04 - chapter 4 cash flow financial planning

8/18/2019 04 - Chapter 4 Cash Flow Financial Planning

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Chapter 4

Cash Flow and Financial Planning

Principles of Managerial Finance

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Learning Goals

LG1 Understand tax depreciation procedures and the effectof depreciation on the firm’s cash flows.

LG2 Discuss the firm’s statement of cash flows, operating

cash flow, and free cash flow.

LG3 Understand the financial planning process, includinglong-term (strategic) financial plans and short-term

(operating) financial plans.


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Learning Goals (cont.)

LG4 Discuss the cash-planning process and the

preparation, evaluation, and use of the cash budget.

LG5 Explain the simplified procedures used to prepare andevaluate the pro forma income statement and the pro

forma balance sheet.

LG6 Evaluate the simplified approaches to pro formafinancial statement preparation and the common uses

of pro forma statements.


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Analyzing the Firm’s Cash Flow

• Cash flow (as opposed to accounting “ profits”) is the primary ingredient in any financial valuation model.

• From an accounting perspective, cash flow is summarized

in a firm’s statement of cash flows.

• From a financial perspective, firms often focus on both

operating cash flow, which is used in managerial

decision-making, and free cash flow, which is closelymonitored by participants in the capital market.


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Depreciation

• Depreciation is the portion of the costs of fixed assets

charged against annual revenues over time.

• Depreciation for tax purposes is determined by using the

modified accelerated cost recovery system (MACRS).

• On the other hand, a variety of other depreciation methods

are often used for reporting purposes.


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Depreciation: An Example

Baker Corporation acquired a new machine at a cost of

$38,000, with installation costs of $2,000. When the

machine is retired from service, Baker expects that it will

sell it for scrap metal and receive $1,000.What is the depreciable value of the machine?

– Regardless of its expected salvage value, the depreciable value

of the machine is $40,000: $38,000 cost + $2,000 installation

cost.


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Depreciation: DepreciableValue and Depreciable Life

• Under the basic MACRS procedures, the depreciable

value of an asset is its full cost, including outlays for

installation.

• No adjustment is required for expected salvage value.

• For tax purposes, the depreciable life of an asset is

determined by its MACRS recovery predetermined

period.• MACRS property classes and rates are shown in

Table 4.1 and Table 4.2 on the following slides.


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Table 4.1 First Four PropertyClasses under MACRS


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Table 4.2 Rounded Depreciation Percentages byRecovery Year Using MACRS for First FourProperty Classes


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Depreciation: An Example

Baker Corporation acquired, for an installed cost of $40,000, a

machine having a recovery period of 5 years. Using the applicable

MACRS rates, the depreciation expense each year is as follows:


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The Orientation of Financial Analysis

• Accounting is concerned with creating financial statements

• Finance is concerned with using the datacontained within financial statements to makedecisions

– The orientation of financial analysis is critical and

investigative


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The Statement of Cash Flows

• Income doesn’t represent cash in the firm’s pocket

• The Statement of Cash Flows (AKA: Statement ofChanges in Financial Position) provides info on the

actual movement of cash in and out of the company• Constructed from the Balance Sheet and Income

Statement


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How the Statement of Cash FlowsWorks—Preliminary Examples

• Requires two consecutive balance sheets andone income statement from which thestatement of cash flows is generated

• Takes net income for the period and makesadjustments

• Then takes the balance sheet items andexamines the changes


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How the Statement of Cash FlowsWorks—Preliminary Examples

Q: Suppose Joe Jones has after-tax income of $50,000 and spends $40,000 onnormal living expenses during the year. Also assume that at the beginning ofthe year he had a bank balance of $10,000 and no other assets or liabilities.Further, assume that during the year he bought a new car costing $30,000,financing $25,000 at the bank with a car loan. At the end of the year he has$15,000 in the bank. Generate a Statement of Cash Flows for Joe.

A: Inflows of cash are known as sources and outflows are known as uses. TheStatement of Cash Flows will show how Joe ended up with $15,000 in his bankaccount.

Joe generated a net source of cash of $10,000, or the difference between hisincome and normal living expenses. He also experienced an inflow of $25,000

from the car loan and used $30,000 to buy the car. Thus, Joe’s Statement ofCash Flows is:

E x a m p l e


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ow e a emen o asFlows Works—Preliminary

Examples

E x a m p l e

$15,000Ending cash balance

$5,000Net cash flow

$10,000Beginning cash balance

$5,000Net inflow/(outflow) of cash

($30,000)Use of cash to buy auto

(40,000)

$50,000

$25,000Source of cash from loan

$10,000Net source of cash from income

Cash used on living expenses

Cash income


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Business Cash Flows

• Cash Flows Rules

– The following rules can be applied to anybusiness’s financial statements

• Asset increase ⇒ use of cash

• Asset decrease ⇒ source of cash

• Liability increase ⇒ source of cash

• Liability decrease ⇒ use of cash


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Inflows and Outflows of Cash


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Business Cash Flows

• Standard Presentation

– Statement of Cash Flows organized to show

• Operating activities

Running business on day-to-day basis

• Investing activities

When firm buys or sells things to do business

» Includes long-term purchases and sales of financial assets

• Financing activities

When firm borrows money, pays off loans, sells stock or paysdividends


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Business Cash Flows

A successfulbusiness has towithdraw cash to

finance growth andreplace worn out

assets, pay taxesand for profit.


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Belfry Company Belfry CompanyBalance Sheet Income Statement

For the period ended 12/31/X2 For the period ended 12/31/X2

Sales 10,000$

12/31/X1 12/31/X2 COGS 6,000$

Cash 1,000 1,400 Gross margin 4,000$

Accounts receivable 3,000 2,900

Inventory 2,000 3,200 Expense 1,600$

CURRENT ASSETS 6,000 7,500 Depreciation 500$

Fixed assets EBIT 1,900$

Gross 4,000 6,000 Interest 400$

Accumulated deprec. (1,000) (1,500) EBT 1,500$

Net 3,000 4,500 Tax 500$

TOTAL ASSETS 9,000 12,000 Net Income 1,000$

Accounts payable 1,500 2,100

Accruals 500 400CURRENT LIABILITIES 2,000 2,500

Long-term debt 5,000 6,200

Equity 2,000 3,300

TOTAL CAPITAL 7,000 9,500

TOTAL LIABILITIES AND EQUITY 9,000 12,000

Assets

Liabilities

Constructing the Statement of CashFlows

Also assume firm paid a $500dividend and sold stock for $800during the year.


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• Operating Activities – Involve the Income Statement and current

Balance Sheet accounts

– Involves activities firm does on a day-to-day basissuch as

• Buying inventory

• Producing and selling product

• Paying expenses and taxes

– Collecting credit sales

Focus of activitiesis generating net

income—the

beginning of acash flowstatement.

Money from operating transactions runs through current balancesheet accounts


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• Thus, for Belfry the cash from Operating Activities is

Net Income $1,000

+ Depreciation $500

= Operating Income $1,500

+ increase in Receivables $100

- increase in Inventory ($1,200)

+ increase in Payables $600- decrease in Accruals ($100)

Cash from operating activities $900


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• Investing Activities

– Typically include purchasing Fixed Assets

– Examine the change in GROSS Fixed Assets, not net

• Because the net value includes an adjustment for depreciation

Depreciation has already been included under operating activities

– Thus, for Belfry the cash from investing activities is

• Purchase of Fixed Assets ($2,000)


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• Financing Activities

– Deal with the capital accounts, long-term debt andequity

– Thus, for Belfry the cash from financing activitiesis

Increase in long-term debt $1,200

Sale of stock $800Dividend paid ($500)

Cash from financing activities $1,500


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• The Equity and Cash Accounts – The change in equity is not included because the changes

are reflected elsewhere in the Statement of Cash Flows

• Net Income is included in Cash Flows from Operations

• Sale of stock and dividends are considered under financingactivities

– The change in the cash account isn’t considered becausethe sum of cash flows from operations, financing activities

and investing activities must equal the change in the cashaccount


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• Thus, for Belfry, the final portion of theStatement is

Beginning Cash Balance $1,000

Net cash flow 400

Ending Cash Balance $1,400


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While the firm was profitable it still hadto borrow money and sale stock to

finance the increase in Fixed Assets.

Belfry CompanyStatement of Cash Flows

For the period ended 12/31/X2

CASH FROM OPERATING ACTIVITIES

Net income 1,000$

Depreciation 500$

Net changes in current accounts (600)$Cash from operating activities 900$

CASH FROM INVESTING ACTIVITIES

Purchase of fixed assets (2,000)$

CASH FROM FINANCING ACTIVITIES

Increase in long-term debt 1,200$

Sale of stock 800$

Dividend paid (500)$Cash from financing activities 1,500$

NET CASH FLOW 400$

Beginning cash balance 1,000$

Net cash flow 400$

Ending cash balance 1,400$


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Table 4.5a Baker CorporationBalance Sheets ($000)


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Table 4.5b Baker CorporationBalance Sheets ($000)


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Operating Cash Flow

• A firm’s operating Cash Flow (OCF) is the cash flowa firm generates from normal operations — from the

production and sale of its goods and services.

• OCF may be calculated as follows:

NOPAT = EBIT × (1 – T)

OCF = NOPAT + Depreciation

OCF = [EBIT × (1 – T)] + Depreciation


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Operating Cash Flow (cont.)

• Substituting for Baker Corporation, we get:

• Thus, we can conclude that Baker ’s operations aregenerating positive operating cash flows.

OCF = [$370 × (1 – .40)] + $100 = $322


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Free Cash Flow

• Free cash flow (FCF) is the amount of cash flow

available to investors (creditors and owners) after the firm

has met all operating needs and paid for investments in

net fixed assets (NFAI) and net current assets (NCAI).

• Where:

FCF = OCF – NFAI – NCAI

NFAI = Change in net fixed assets + Depreciation

NCAI = Change in CA – Change in (A/P + Accruals)


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Free Cash Flow (cont.)

• Using Baker Corporation we get:

• Thus, the firm generated adequate cash flow to cover allof its operating costs and investments and had free cash

flow available to pay investors.

FCF = $322 – $300 – $0 = $22

NFAI = [($1,200 – $1,000) + $100] = $300

NCAI = [($2,000 – $1,900) - ($800 - $700)] = $0


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The Financial Planning Process

• The financial planning process begins with long-term,

or strategic, financial plans that in turn guide the

formulation of short-term, or operating, plans and

budgets.

• Two key aspects of financial planning are cash planning

and profit planning.

– Cash planning involves the preparation of the firm’s cash budget.

– Profit planning involves preparation of pro forma statements.


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The Financial Planning Process:Long-Term (Strategic) Financial Plans

• Long-term (strategic) financial plans lay out acompany’s planned financial actions and the anticipatedimpact of those actions over periods ranging from 2 to 10years.

• Firms that are subject to high degrees of operatinguncertainty, relatively short production cycles, or both,tend to use shorter planning horizons.

• These plans are one component of a company’s integratedstrategic plan (along with production and marketing plans) that guide a company toward achievement of itsgoals.


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The Financial Planning Process:Long-Term (Strategic) Financial Plans

• Long-term financial plans consider a number of financialactivities including:

– Proposed fixed asset investments

– Research and development activities

– Marketing and product development

– Capital structure

– Sources of financing

• These plans are generally supported by a series of annual

budgets and profit plans.


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The Financial Planning Process:Short-Term (Operating) Financial Plans

• Short-term (operating) financial plans specify short-term financial actions and the anticipated impact of those

actions.

• Key inputs include the sales forecast and other operatingand financial data.

• Key outputs include operating budgets, the cash budget,

and pro forma financial statements.

• This process is described graphically on the following

slide.

Fi 4 1


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Figure 4.1Short-Term Financial Planning


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The Financial Planning Process:Short-Term (Operating) Financial Plans

• As indicated in the previous exhibit, short-term financial planning begins with a sales forecast.

• From this sales forecast, production plans are developed

that consider lead times and raw material requirements.• From the production plans, direct labor, factory overhead,

and operating expense estimates are developed.

• From this information, the pro forma income statementand cash budget are prepared — ultimately leading to thedevelopment of the pro forma balance sheet.


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Cash Planning: Cash Budgets

• The cash budget or cash forecast is a statement of thefirm’s planned inflows and outflows of cash that is used toestimate its short-term cash requirements.

• Typically, the cash budget is designed to cover a 1-year period, divided into smaller time intervals.

• The more seasonal and uncertain a firm’s cash flows, thegreater the number of intervals.

C h Pl i


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Cash Planning:Cash Budgets (cont.)

• A sales forecast is a prediction of the sales activity during a given period, based on external and/or internal data.

• The sales forecast is then used as a basis for estimating the monthlycash flows that will result from projected sales and from outlays

related to production, inventory, and sales.• The sales forecast may be based on an analysis of external data,

internal data, or a combination of the two.

– An external forecast is a sales forecast based on the relationships observed between the firm’s sales and certain key external economic indicators.

– An internal forecast is a sales forecast based on a buildup, or consensus, ofsales forecasts through the firm’s own sales channels.

T bl 4 7 Th G l F t f


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Table 4.7 The General Format ofthe Cash Budget

C h Pl i C h B d t


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Cash Planning: Cash Budgets An Example: Coulson Industries

Coulson Industries, a defense contractor, is developing acash budget for October, November, and December.

Coulson’s sales in August and September were $100,000and $200,000 respectively. Sales of $400,000, $300,000 and

$200,000 have been forecast for October, November, and

December. Historically, 20% of the firm’s sales have beenfor cash, 50% have been collected after 1 month, and the

remaining 30% after 2 months. In December, Coulson willreceive a $30,000 dividend from stock in a subsidiary.


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Table 4.8 A Schedule of Projected CashReceipts for Coulson Industries ($000)


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Cash Planning: Cash Budgets An Example: Coulson Industries (cont.)

Coulson has also gathered the relevant information for thedevelopment of a cash disbursement schedule. Purchases

will represent 70% of sales — 10% will be paid immediatelyin cash, 70% is paid the month following the purchase, and

the remaining 20% is paid two months following the

purchase. The firm will also expend cash on rent, wages and

salaries, taxes, capital assets, interest, dividends, and a

portion of the principal on its loans. The resultingdisbursement schedule thus follows.


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Table 4.9 A Schedule of Projected CashDisbursements for Coulson Industries ($000)

C h Pl i C h B d


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Cash Planning: Cash Budgets An Example: Coulson Industries (cont.)

The Cash Budget for Coulson Industries can be derived bycombining the receipts budget with the disbursements

budget. At the end of September, Coulson’s cash balancewas $50,000, notes payable was $0, and marketable

securities balance was $0. Coulson also wishes to maintain a

minimum cash balance of $25,000. As a result, it will have

excess cash in October, and a deficit of cash in November

and December. The resulting cash budget follows.

Table 4 10 A Cash Budget for


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Table 4.10 A Cash Budget forCoulson Industries ($000)


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Evaluating the Cash Budget

• Cash budgets indicate the extent to which cash shortagesor surpluses are expected in the months covered by theforecast.

• The excess cash of $22,000 in October should be investedin marketable securities. The deficits in November andDecember need to be financed.

Coping with Uncertainty in the


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Coping with Uncertainty in theCash Budget

• One way to cope with cash budgeting uncertainty is to prepare several cash budgets based on several forecastedscenarios (e.g., pessimistic, most likely, optimistic).

• From this range of cash flows, the financial manager candetermine the amount of financing necessary to cover themost adverse situation.

• This method will also provide a sense of the riskiness of

alternatives.• An example of this sort of “sensitivity analysis” for

Coulson Industries is shown on the following slide.

T bl 4 11 A S i A l i f


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Table 4.11 A Scenario Analysis ofCoulson Industries’ Cash Budget ($000)

Profit Planning:


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Profit Planning:Pro Forma Statements

• Pro forma financial statements are projected, orforecast, income statements and balance sheets.

• The inputs required to develop pro forma statements usingthe most common approaches include:

– Financial statements from the preceding year

– The sales forecast for the coming year

– Key assumptions about a number of factors

• The development of pro forma financial statements will be demonstrated using the financial statements for VectraManufacturing.

Table 4.12 Vectra Manufacturing’s


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Table 4.12 Vectra Manufacturing sIncome Statement for the Year EndedDecember 31, 2012

Table 4 13 Vectra Manufacturing’s


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Table 4.13 Vectra Manufacturing sBalance Sheet, December 31, 2012

Table 4 14 2010 Sales Forecast


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Table 4.14 2010 Sales Forecastfor Vectra Manufacturing

Profit Planning: Pro Forma


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Profit Planning: Pro FormaFinancial Statements (cont.)

Step 1: Start with a Sales Forecast (cont.)

– The previous sales forecast is based on an increase in price from

$20 to $25 per unit for Model X and from $40 to $50 per unit

for Model Y.

– These increases are required to cover anticipated increases in

various costs, including labor, materials, & overhead.



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Step 2: Preparing the Pro Forma Income Statement

– A simple method for developing a pro forma income statement

is the percent-of-sales method.

– This method starts with the sales forecast and then expresses thecost of goods sold, operating expenses, interest expense, and

other accounts as a percentage of projected sales.

– Using the Vectra example, the easiest way to do this is to recast

the historical income statement as a percentage of sales.



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Step 2: Preparing the Pro Forma Income Statement (cont.)

– By using dollar values taken from Vectra’s 2012 incomestatement (Table 4.12), we find that these percentages are

Table 4.15 A Pro Forma Income Statement, Using the


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Table 4.15 A Pro Forma Income Statement, Using thePercent-of-Sales Method, for Vectra Manufacturing for theYear Ended December 31, 2013



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Step 2: Preparing the Pro Forma Income Statement (cont.)

– Clearly, some of the firm’s expenses will increase with the levelof sales while others will not.

– the use of past cost and expense ratios generally tends tounderstate profits when sales are increasing. (Likewise, it tends

to overstate profits when sales are decreasing.)

– The best way to generate a more realistic pro forma income

statement is to segment the firm’s expenses into fixed andvariable components, as illustrated in the following example.



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Step 3: Preparing the Pro Forma Income Statement(cont.)

– Clearly, some of the firm’s expenses will increase with thelevel of sales while others will not.

– As a result, the strict application of the percent-of-salesmethod is a bit naïve.

– The best way to generate a more realistic pro formaincome statement is to segment the firm’s expenses intofixed and variable components.

– This may be demonstrated as follows.




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Step 3: Preparing the Pro Forma Balance Sheet

– The judgmental approach is a simplified approach for

preparing the pro forma balance sheet under which the firm

estimates the values of certain balance sheet accounts and uses

its external financing as a balancing, or “ plug,” figure.

– To apply this method to Vectra Manufacturing, a number of

simplifying assumptions must be made.



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Step 3: Preparing the Pro Forma Balance Sheet (cont.)1. A minimum cash balance of $6,000 is desired.

2. Marketable securities will remain at their current level of $4,000.

3. Accounts receivable will be approximately $16,875 whichrepresents 45 days of sales (about 1/8th of a year) on average[(45/365) × $135,000].

4. Ending inventory will remain at about $16,000. 25% ($4,000)represents raw materials and 75% ($12,000) is finished goods.

5. A new machine costing $20,000 will be purchased. Totaldepreciation will be $8,000. Adding $20,000 to existing net fixedassets of $51,000 and subtracting the $8,000 depreciation yields anet fixed assets figure of $63,000.



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Step 3: Preparing the Pro Forma Balance Sheet (cont.)6. Purchases will be $40,500 which represents 30% of annual sales

(30% × $135,000). Vectra takes about 73 days to pay on its accounts payable. As a result, accounts payable will equal $8,100 [(73/365) × $40,500].

7. Taxes payable will be $455 which represents one-fourth of the 2013tax liability.

8. Notes payable will remain unchanged at $8,300.

9. There will be no change in other current liabilities, long-term debt,and common stock.

10. Retained earnings will change in accordance with the pro formaincome statement.

Table 4.16 A Pro Forma Balance Sheet,


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Using the Judgmental Approach, forVectra Manufacturing (December 31, 2013)

Evaluation of Pro Forma


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Evaluation of Pro FormaStatements

• The major weaknesses of the approaches to pro formastatement development outlined above lie in two

assumptions:

– That the firm’s past financial performance will be replicated inthe future

– That certain variables (such as cash, accounts receivable, and

inventories) can be forced to take on certain “desired ” values.

• These assumptions cannot be justified solely on the basisof their ability to simplify the calculations involved.

Evaluation of Pro Forma


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Evaluation of Pro FormaStatements (cont.)

However pro forma statements are prepared, analysts mustunderstand how to use them to make financial decisions.

– Financial managers and lenders can use pro forma statements toanalyze the firm’s inflows and outflows of cash, as well as its

liquidity, activity, debt, profitability, and market value. – Various ratios can be calculated from the pro forma income

statement and balance sheet to evaluate performance.

– Cash inflows and outflows can be evaluated by preparing a pro

forma statement of cash flows. – After analyzing the pro forma statements, the financial manager

can take steps to adjust planned operations to achieve short-termfinancial goals.

04 - chapter 4 cash flow financial planning

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