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The Statement of Cash Flows

The firm requires cash when it buys new plant and machinery or when it pays interest to the bank and dividends to the shareholders. Therefore, the financial manager needs to keep track of the cash that is coming in and going out.

We have seen that the firm`s cash flow can be quite different from its net income. These differences can arise for at least two reasons:

1. The income statement does not recognize capital expenditures as expenses in the year that the capital goods are paid for. Instead, it spreads those expenses over time in the form of an annual deduction for depreciation.

2. The income statement uses the accrual method of accounting, which means that revenues and expenses are recognized as they are incurred rather than when the cash is received or paid out.

The statement of cash flows shows the firm`s cash inflows and outflows from operations as well as from its investments and financing activities. Table A.3 is the cashflow statement for Pepsi. It contains three sections. The first shows the cash flow from operations. This is the cash generated from Pepsi`s normal business activities. Next comes the cash that Pepsi has invested in plant and equipment or in the acquisition of new businesses. The final section reports cash flows from financing activities such as the sale of new debt or stocks. We will look at these sections in turn.

The first section, cash flow from operations, starts with net income but adjusts that figure for those parts of the income statement that do not involve cash coming in or going out. Therefore, it adds back the allowance for depreciation because depreciation is not a cash flow even though it is treated as an expense in the income statement. Any additions to current assets need to be subtracted from net income, since these absorb cash but do not show up in the income statement. Conversely, any additions to current liabilities need to be added to net income because these release cash.

For example, you can see that the increase of $303 million in accounts receivable is subtracted from income, because this represents sales that Pepsi includes in its income statement even though it has not yet received payment from its customers. On the other hand, Pepsi increased accounts payable by $253 million. The accountant deducted this figure as part of the cost of the goods sold by Pepsi in 1998, even though Pepsi had not yet paid for these goods. Thus the $253 million increase in accounts payable must be added back to calculate the cash flow from operations.

We have pointed out that depreciation is not a cash payment; it is simply the accountant`s allocation to the current year of the original cost of the capital equipment.

However, cash does flow out the door when the firm actually buys and pays for new capital equipment. Therefore, these capital expenditures are set out in the second section of the cash-flow statement. You can see that Pepsi spent $1,271 on new capital equipment and $4,520 to purchase new businesses. It also raised $772 million on other noncurrent assets. Total cash used by investments was $5,019 million.

Finally, the third section of the cash-flow statement shows the cash from financing activities. Pepsi raised $2,762 million by issuing debt, but it used $1,815 million to buy back its stock and $757 million to pay dividends to its stockholders.4

To summarize, the cash-flow statement tells us that Pepsi generated $3,212 million from operations, it spent $5,019 million on new investments, and it raised a net amount of $190 million in new finance. Pepsi spent more cash than it earned and raised. Therefore, its cash balance fell by $1,617 million. To calculate this change in cash balance, we subtract the uses of cash from the sources:

STATEMENT OF CASH FLOWS Financial statement that shows the firm`s cash receipts and cash payments over a period of time.