It's the Fourth of July, and Mike thinks he can make a few bucks by setting up a hot dog stand near the parade route. Mike has $ioo to start his hot dog—selling operation, with the money provided by the First National Bank of Mom.

ASSETS	Before	Change	After
Cash	O	+IOO	IOO
LIABILITIES
Long-term debt	o	+IOO	IOO

Mike spends $70 for lumber, nails, and paint to assemble the stand as well as tongs for turning the dogs on the grill. (He's borrowing Dad's grill to cook the dogs.) Then he buys $20 "worth of hot dogs, buns, ketchup, and mustard, and some charcoal and lighter fluid for the grill. He keeps the remaining $10 for making change and such.

ASSETS	Before	Change	After
Cash	IOO	-90	10
Inventory	o	+20	20
PP&E	o	+70	70

He's spent $90 ($70 for the stand and $20 for ingredients), but that money hasn't disappeared—it's turned Into assets and inventory. As shown in the chart, the $70 he spent on the hot dog stand and the tongs is "property, plant, and equipment," while the $20 in buns and such has become "inventory," and the $10 in cash is just that. Look at the simplified balance sheet in Figure 4.2 to see how this would look if Mike had to file an annual report. (Don't worry if you see an unfamiliar line item—we'll cover it later in the chapter.)

Mike opens for business while the crowd is gathering for the parade and sells 30 hot dogs at Si apiece. By noon , half the hot dogs, buns, condiments, and charcoal are gone, so Mike's "cost of goods sold" is $10, or half of the $20 he spent to buy supplies. Seven people didn't have any cash on them, so Mike let them buy their dogs on credit—which means we need to record $7 in accounts receivable, which is the money that folks owe to Mike.

ASSETS	Before	Change	After
Cash	10	+23	33
Accounts receivable	0	+7	7
Inventory	20	-10	10

In the middle of the day, Mike runs out of buns, so he has to run over to the corner grocery store to buy more. But "when he arrives, he realizes he left his money back at the stand, so he promises the grocer he'll come back with the money on Monday when the hot dog biz slows down. We post $5 to accounts payable, which is money that Mike owes to the grocery store for the buns. (Think of accounts payable like your credit card. If you buy a shirt or a stereo on your Visa, you can use it right away—but you still owe the credit card issuer some cash.)

ASSETS	Before	Change	After
Cash	33		33
Inventory	IO	+5	15
LIABILITIES
Accounts payable		+5	5

At the end of the second day, Mike realizes that his tongs aren't working as well as they used to, and it's taking him longer to grill each hot dog. The accounting name for this wear-and-tear is depreciation, which lets us record the fact that Mike's equipment isn't as productive as it used to be. (In the real world, depreciation isn't recorded at the moment something starts wearing out. It's actually a regular charge that assumes that an asset wears out over a set time period—as long as forty years for a building, and as short as three years for a computer.) Depreciation is a cost of doing business, just like buying hot dogs and buns, because Mike will eventually have to buy another set of tongs if he wants to stay in business. Because all costs have to be recorded—accounting is funny that way—we post $i to depreciation.

After a long day of serving up delicious dogs to parade-goers, Mike's income statement is shown in Figure 4.3.

The eagle-eyed reader will notice that although Mike's net profit was $19, his cash account went up by $23—from $10 to $33—on his personal balance sheet. Why the difference? Let's find out by developing a statement of cash flows from the income statement and balance sheet information that we have available. By following this example, you'll see into the heart and soul of accounting.

To understand how much cash Mike's little business generated, we start with his $19 in net profits, which is the difference between what he paid for

Sales	30
- Cost of goods sold	10
- Depreciation	1

Figure 4.3 Simple income statement for Mike's hot dog stand. Source/Morningstar, Inc.

the hot dogs, buns, and condiments, and what he received in payment for the hot dogs. But to arrive at the cash profits, we first need to add back the Si in depreciation. You see, although we need to keep track of the expense that Mike incurred by partially wearing out his grilling tongs—remember, accounting is all about keeping score—Mike didn't have to pay out $1 in cash to cover the wear and tear. He'll have to replace the tongs eventually, but as yet, he still has his slightly worn-out pair, and he hasn't laid out any green to fix it. This is the critical difference between accounting profits and cash profits— accounting profits match revenues (hot dogs sold) with expenses (a worn-out

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 asource 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:

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

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 Si 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.