded? Well, sales typically that involves cashflow. Most of my operating expenses involve cashflow because, you know, so again, think of Walmart, they sell stuff to you while they get money from you. When you buy a bag full of stuff, operating expenses, they pay their employees. They pay them with money. So that involves cashflow. The one that sticks out though, is depreciation. There's no cashflow with depreciation. Depreciation is called a non-cash expense. So it's a special expense and we're going to deal with depreciation throughout the course. So it's just worth knowing. Okay. Depreciation never involves cash. So EBIT isn't cashflow because it includes depreciation. So we want to know cash, right? So let's take that depreciation out of our EBIT. Now, how, how do I take it out? Well, I went 30 minus 18 minus three is nine. Well, let's pretend I didn't have that. It would be 30 minus 18. It should be 12. So this should be 12. So I'm going to actually have to add back depreciation. So I add depreciation of 3000. So now my subtotal is 12, right? So it's again, there's many different ways we could calculate this. This is one of them. Okay. Let's look below the line. We've got two more expenses. We got interest because it's earning before interest and tax. We got interest and tax. Interest can involve cash, but it's not considered an operating cashflow. It's not considered part of the day-to-day business of the company. Uh, and it's, it's a payment out to creditors, right? So it's something different. It's a different kind of cashflow. Taxes though, are operating cashflows. This $2,000 in taxes is a $2,000 deduction from our cash. So minus 2000 equals nine plus three is 12 minus two is 10. That is my operating cashflow, which we will abbreviate in this course as OCF. So the formula is EBIT plus depreciation minus taxes. Now, later in the course, we will go through so many different ways to calculate this. You can really calculate OCF in myriad different ways, but it becomes a really useful and powerful number right now. Okay. You know, we're just like, we're calculating it going through like an intellectual exercise. Later in the class, we will use this number to do powerful things. So I hope you'll stick with me because I want to do powerful things together. And just, uh, you know, if you're planning to stick with me, I hope you'll hit one of those buttons. Thanks for watching. Have a great day. See you in the next video. Bye bye.