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Total Liabilities & Equity 100 124

Total Liabilities & Equity 100 124

set of grilling tongs) as closely as possible, whereas cash profits measure only the actual dollar bills flowing into and out of a business.

Next, we need to take into account the fact that Mike used up half his original inventory of hot dogs and buns, as well as the fact that he went out and bought an additional $5 worth of buns. His inventory went from $20, to $10, and back to $15. This net decrease in inventory from $20 to $15 is a source of cash. In other words, Mike had $20 of capital tied up in inventory at the start of the weekend, but now he has only $15 of capital invested in inventory. As a result, he converted $5 in inventory to $5 in cash.

However, Mike also is owed $7 by hot dog eaters who haven't paid him yet. Because Mike had to pay to produce the dogs they ate and they haven't yet given him any cash, he's used up some money by letting those folks nosh on his tasty dogs on credit. In other words, Mike paid out cash to get the ingredients he needed to make the hot dogs, but he hasn't yet received any cash in return, so his decision to extend credit used up $7 in cash.

Finally, let's not forget that Mike himself is the beneficiary of credit because he still owes the grocer $5 for those extra buns he bought. Because Mike received something without paying out cash for it, his cash account increases by $5.

We can follow the trail from Mike's $19 in net profits to his $23 in cash flow with this simple table:

Net profits = $19

+ $1 depreciation + $10 inventory (hot dogs sold)

— $5 inventory (extra buns purchased)

— $7 accounts receivable (money owed to Mike) + $5 accounts payable (money owed by Mike)

= $23 in operating cash flow

As you can see, the $23 in operating cash flow differs from the $19 in net income because of the choices Mike made in running his little business. For example, if Mike hadn't let anyone buy on credit, but had the same amount of sales, his cash flow would have been $30 ($23 plus $7). Conversely, if the grocer had forced Mike to pay cash for those extra buns, Mike's cash flow would have been $18 ($23 minus $5.) In both cases, however, Mike's net profits would have remained $19.

The key takeaway here is that the income statement and cash flow statement can tell different stories about a business because they're constructed using different sets of rules. The income statement strives to match revenues and expenses as closely as possible—that's why we had to deduct the $i in depreciation from Mike's profits, and that's why Mike gets to record the $7 in sales that he made on credit. But the cash flow statement cares only about the dollar bills that go in and out the door, regardless of the timing of the actions that generated those dollar bills.

If you look only at the income statement without checking to see how much cash a company is creating, you won't be getting the whole story by a long shot. This simple concept—the difference between accounting profits and cash profits—is the key to understanding almost everything there is to know about how a business works, as well as how to separate great businesses from poor ones. In subsequent chapters, we'll move from our simple hot dog stand to real-world companies to learn how to analyze all three of the financial statements in detail.

Investor's Checklist: The Language of Investing

3 The balance sheet is like a company's credit report because it tells you how much the company owns (assets) relative to what it owes (liabilities). 3 The income statement shows how much the company made or lost in accounting profits during a year or a quarter. Unlike the balance sheet, which is a snapshot of the company's financial health at a precise moment, the income statement records revenues and expenses during a set period, such as a fiscal year. 3 The third key financial statement—the statement of cash flows—records all the cash that comes into a company and all of the cash that goes out. 3 Accrual accounting is a key concept for understanding financial statements. The income statement matches sales with the corresponding expenses when a service or a good is provided to the buyer, but the cash flow statement is concerned only with when cash is received and when it goes out the door.

3 The income statement and cash flow statement can tell different stories about a business because they're constructed using different sets of rules. To get the most complete picture, be sure to look at both.

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