chapter 4 cash flow financial planning (1)

7/28/2019 Chapter 4 Cash Flow Financial Planning (1)

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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 firms cash flows.

LG2 Discuss the firms 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 Firms 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 firms 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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Developing the Statement ofCash Flows

The statement of cash flows summarizes the firms cashflow over a given period of time.

Firms cash flows fall into three categories:

Operating flows: cash flows directly related to sale andproduction of the firms products and services.

Investment flows: cash flows associated with purchase and saleof both fixed assets and equity investments in other firms.

Financing flows: cash flows that result from debt and equityfinancing transactions; include incurrence and repayment ofdebt, cash inflow from the sale of stock, and cash outflows torepurchase stock or pay cash dividends.


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Table 4.3Inflows and Outflows of Cash


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Table 4.4 Baker Corporation2009 Income Statement ($000)


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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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Table 4.6 Baker Corporation Statement of CashFlows ($000) for the Year Ended December 31,2012


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Interpreting Statement ofCash Flows

The statement of cash flows ties the balance sheet at the

beginning of the period with the balance sheet at the end

of the period after considering the performance of the

firm during the period through the income statement. The net increase (or decrease) in cash and marketable

securities should be equivalent to the difference between

the cash and marketable securities on the balance sheet at

the beginning of the year and the end of the year.


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Operating Cash Flow

A firms operating Cash Flow (OCF) is the cash flow

a firm generates from normal operationsfrom 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 Bakers operations are

generating 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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Focus on Practice

Free Cash Flow at Cisco Systems

On May 13, 2010, Cisco Systems reported earnings per share of $0.42 for the

most recent quarter, ahead of the expectations of Wall Street experts who had

projected EPS of $0.39.

In subsequent analysis, one analyst observed that of the three cents by whichCisco beat the streets forecast, one cent could be attributed to the fact that the

quarter was 14 weeks rather than the more typical 13 weeks. Another penny

was attributable to unusual tax gains, and the third was classified with the

somewhat vague label, other income.

Free cash flow is often considered a more reliable measure of a companys

income than reported earnings. What are some possible ways that corporate

accountants might be able to change their earnings to portray a more

favorable earnings statement?


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The Financial Planning Process

The financial planningprocessbegins 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 firms 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 acompanys 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 companys integratedstrategic plan (along with production and marketingplans) 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 financial

activities 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.


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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 preparedultimately leading to the

development of the pro forma balance sheet.


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Cash Planning: Cash Budgets

The cash budget orcash forecast is a statement of the

firms planned inflows and outflows of cash that is used to

estimate its short-term cash requirements.

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

The more seasonal and uncertain a firms cash flows, the

greater the number of intervals.


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Cash Planning:Cash Budgets (cont.)

A sales forecast is a prediction of the sales activity during a givenperiod, 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 firms sales and certain key external economic indicators. An internal forecast is a sales forecast based on a buildup, or consensus, of

sales forecasts through the firms own sales channels.


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Table 4.7 The General Format ofthe Cash Budget


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Cash Planning: Cash BudgetsAn Example: Coulson Industries

Coulson Industries, a defense contractor, is developing a

cash budget for October, November, and December.

Coulsons sales in August and September were $100,000

and $200,000 respectively. Sales of $400,000, $300,000 and

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

December. Historically, 20% of the firms sales have been

for 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 BudgetsAn Example: Coulson Industries (cont.)

Coulson has also gathered the relevant information for the

development of a cash disbursement schedule. Purchases

will represent 70% of sales10% will be paid immediately

in 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)


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Cash Planning: Cash BudgetsAn 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, Coulsons cash balance

was $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.

T bl 4 10 A C h B d t f


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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.

C i ith U t i t i th


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Coping with Uncertainty in theCash Budget

One way to cope with cash budgeting uncertainty is toprepare 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 ofsensitivity analysis for

Coulson Industries is shown on the following slide.


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


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Table 4 12 Vectra Manufacturings


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

T bl 4 13 V t M f t i


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Table 4.13 Vectra ManufacturingsBalance Sheet, December 31, 2012

T bl 4 14 2010 S l F t


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Table 4.14 2010 Sales Forecastfor Vectra Manufacturing

P fit Pl i P F


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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.

Profit Planning: Pro Forma


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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 Vectras 2012 income

statement (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 the

Year Ended December 31, 2013



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

Clearly, some of the firms expenses will increase with the level

of 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 firms expenses into fixed andvariable components, as illustrated in the following example.

Profit Planning Pro Forma


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

Clearly, some of the firms 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 nave.

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

This may be demonstrated as follows.




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Step 3: Preparing the Pro Forma Balance Sheet

Thejudgmental 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, orplug, 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 accountspayable. 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 1998tax 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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Table 4.16 A Pro Forma Balance Sheet,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 firms 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 firms 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 managercan take steps to adjust planned operations to achieve short-termfinancial goals.


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Review of Learning Goals

LG1 Understand tax depreciation procedures and the effect ofdepreciation on the firms cash flows.

Depreciation is an important factor affecting a firms cash flow. Anassets depreciable value and depreciable life are determined by usingthe MACRS standards in the federal tax code.

LG2 Discuss the firms statement of cash flows, operating cashflow, and free cash flow.

The statement of cash flows is divided into operating, investment,and financing flows. It reconciles changes in the firms cash flows

with changes in cash and marketable securities for the period. From astrict financial point of view, a firms operating cash flow is definedto exclude interest. Of greater importance is a firms free cash flow,which is the amount of cash flow available to creditors and owners.



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Review of Learning Goals(cont.)

LG3 Understand the financial planning process, including long-term(strategic) financial plans and short-term (operating) financial

plans.

The two key aspects of the financial planning process are cash planning

and profit planning. Long-term (strategic) financial plans act as a guidefor preparing short-term (operating) financial plans. Long-term plans

tend to cover periods ranging from 2 to 10 years; short-term plans most

often cover a 1- to 2-year period.


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

sheet.

A pro forma income statement can be developed by calculating past

percentage relationships between certain cost and expense items and thefirms sales and then applying these percentages to forecasts.

Under the judgmental approach, the values of certain balance sheet

accounts are estimated and the firms external financing is used as a

balancing, orplug, figure.



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LG6 Evaluate the simplified approaches to pro forma financialstatement preparation and the common uses of pro forma

statements.

Simplified approaches for preparing pro forma statements assume that

the firms past financial condition is an accurate indicator of the future.Pro forma statements are commonly used to forecast and analyze the

firms level of profitability and overall financial performance so that

adjustments can be made to planned operations to achieve short-term

financial goals.

Chapter Resources on


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chapter 4 cash flow financial planning (1)

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