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Gitman, Juchau, Flanagan, Principles of Managerial Finance 5e : © 2008 Pearson Education Australia

BFA281 Financial Management

Tony Stanger

Gitman, Juchau, Flanagan, Principles of Managerial Finance 5e: © 2008 Pearson Education Australia 1

Week 2

Cash Flow and Financial Planning (Chapter 3)

Learning Objectives

• Importance of cash flow to business survival

• Describe the firm’s cash flow statement, operating cash flow and free cash flow

• Understand the financial planning process


Understand the financial planning process

• Discuss cash planning process and budgets

• Prepare pro forma financial statements

• Evaluate the approaches to pro forma financial statement preparation

Importance of a firm’s cash flow

What is cash flow?• the actual net cash (not net income or accounting

profit) that flows in or out of a firm during a specified period


The importance of cash flow• ‘lifeblood’ of the firm - payment for inventory and other

current assets (CA), non-current assets (NCA), wages/salaries (CL), interest on debt (repayment of principal) (CL & NCL), dividends … must all be paid with cash and on time


Importance of a firm’s cash flow

The importance of cash flow (cont.)

• a firm can be profitable, but have poor (or negative) cash flow, leading to insolvency


• a firm can ‘fail’ the day it misses paying a creditor, due to legal action leading to receivership/ bankruptcy e.g. Hartz Mineral Water

Analysing the firm’s cash flow

Tools for analysing a firm’s cash flow include

• Past - statement of cash flows


• Future – financial planning can involve

• Cash budgeting

• Pro forma financial statements• Income statement

• Balance sheet

Statement of cash flows

Three types of cash flow• Operating cash flow

• associated with the production (outflow) and sale of goods and services (inflow) i.e. normal operations


• Investing cash flow• arise from the purchase (outflow) and sale of NCA

like property, plant and equipment (inflow)

• Financing cash flow• result from the issue of debt and equity securities

(inflow), and payment of interest/ dividends, repayment/ repurchase of principal/ shares (outflow)



Step one:

• Classifying transaction as inflows and outflows of cash


inflows outflowsdecrease in asset increase in assetincrease in liability decrease in liabilitynet profits after tax net lossdepreciation dividends paidsale of shares repurchase of shares


Step two:

• Involves categorising inflows and outflows of cash into operating, investing and


financing flows

• Covered in Financial Accounting units

• Students not required to prepare a statement of cash flows in BFA281, rather to understand and interpret


Step three:

• Interpreting the statement of cash flows by answering 3 questions


• What were the sources of funds during the year?

• How did the firm use available funds?

• Did operations during the year tend to increase or decrease the firm’s liquidity, as measured by cash and marketable securities balance


Operating cash flow (OCF)

• Reconciling OCF from the Income Statement

• Alternative definitions of OCF exist


• Accounting definition• cash flow from operations (CFO) = net profits after

tax + depreciation and other non cash charges (amortisation & depletion) [3.1]

• Includes interest as an operating expense

• This assumes no change in CA (debtors, inventory) and CL (creditors, accrued expenses)


• Reconciling OCF from the Income Statement (cont.)

• Finance definition


Finance definition• OCF = net operating profits after tax + depreciation

and other non-cash charges ( amortisation & depletion) [3.4]

• = NOPAT + (deprec, amort & depletion)

• = [EBIT x (1-T)] + (deprec, amort & depletion)

• Interest is excluded as an operating cash flow as it is a financing cash flow


Why allow for (add back) depreciation?

• Definition: annual non-cash charge against income for the portion of non-current assets

d i d ti


used up in production

• Depreciation expense determined by• depreciable ‘value’ of NCA• depreciable ‘life’ of NCA• depreciation method used i.e. prime cost (straight

line) or diminishing value (reducing balance)


Free cash flow (FCF)

• FCF is the cash available to owners (shareholders and creditors) after meeting all operating needs and paying for investments in NNCA and NCA


• Some firms count essential maintenance of e.g. gas transmission and distribution pipelines as an operating need e.g. Envestra

Free cash flow (FCF)

• FCF = OCF – NNCAI – NCAI [3.5]

• Where• NNCAI = net non-current asset investment


= change in net non-current assets + depreciation [3.6]

• NCAI = net current asset investment= change in current assets – change in (accounts

payable and accruals) [3.7]

Examples of CFO, OCF & FCF

• Using the Baker Corporation example in Gitman

• CFO = net profit after tax + depreciation expense= $180 + $100 = $280


• OCF = EBIT (1 – Tax rate) + depreciation= $370 (1 – 0.4) + $100 = $322

• FCF = OCF – NNCAI – NCAI= $322 – (1,200 – 1,000 + 100) – [(2,000 – 1,900)* - (800 – 700)**]

= $322 - $300 -$0 = $22* current assets – cash, marketable securities, debtors, invent.** current liabilities – accounts payable, accruals


Financial planning process

What is financial planning?

• Sets financial goals

• Formulates strategies for achieving goals

Statement of what is to be done in the


• Statement of what is to be done in the future• Most decisions involve long lead times and

therefore decisions must be made far in advance of their implementation

• e.g. to build a factory in 2012 we may need to arrange contractors and financing in 2010


Growth as a financial management goal?

• Growth rates are commonly used in the


planning process as it is convenient in summarising aspects a firm’s financial and investment policies

• But, growth may not guarantee an increase in share price


Growth as a financial management goal?• Example: Is sales growth of 15% with constant

net profit margin of 6% preferred over increased profit margin to 7% on constant


sales and reduced costs?• In this case firm value is enhanced more by the

latter e.g. let original sales = $100• $100 x 1.15 x 0.06 = $6.90 net profit, which is less than

the alternative goal

• $100 x 0.07 = $7.00 net profit



Dimensions of financial planning

• Planning horizon


• long run = ‘strategic’• 2 to 10 years, depending on uncertainty and

production cycles e.g. cars v fashion

• short run = ‘operating’• 1 to 2 years


Dimensions of financial planning (cont.)

• Aggregation


• smaller investment proposals of each operational unit are added up to and treated as one big project


Dimensions of financial planning (cont.)

• Establish inputs in form of alternative sets


of assumptions for important variables• Pessimistic or worst case

• Normal case – most likely assumptions about company and economy

• Optimistic or best case



Benefits of financial planning

• Interactions• Linkages between investment and financing

• Options


Options• Develop, analyse and compare different scenarios in a

consistent way

• Avoiding surprises• Develop contingency plans in case assumptions about the

future seriously wrong

• Feasibility and internal consistency• Prioritise conflicting goals e.g. growth over debt reduction



Cash planning

Components of the cash budget

• Sales forecastt l f t


• external forecast• observable relationships between sales and

e.g. GDP, new housing starts, unemployment rate

• internal forecast• firm’s view on sales as per sales manager and

production limitations


Cash planning

Components of the cash budget (cont.)


Cash planning


• cash receipts


cash receipts

- forecast sales

- cash sales

- collections of A/R

- lagged

- other

Cash planning


• cash disbursementscash dividends


- cash dividends- purchases- rent- wages- tax- non current assets- interest/principal


Cash planning

Interpreting the cash budget

• net cash flow• combined effect of operating, investing and financing activities


• ending cash• beginning balance + net cash flow = ending balance

• excess cash balance• Repay debt, invest or return to shareholders?

• required total financing• raise funds – how, where, amount, terms?

Cash planning

Evaluating the cash budget

• meeting a cash shortfall• issue debt or equity, short or long term?


• coping with uncertainty• run simulations; or pessimistic, most likely and

optimistic scenarios

• cash flow within the month (intra month)• day to day cash flows and solvency

Profit planning

Profit planning: projecting the firm’s overall financial position

• ‘pro forma’ statements are used (projections)


p (p j )• estimations involved and assume relationships in past

FS will apply this period

• two ingredients needed• previous year’s financial statements• sales forecast for coming year

• accuracy important and marketing department input necessary


Profit planning

Preparing the pro forma income statement

• percent-of-sales method, e.g. Vectra Manufacturing 31/12/2007 (pp.117-20)

( t f d ld) / ( l ) 80%


• (cost of goods sold) / (sales) = 80%

• (operating expenses) / (sales) = 10%

• (interest expense) / (sales) = 1%

• Vectra example assumes all expenses variable• understates Net Profit when sales grow

• validity of this assumption?

Profit planning

Preparing the pro forma income statement (cont.)

• fixed costs may exist in reality


• fixed over a relevant range of sales e.g. depreciation, administrative and sales staff?

• variable costs• factory labour, materials, power, taxes

• existence of fixed costs creates ‘operating leverage’

Profit planning

Preparing the pro forma balance sheet to determine external funds required

• Judgmental approach – most popular and incorporates:


• percent-of-sales method which assumes• Most BS accounts tied directly to sales

• The current levels of all assets are optimal for the current sales level

• calculation of items that change spontaneously• CA - e.g. inventory, debtors

• CL- e.g. creditors, accruals, taxes

• SHE - retained profits (for a given dividend policy/payout ratio)

• CL and Retained Earnings are sources of spontaneous financing


Profit planning

Preparing the pro forma balance sheet to determine external funds required (cont.)

• Judgmental approach – most popular and incorporates:


• estimation of others – specific management action or discretion required

• NCA – ↑ if no excess capacity, but investment ‘lumpy’

• NCL – will long-term debt (e.g. notes payable, bonds, term loans) change?

• SHE – will Issued Capital change?

• NCL and Issued Capital are sources of discretionary financing used to maintain the accounting equation A = L + OE

Profit planning

Preparing the pro forma balance sheet to determine external funds required (cont.)

• If A > L+OE additional financing needed (AFN) is the ‘plug’ figure in the Balance Sheet


p g g• AFN can be sourced from

• ↑CL – e.g. bank bills, overdraft

• ↑NCL – e.g. notes payable, bonds, term loans

• If A < L+OE, suggests sales contraction and excess financing exists

Profit planning

Evaluating the pro forma statements/ limitations of the percent-of-sales method

• Benefit of method is its simplicity


• But assumes we can accurately forecast future financial items like assets as a given % of sales• This may be valid assumption where e.g. inventory levels rise and

fall in direct proportion to sales volume

• But, depending on nature of firm operations and types of assets used, this 1-to-1 relationship may not hold


Profit planning


• Non-current assets• Large-scale equipment may need to be purchased or built well

beyond the capacity required i.e. ‘lumpy assets’


y p y q py

• Where excess capacity exists, investment may not increase for a given level of sales

• Current assets• Are assumed values of some variables realistic?

• Cash, debtors and inventories may be hard to control• e.g. ↑interest rates reduce business optimism and affect debtor

payments

• huge price rises for commodities in mining sector

Profit planning


• Current assets


• Relationships between sales and other accounts may change beyond a relevant range e.g.

• quantity discounts impacting inventory and COGS

• Some firms purchase finished goods inventories daily on demand, while others maintain a base level which grows less rapidly than sales, so the ratio of inventory to sales declines

Profit planning

Determinants of a sustainable growth rate

• Profit margin


• Dividend policy

• Financial policy

• Total asset turnover


Quiz

1. If EBIT = $2,700, taxes = $200 and depreciation = $500, then operating cash flow equals:

A) $2,900

B) $2,500

C) $2,200

D) $3,000

2 All of the following are used in cash planning EXCEPT:


2. All of the following are used in cash planning EXCEPT:

A) internal forecasts

B) external forecasts

C) accruals

D) sales forecasts

3. A pro forma statement summarises:

A) the firm's projected income and/or balance sheet

B) the current level of retained earnings

C) inventory holdings

D) the balance sheet

Quiz

4. When preparing the pro forma income statement, the use of past ratios:

A) maximises net profits after taxes

B) is legally compulsory

C) tends to overstate profits when sales are falling

D) cannot distinguish between fixed and variable costs

5. Under the judgemental approach to pro forma statements:

A) all the items are econometrically modelled


) a t e te s a e eco o et ca y ode ed

B) some of the items are set by the governing authorities

C) none of the revenue items can be entered

D) some values are estimated and others are calculated

6. The firm will often use different methods of depreciation for tax reporting than for internal reporting because:

A) it wants to avoid triple taxation on dividends

B) the objectives of financial reporting are different from those of tax legislation

C) there is no incentive to encourage investors to increase their shareholding

D) to lower the cost of equity financing for the company

Week 3 Tutorial

Review Questions and Problems from Chapter 3 to be covered in the Week 3 Tutorial:

Review Questions 3.4, 3.11, 3.13, 3.14 & 3.17


Problems 3.10, 3.14 & 3.24

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