Bba 2204 fin mgt week 4 cashflow & financial planning

BBA 2204 FINANCIAL MANAGEMENT

Cashflow
Cashflow
and
and
Financial Planning
Financial Planning
by
Stephen Ong
Visiting Fellow, Birmingham City
University Business School, UK
Visiting Professor, Shenzhen

Learning Goals

1. Understand tax depreciation procedures and the effect of
depreciation on the firm’s cash flows.
2. Discuss the firm’s statement of cash flows, operating cash
flow, and free cash flow.
3. Understand the financial planning process, including longterm (strategic) financial plans and short-term (operating)
financial plans.
4. Discuss the cash-planning process and the preparation,
evaluation, and use of the cash budget.
5. Explain the simplified procedures used to prepare and evaluate
the pro forma income statement and the pro forma balance
sheet.
6. Evaluate the simplified approaches to pro forma financial
statement preparation and the common uses of pro forma
statements.

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 closely monitored by participants in the
capital market.

4-4

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.

4-5

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.
4-6

Depreciation: Depreciable Value
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.

4-7

Table 4.1 First Four Property
Classes under MACRS

4-8

Table 4.2 Rounded Depreciation
Percentages by Recovery Year Using
MACRS for First Four Property Classes

4-9

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:

4-10

Developing the Statement of
Cash Flows

• The statement of cash flows summarizes the firm’s cash
flow over a given period of time.
• Firm’s cash flows fall into three categories:
∗ Operating flows: cash flows directly related to sale
and production of the firm’s products and services.
∗ Investment flows: cash flows associated with
purchase and sale of both fixed assets and equity
investments in other firms.
∗ Financing flows: cash flows that result from debt and
equity financing transactions; include incurrence and
repayment of debt, cash inflow from the sale of stock,
and cash outflows to repurchase stock or pay cash
dividends.
4-11

Table 4.3
Inflows and Outflows of Cash

4-12

Table 4.4 Baker Corporation 2012
Income Statement ($000)

4-13

Table 4.5a Baker Corporation
Balance Sheets ($000)

4-14

Table 4.5b Baker Corporation
Balance Sheets ($000)

4-15

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

4-16

Interpreting Statement of
Cash 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.
4-17

Operating Cash Flow
• A firm’s operating Cash Flow (OCF) is the cash flow
a 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

Operating Cash Flow (cont.)
• Substituting for Baker Corporation, we get:
OCF = [$370 × (1 – .40)] + $100 = $322

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

4-19

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).

FCF = OCF – NFAI – NCAI
• Where:
NFAI = Change in net fixed assets + Depreciation
NCAI = Change in CA – Change in (A/P + Accruals)
4-20

Free Cash Flow (cont.)
• Using Baker Corporation we get:
NFAI = [($1,200 – $1,000) + $100] = $300
NCAI = [($2,000 – $1,900) + ($800 - $700)] = $0

FCF = $322 – $300 – $0 = $22
• Thus, the firm generated adequate cash flow to
cover all of its operating costs and investments
and had free cash flow available to pay
investors.

4-21

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 which Cisco beat the street’s 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
company’s income than reported earnings. What are some possible
ways that corporate accountants might be able to change their
4-22 earnings to portray a more favorable earnings statement?

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.

The Financial Planning Process:
Long-Term (Strategic) Financial Plans
• Long-term (strategic) financial plans lay out a
company’s planned financial actions and the
anticipated impact of those actions over periods
ranging from 2 to 10 years.
• Firms that are subject to high degrees of operating
uncertainty, relatively short production cycles, or
both, tend to use shorter planning horizons.
• These plans are one component of a company’s
integrated strategic plan (along with production
and marketing plans) that guide a company
toward achievement of its goals.

4-24

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.

4-25

Focus on Ethics

∗ How Much Is a CEO Worth?

4-26

∗ Bob Nardelli abruptly resigned his position as Home Depot CEO
on
January 3, 2007.
∗ Nardelli’s total severance package amounted to $210 million,
including
$55.3 million of life insurance coverage, reimbursement of $1.3
million of personal taxes related to the life insurance, $50,000
to cover his legal fees, $33.8 million in cash due July 3, 2007, an
additional $18 million over 4 years for abiding by the terms of
the deal, and the balance of the package from accelerated
vesting of stock options.
∗ In addition, Nardelli and his family would receive health-care
benefits from the company for the next 3 years.
∗ What are some possible activities that Nardelli must avoid in
order to reap the additional $18 million over 4 years?

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
operating and financial data.
• Key outputs include operating budgets, the cash
budget, and pro forma financial statements.
• This process is described graphically on the
following slide.
4-27

Figure 4.1
Short-Term Financial Planning

4-28

Short-Term (Operating) Financial Plans

4-29

• 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 labour, factory
overhead, and operating expense estimates are
developed.
• From this information, the pro forma income statement
and cash budget are prepared—ultimately leading to
the development of the pro forma balance sheet.

Personal Finance Example
∗ First step – define your goals.

4-30

∗ Short-term (1 year)
∗ Intermediate-term (2–5 years)
∗ Long-term (6+ years)
∗ Each goal should be clearly defined and have a
priority, time frame, and cost estimate.
∗ For example, a college senior’s intermediate-term
goal in 2012 might include earning a master’s
degree at a cost of $40,000 by 2012, and his or
her long-term goal might be to buy a
condominium at a cost of $125,000 by 2016.

Cash Planning: Cash Budgets
• The cash budget or cash forecast is a
statement of the firm’s 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-year period, divided into smaller
time intervals.
• The more seasonal and uncertain a firm’s cash
flows, the greater the number of intervals.

4-31

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 monthly cash 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.

4-32

∗ 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, of sales forecasts through the firm’s own sales
channels.

Table 4.7 The General Format
of the Cash Budget

4-33

An Example: Coulson Industries

∗Coulson Industries, a defence contractor, is
developing a cash budget for October, November,
and December. Coulson’s 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
firm’s sales have been for cash, 50% have been
collected after 1 month, and the remaining 30%
after 2 months. In December, Coulson will receive a
$30,000 dividend from stock in a subsidiary.

4-34

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

4-35

An Example: Coulson Industries (cont.)
∗Coulson has also gathered the relevant information
for the development of a cash disbursement
schedule. Purchases will represent 70% of sales—
10% 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 resulting
disbursement schedule thus follows.
4-36

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

4-37

An Example: Coulson Industries (cont.)

∗The Cash Budget for Coulson Industries can be
derived by combining the receipts budget with the
disbursements budget. At the end of September,
Coulson’s 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.
4-38

Table 4.10 A Cash Budget for
Coulson Industries ($000)

4-39

Evaluating the Cash Budget
• Cash budgets indicate the extent to which cash
shortages or surpluses are expected in the months
covered by the forecast.

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

Personal Finance Example
• Because individuals receive only a finite amount of
income (cash inflow) during a given period, they need to
prepare budgets in order to make sure they can cover
their expenses (cash outflows) during the period.

4-41

Coping with Uncertainty in
the Cash Budget
•

One way to cope with cash budgeting uncertainty
is to prepare several cash budgets based on
several forecasted scenarios (e.g., pessimistic,
most likely, optimistic).
optimistic
• From this range of cash flows, the financial
manager can determine the amount of financing
necessary to cover the most 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.

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

4-43

Profit Planning:
Pro Forma Statements

• Pro forma financial statements are projected, or
forecast, income statements and balance sheets.
• The inputs required to develop pro forma
statements using the 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 Vectra Manufacturing.
4-44

Table 4.12 Vectra Manufacturing’s
Income Statement for the Year Ended
December 31, 2012

4-45

Table 4.13 Vectra Manufacturing’s
Balance Sheet, December 31, 2012

4-46

Table 4.14 2010 Sales Forecast
for Vectra Manufacturing

4-47

Profit Planning: Pro Forma
Financial 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 labour, materials, & overhead.

4-48


∗ 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 the cost 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.
4-49


(cont.)
∗ By using dollar values taken from Vectra’s 2012 income
statement (Table 4.12), we find that these percentages are

4-50

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

4-51


(cont.)

4-52

∗ Clearly, some of the firm’s expenses will increase with
the level of sales while others will not.
∗ the use of past cost and expense ratios generally tends to
understate 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 and variable components, as illustrated in the
following example.


∗ 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.
4-53


(cont.)
1.
2.
3.
4.
5.
4-54

A minimum cash balance of $6,000 is desired.
Marketable securities will remain at their current level of
$4,000.
Accounts receivable will be approximately $16,875 which
represents 45 days of sales (about 1/8th of a year) on average
[(45/365) × $135,000].
Ending inventory will remain at about $16,000. 25% ($4,000)
represents raw materials and 75% ($12,000) is finished goods.
A new machine costing $20,000 will be purchased. Total
depreciation will be $8,000. Adding $20,000 to existing net fixed
assets of $51,000 and subtracting the $8,000 depreciation yields
a net fixed assets figure of $63,000.


(cont.)

4-55

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 1998 tax liability.
8. Notes payable will remain unchanged at $8,300.
9. There will be no change in other current liabilities, longterm debt, and common stock.
10. Retained earnings will change in accordance with the pro
forma income statement.

Table 4.16 A Pro Forma Balance Sheet,
Using the Judgmental Approach, for
Vectra Manufacturing (December 31, 2013)

4-56

Evaluation of Pro Forma
Statements
• The major weaknesses of the approaches to pro

forma statement development outlined above lie in
two assumptions:
∗ That the firm’s past financial performance will be
replicated in the 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
basis of their ability to simplify the calculations
involved.

4-57

Evaluation of Pro Forma
Statements (cont.)

∗However pro forma statements are prepared, analysts must
understand how to use them to make financial decisions.
∗ Financial managers and lenders can use pro forma statements to
analyze 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-term
financial goals.
4-58

Review of Learning Goals

Understand tax depreciation procedures and the effect of
depreciation on the firm’s cash flows.
•Depreciation is an important factor affecting a firm’s cash flow.
An asset’s depreciable value and depreciable life are determined
by using the MACRS standards in the federal tax code.

Discuss the firm’s statement of cash flows, operating cash
flow, and free cash flow.

∗ The statement of cash flows is divided into operating, investment,
and financing flows. It reconciles changes in the firm’s cash flows
with changes in cash and marketable securities for the period.
From a strict financial point of view, a firm’s operating cash flow
is defined to exclude interest. Of greater importance is a firm’s free
cash flow, which is the amount of cash flow available to creditors
4-59 and owners.

Review of Learning Goals (cont.)
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 guide for preparing shortterm (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.

Discuss the cash-planning process and the preparation, evaluation,
and use of the cash budget.
∗The cash-planning process uses the cash budget, based on a sales forecast, to
estimate short-term cash surpluses and shortages. The cash budget nets cash
receipts and disbursements for each period to calculate net cash flow. Ending cash
is estimated by adding beginning cash to the net cash flow. By subtracting the
desired minimum cash balance from the ending cash, the firm can determine
required total financing or the excess cash balance.
4-60

Explain the simplified procedures used to prepare and evaluate
the 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 the firm’s sales and then applying these
percentages to forecasts.
∗Under the judgmental approach, the values of certain balance
sheet accounts are estimated and the firm’s external financing is
used as a balancing, or “plug,” figure.

4-61

Evaluate the simplified approaches to pro forma financial
statement preparation and the common uses of pro forma
statements.
∗Simplified approaches for preparing pro forma statements
assume that the firm’s past financial condition is an accurate
indicator of the future. Pro forma statements are commonly
used to forecast and analyze the firm’s level of profitability
and overall financial performance so that adjustments can
be made to planned operations to achieve short-term
financial goals.
4-62

Further Reading
∗ Gitman, Lawrence J. and Zutter ,Chad
J.(2013) Principles of Managerial
Finance, Pearson,13th Edition
∗ Brooks,Raymond (2013) Financial
Management: Core Concepts ,
Pearson, 2th edition
1 - 63

Bba 2204 fin mgt week 4 cashflow & financial planning

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