PROFITS VERSUS CASH FLOW
It is important to
distinguish between Pepsi`s profits and the cash that the company generates.
Here are three reasons why profits and cash are not the same:
1. When Pepsi`s accountants
prepare the income statement, they do not simply count the cash coming in and
the cash going out. Instead the accountant
starts with the cash payments but then divides these payments into two
groups current expenditures (such as wages) and capital expenditures (such as the purchase of new
machinery). Current expenditures are deducted from current profits. However,
rather than deducting the cost of
machinery in the year it is purchased, the accountant makes an annual charge
for depreciation. Thus the cost of machinery is spread over its forecast life.
When calculating profits,
the accountant does not deduct the expenditure on
new equipment that year, even though cash is paid out. However, the accountant does deduct depreciation on
assets previously purchased, even though no cash is currently paid out.
To calculate the cash produced by the business it is
necessary to add back the depreciation charge (which is not a cash payment) and to subtract the expenditure on new capital equipment (which is a
cash payment).
2. Consider the following stages in a manufacturing
business. In period 1 the firm produces the goods; it sells them in period 2
for $100; and it gets paid for them in
period
3. Although the cash does not arrive until period 3,
the sale shows up in the income statement for period 2. The figure for accounts
receivable in the balance sheet for
period 2 shows that the company`s customers owe an extra $100 in unpaid bills.
Next period, after the customers have paid
their bills, the receivables decline by $100.
The cash that the company receives is equal to the sales shown in the income statement
less the increase in unpaid bills:
3. The accountant also tries to match the costs of
producing the goods with the revenues from the sale. For example, suppose that
it costs $60 in period 1 to produce the
goods that are then sold in period 2 for $100. It would be misleading to say
that the business made a loss in period 1
(when it produced the goods) and was very profitable in period 2 (when
it sold them). Therefore, to provide a fairer measure of the firm`s profitability, the income statement will not
show the $60 as an expense of producing the goods until they are sold in period
2. This practice is known as accrual accounting. The accountant gathers together all expenses that are
associated with a sale and deducts them from the revenues to calculate profit, even though the expenses
may have occurred in an earlier period.
Of course the accountant cannot ignore the fact that
the firm spent money on producing the goods in period 1. So the expenditure
will be shown in period 1 as an investment in inventories. Subsequently in period 2, when the
goods are sold, the inventories would decline again.
In our example, the cash is paid out when the goods
are manufactured in period 1 but this expense is not recognized until period 2
when the goods are sold.
The cash outflow is equal to the cost of goods sold, which is shown in
the income statement, plus the change in inventories:
Category: Corporate finance
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