Quick question. Is this baloney? Meaning is a part good part I don't know what or is it all real cash flow? If you think about it, it is baloney and the reason is if you look up, you have revenues, cost of goods sold, selling and general administration specific to your product but then there's this guy called depreciation, which you've subtracted, but you subtract it to do what? To save money on taxes. Now that you've subtracted it, guess what we do? This is the, we have to add it back. We add back what? One million. Why have I added it back? Because it wasn't real at all. Now this is where when I first saw this, I said, "Man, what is going on here?" Sometimes you subtract and then you add it back. But then when you stare at it, you realize what has depreciation done. Depreciation is called the classic non-cash flow item, i.e. it's really is not happening in that year. Its an implication of something that happened in the past for the future. Remember, I subtracted one million, now I'm adding back, add up the two what do you get? Zero, so why am I doing it? Very simple. It's effects are showing up somewhere. I'll let you pause for a second and answer the question, "Where?" There is an item above in the list of items where depreciation has had its impact? Because I subtracted it above before calculating what? Well, taxes. If you figured it was taxes, you're right. Because I subtracted depreciation before calculating taxes, my taxes are higher or lower? They are lowered. If I'm allowed to depreciate and deduct it as at one million. I will, because my taxes now are 0.5 million. Let me ask you, what would your taxes have been if you didn't subtract it? Higher or lower? Higher. The fact that my taxes are already lower to 0.5 million means depreciation has done its job. Let me now add it back. Let me give you a thing to worry about and please do it on your own time. Quick question, how much taxes have I saved because of my depreciation? Do it on your own time and we'll talk about it later. I want you to do it on your own time because it's something that if you work through, you'll understand. When we come back later, I'll give you the answer, not in terms of the answer's right but the way of thinking about it. Okay? Now, how much am I left with? I have five million minus two is three minus 0.5 is 2.5 minus one million depreciation. Remember in your head, what should you think? Fake? Yeah right, but you subtract it because taxes are allowed to be reduced by that much. 1.5 million, so your taxes are 0.3. If your tax rate is 0.33, you're left with one million net operating profits after tax but that's really not real. Why? Because depreciation wasn't real and there are other items like depreciation and cash flow statements. I'll talk a little bit about them soon but right now, depreciation is the main item which you need to worry about and think about. Okay. What do I have left? I have to subtract out capital expenditures. Before I do that, how much money do I have from net operating profits plus adding depreciation back? Remember I'm here. Please remember now you have two million, right? What is capital expenditures and why did I draw that line? The reason I drew that line was we are now talking about suddenly not flows. We are talking about fixed costs, which are what? Like a snapshot. Capital expenditures is also called cap-ex, is the amount of money you spend on things that last a while. Cap-ex in year one or year two or year three is likely to be low. I'll put a zero here just for convenience. Why is it likely to be low in a particular year in the middle of your project? Is because when does major capital expenditures take place? When you start the project. In a specific year, it's likely to be a low number. That doesn't mean is exactly zero. You may need after five years, another injection of a smaller machine into your system. But the key to CapEx is, everything above the line has come from income statements. Income; this comes from balance sheet because as soon as you buy an equipment, which is supposed to last for a really long time or even multiple years, it shows up in the balance sheet. As soon as you spend $10 million at the beginning, it'll show up as $10 million. Here I'm assuming that in this specific year, you are in the middle of the project and you don't need the infusion of a fixed item to produce for things for multiple years. I'm marketing now, now comes the really, really dicey part of not so sure but dicey means a little bit, slippery, is another word for dicey. Here is a slippery one. It is increases in working capital. I want you to again focus on the word capital. As soon as you see these words, you should again think of balance sheet. As soon as you think of balance sheet, what you're thinking of? A snapshot. A snapshot is not a flow. Look at the word increases. Increases or decreases it should say both could happen, but increases in working capital. By definition, what is increases? A change. As soon as you think of balance sheet, what should you be thinking of? Delta. Delta is a symbol used in math for changes. So what is working capital? Working capital is because life sucks. Life is not easy. When I say that, I mean it. Working capital is due to the simple fact that to produce something, you have to spend resources before it's produced. Let me give you the simplest example of working capital. You start a little store around the corner and people stop to buy soda or Coke or whatever. You carry some cash in your registry. Why do you carry cash? It's an inventory. Why do you use it there? Where would that cash rather sit? Somewhere earning money, right? You keep cash in there because it's like an inventory, the most fundamental inventory that you need to make things happen. Let me give you an example. You've cash sitting in there. Suppose somebody walks into the door and that somebody is the supplier of your drinks, that you offer. Drinks as not an alcohol but soda pop. The person walks in and says, " Here is the supply for today." Your inventory for selling things over time. But guess what? I don't take credit, I need cash. What happens? If you have cash, you're able to get the inventory, convert it into the stuff people want from you. The people don't want to cash from you, not the bank. They want soda. But if you don't have cash to buy the soda, you give up the opportunity of selling your inventory, real inventory because you can't convert it. You keep cash just in case. But that has a cost to it. The cost is, it's just sitting there. Similarly, when it's converted into inventory, why do you buy a bunch of soda cans beforehand? Because people come in on their own time to buy soda. Ideally, what would you love to do? Even in an ideal world, what would you love to do? You would love to have exactly the amount of cans in there of soda as the number of people walking in. They should somehow come through by magic. Every time somebody wants something, that's exactly what you have in your store. By the way, the reason I'm emphasizing this is that inventory management and working capital management is probably the biggest value creation of the Internet boom. Let me say this one more time. Value can be created in ways that are not sexy. I came up with this brilliant new idea of thinking of a value product or whatever an iPad, value is many times created by doing your business really well. When you are working capital management well, you're keeping your inventory low. That saves you money, because when you keep your inventory low, the resources that are loosened up by that process, that are released, can earn money for you. Let me ask you the following question: what does Walmart do? I think it would be silly to say Walmart sells almost anything, because that's true, but that's not telling me anything. I mean I can see that for myself when I walk into Walmart, but would you say Walmart is producing commodities that no, you can't see elsewhere? The answer is obviously no. What is Walmart doing? Walmart is selling existing things which do not typically have huge margins. So how does Walmart exist? Walmart is the king of working capital management. In fact, there's an advertisement I love. It has nothing to do with Walmart, but I love it. I think it's an orange juice advertisement. What happens is this person goes and puts their hand in a shelf at a store, and suddenly from somewhere, the orange juice comes. Just one for them, and it's coming from Florida which in the US is place for orange. I think that is a classic ad for actually Walmart instead of orange juice, because Walmart manages its shelf so well that it minimizes its inventory, and therefore minimize its costs of doing business. I'm going to come back to this, but the reason I brought it up was that you should never forget the capital that is used to manage your system, apart from the capital that was used to buy the machine. Another way to think about working capital is, think about it as grease that's used to run your machine. You need your machine, but every period you need grease to manage it. It would be a great machine if it didn't need much grease, so that's one way to think about it. So you subtract your working capital, and you get cashflows from operations, and that's the guy we want, but I haven't put a number here. Let me put a number of negative 0.1 million. Remember it's negative, that means you have an increased need for inventory or something like that. In the end, how much do I have? Five million, two million, subtract three million, two and a half million, one and a half million. Fake, to what extent? The one million, and then you subtract out 0.5 million, you're left with one million. This is net operating profit. Add back the one million depreciation, you have two million. Subtract the 0.1 million of working capital. Big assumption: this is the middle of the project and I don't need capital expenditures, plus 1.9 million. I would encourage you to take a break if you haven't. I have worked through a specific year, now what I'm going to do is I'm going to try to highlight things that are extremely important to all things put together, and not to worry about detail. However, I want you to spend a good time working through this example and thinking about questions you may have. Remember now what I'm going to do is I'm not going to go through detail one step at a time, I'm going to really highlight the key issues you need to worry about for all years put together. One more time, this is a specific year, let's assume it's Year 1, and you need to worry about these key items for every year. As we'll see later, for some years, especially Year 0, and the last year of the project, you don't have to worry about many of these items maybe, but we'll worry about that as we get there. I'm going to repeat a lot of issues here, but I want you to keep this image at the back of your mind. Okay? Good luck. See you soon. Think about it. I'm going to come back and continue the rest of cashflows which is going to be the last piece for this week, and it'll be general, but please do this example one more time before you join me. Thanks.
