Cash Flow and Financial Planning Chapter (3) Cash Flow and Financial Planning

Objectives to be achieved Understand tax depreciation & effect of depreciation on cash flow Discuss the statement of cash flows, operating cash flow, & free cash flow Understand the financial planning process, incl. long-term (strategic) financial plans & short-term (operating) financial plans

Objectives to be achieved Discuss the cash-planning process & the preparation, evaluation, & use of cash budget Explain the simplified procedures used to prepare and evaluate the pro forma income statement/pro forma balance sheet Evaluate the simplified approaches to pro forma financial statement preparation & common uses of pro forma statements

Analyzing the Firm’s Cash Flow Cash flow (as opposed to accounting “profits”) is the primary focus of the financial manager (not cash charges) • An important factor affecting cash flow is depreciation. • 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.

Analyzing the Firm’s Cash Flow Depreciation is the systematic charging of a portion of the costs of fixed assets 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 (e.g. straight-line, double-declining balance…etc)

Analyzing the Firm’s Cash Flow Depreciation: Financial managers are much more concerned with cash flows rather than profits. To adjust the income statement to show cash flows from operations, all non-cash charges should be added back to net profit after taxes. By lowering taxable income, depreciation and other non-cash expenses create a tax shield and enhance cash flow.

Analyzing the Firm’s Cash Flow: Depreciation: + Notes: Tax Shield is a reduction in income taxes that results from taking an allowable deduction from taxable income. The shorter the depreciable life, the more quickly the cash flow created by the depreciation write-off will be received. It is preferable by financial managers! Land values are not depreciable. The depreciable value of real estate should exclude land values.

Analyzing the Firm’s Cash Flow Depreciable Value/Life Under the basic MACRS procedures, the depreciable value of an asset is its full cost, including outlays for installation (example). No adjustment is required for expected salvage value. For tax purposes, the depreciable life (time period over which an asset is depreciated) of an asset is determined by its MACRS recovery predetermined period. There are six recovery periods. MACRS property classes and rates are shown in Table 3.1 and Table 3.2 on the following slides.

Depreciation

Depreciation

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 in the following slide: (page 106 below) Note: Because financial managers focus on cash flows, only tax depreciation methods will be utilized throughout this text.

Depreciation: An Example

Developing the Statement of Cash Flows The statement of cash flows summarizes the firm’s cash flow over a given period of time. The statement of cash flows is divided into three sections: – Operating flows – Investment flows – Financing flows The nature of these flows is shown in Figure 3.1 page 107 (have a look at it)

Developing the Statement of Cash Flows The operating flows are cash inflows and outflows directly related to the sale & production of the firm’s products and services. The investment flows are cash flows associated with the purchase & sale of both fixed assets and business interests The financing flows are generated from debt and equity financing transactions. Incurring (or repaying) either short-term or long-term debt would result in a corresponding cash inflows/outflows

Developing the Statement of Cash Flows: Classifying Inflows and Outflows of Cash The statement of cash flows essentially summarizes the inflows and outflows of cash during a given period as shown in the following slide (Table 3.3) 1- Decrease/increase in any asset: (difficult for many to grasp (focus on the movement of funds in and out of your pocket: a decrease in cash (from the bucket) is an inflow (to your pocket); an increase in cash (in the bucket) is an outflow (from your pocket) 2- Depreciation (amortization & depletion) is a Non-cash charge. Because it shields the firm from taxes by lowering taxable income, the non-cash charge is considered as a cash inflow.

Developing the Statement of Cash Flows:

Preparing the Statement of Cash Flows: Income Statement

Preparing the Statement of Cash Flows: Income Statement (cont.)

Preparing the Statement of Cash Flows: Balance Sheet

Preparing the Statement of Cash Flows: Balance Sheet (cont.)

Preparing the Statement of Cash Flows: Statement of cash flows is developed using the income statement & balance sheet All cash inflows, net profits after taxes & depreciation are treated as positive values All cash outflows, any losses, and dividends paid are treated as negative values

Preparing the Statement of Cash Flows: Cash Flows Statement

Preparing the Statement of Cash Flows: Cash Flows Statement (con)

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.

Interpreting Statement of Cash Flows (cont.) Financial managers should pay special attention both to the major categories of cash flows and to the individual items of cash inflow and outflow, to assess whether any developments have occurred that are contrary to the company’s financial policies The statement is used to evaluate progress towards projected goals or to isolate inefficiencies (e.g. increases in A/Rec. or Inv. resulting in major cash outflows which indicate at forthcoming problems)

Cash Flow (Lifeblood of the Firm) The simple accounting definition of cash flow can be introduced – as an estimate -thru’ the following equation: (Cash flow from operation = N/Profits after tax + Dep. & other non-cash charge) Note that a firm can have a net loss (negative net profits after taxes) and still have positive cash flow from operations when depreciation (& other non-cash charges) during the period is greater than the net loss.

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 by finding 1st Net Operating Profit after Taxes (NOPTA) as follows: (this equation exclude interest & tax to get the true cash instead of the estimated cash) NOPTA is a firm’s earnings before interest and after taxes: NOPAT = EBIT x (1 – T) To convert NOPTA to operating cash flow, we add depreciation : OCF = NOPAT + Depreciation OCF = [EBIT x (1 – T)] + Depreciation

Operating Cash Flow (cont.) Substituting for Baker Corporation’s income statement (table 3.4), we get: OCF = [$370 x (1 - .40) + $100 = $322 Thus, we can conclude that Baker’s operations are generating positive operating cash flows. Notes: The finance definition of OCF excludes interest – a financing cost – as an operating cash flow, whereas the accounting definition includes it as an operating flow. When a firm has no interest expense, the accounting definition and the finance definition of operating cash flow would be the same.

Free Cash Flow Free Cash Flow (FCF) is the amount of cash flow available to debt and equity holders after meeting all operating needs and paying for its net fixed asset investments (NFAI) and net current asset investments (NCAI). FCF = OCF – NFAI - NCAI Where: NFAI = Change in net fixed assets + Depreciation NCAI = Change in CA – Change in A/P and Accruals

Accruals accruals are liabilities to pay for goods or services that have been received or supplied but have not been paid, invoiced or formally agreed with the supplier, including amounts due to employees (for example, amounts relating to accrued vacation pay). Although it is sometimes necessary to estimate the amount or timing of accruals, the uncertainty is generally much less than for provisions. "Accruals are often reported as part of trade and other payables, whereas provisions are reported separately." To add to the confusion, some legalistic accounting systems take a simplistic view of “’accrued revenue”’ and “’accrued expenses”’, defining each as revenue / expense that has not been formally invoiced. This is primarily due to tax considerations, since the act of issuing an invoice creates, in some countries, taxable revenue, even if the customer does not ultimately pay and the related receivable becomes uncollectible.

What is the difference between Notes Payable and Accounts Payable? While both of these are liabilities, Notes Payable involves a written promissory note. For example, if your company wishes to borrow $100,000 from its bank, the bank will require company officers to sign a formal loan agreement before the bank provides the money. (The bank might also require your company to pledge collateral and for the company owners to personally guarantee the loan.) Perhaps the loan paperwork will be a half inch high. Your company will record this loan in its general ledger account, Notes Payable. (The bank will record the loan in its general ledger account Notes Receivable.) Contrast the bank loan with phoning one of your company’s suppliers and asking for a delivery of products or supplies. On the next day the products arrive and you sign the delivery receipt. A few days later your company receives an invoice from the supplier and it states that the payment for the products is due in 30 days. This transaction did not involve a promissory note. As a result, this transaction is recorded in your company’s general ledger account Accounts Payable. The supplier will record the transaction with a debit to its asset account Accounts Receivable (and a credit to its account Sales).

Free Cash Flow (cont.) Using Baker Corporation we got: NFAI = [($1,200 yr 06 - $1,000 yr 05) + $100] = $300 i.e. Baker Corp. invested $300K in fixed assets during 2006 which represents a net cash outflow to acquire fixed assets And, if depreciation is more than change in FA then will have a negative NFAI which represents a net cash inflow, i.e. firm sold more assets than it acquired during the year!

Free Cash Flow (cont.) FCF = $322 – $300 - $0 = $22 NCAI = [($2,000 yr 06 - $1,900 yr 05) - ($800-$700)] = $0 * This means that Baker Corp. made no invest. in its CA, net of A/P & accruals. FCF = $322 – $300 - $0 = $22 This FCF can be used to pay its creditors (payment of interest) and equity holders (dividends). Therefore, we can say that the firm generated adequate cash flow to cover all of its operating costs & investments & had free cash flow available to pay investors.

The Financial Planning Process Financial planning involves guiding, coordinating, and controlling the firm’s actions to achieve its objectives. 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 the preparation of both cash budgets and pro forma financial statements. Pro forma statements - Financial statements that are projected for future time periods. Balance sheets, cash flow statements, and income statements are often projected to determine the expected future financial status of a business.

The Financial Planning Process: Long-Term (Strategic) Financial Plans The Fin. Planning process begins with long-term, or strategic, financial plans. These guide the formulation of short-term (operating) plans and budgets 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 exposed to a high degree of operating uncertainty tend to use shorter plans. 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.

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

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 and typically cover a one to two year operating period. 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 in figure 3.2 (page 115)

Cash Planning: Cash Budgets The cash budget or cash forecast is a statement of the firm’s planned inflows and outflows of cash. It is used to estimate short-term cash requirements with particular attention to anticipated cash surpluses and shortfalls. Surpluses must be invested and deficits must be funded. The cash budget is a useful tool for determining the timing of cash inflows and outflows during a given period. Typically, monthly budgets are developed covering a 1-year time period.

Cash Planning: Cash Budgets (cont.) The cash budget begins with a sales forecast, which is simply a prediction of the sales activity during a given period. A prerequisite to the sales forecast is a forecast for the economy, the industry, the company and other external (GDP, consumer confidence, Disposable PI, un-employment rate) and internal factors (sales channels, sales people, type of product, production capabilities) that might influence company sales. The sales forecast is then used as a basis for estimating the monthly cash inflows that will result from projected sales—and outflows related to production, overhead and other expenses. * The internal data provide insight into sales expectations, and external data provide a means of adjusting these expectations to take into account general economic factors.

Cash Planning: Preparing the Cash Budget (cont.)

Cash Planning: Preparing the Cash Budget (cont Cash Planning: Preparing the Cash Budget (cont.) – Net cash flow, Ending cash, Financing, and Excess Cash The net cash flow is found by subtracting the cash disbursement from cash receipts in each period. Adding the beginning cash to the firm’s net cash flow determine the ending cash for each period. Subtracting the desired minimum cash balance from ending cash results in either the required total financing or the excess cash balance.

Cash Receipts & Cash Disbursements The common components of cash receipts are cash sales, collections of A/Rs, and other cash receipts (e.g. interest received, dividends received, proceeds from the sale of equip., stock & bond sale proceeds, and lease receipts As for disbursements, it includes cash purchases, payments of A/Ps, rent (& lease) payments, wages/salaries, tax payments, FA outlays, interest payments, cash dividend payments, principal payments (loan) & repurchases/retirements of stock

Cash Planning: Cash Budgets An Example: Coulson Industries Coulson Industries, a defence contractor, is developing a cash budget for October, November, and December. Halley’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 (this assumes no bad debts!). In December, Coulson will receive a $30,000 dividend from stock in a subsidiary.

Cash Planning: Cash Budgets An Example: Coulson Industries (cont.) Based on this information, we are able to develop the following schedule of cash receipts for Coulson Industries (Table 3.8 – page 119)

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

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

Cash Planning: Cash Budgets 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.

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

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

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.

Cash Planning: Cash Budgets An Example: Coulson Industries (cont.) We can summarize the financial activities for each month as follows: October: invest $22K excess cash balance in marketable securities. November: liquidate the $22K of market. Securities and borrow $76K (notes payables) December: Repay $35K of N/Ps to leave $41K of outstanding required total financing FM’ll seek to borrow > the max. financing indicated because of uncertainty of ECVs

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). 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” or “what if” for Coulson Industries is shown on the following slide.

Coping with Uncertainty in the Cash Budget (cont.)

Coping with Uncertainty in the Cash Budget A second & more sophisticated way of coping with uncertainty in cash budget is Simulation. By simulating the occurrence of sales and other uncertain events, the firm can develop a probability distribution of its ending cash flows for each month. The financial decision maker can then use the probability distribution to determine the amount of financing needed to protect the firm adequately against any expected cash shortage. This will be discussed in details in Ch.10.

Cash Flow within the Month The information provided by the cash budget is not necessarily adequate for ensuring Solvency A firm must look more closely at its pattern of daily cash receipts and cash disbursements to ensure that adequate cash is available for paying bills as they come due. Because a firm’s cash flows are quite variable when viewed on a daily basis, effective cash planning requires a look beyond the cash budget Therefore, the FM should plan and monitor cash flow more frequently than on a monthly basis.

Profit Planning: Pro Forma Statements We’ve already learnt that: 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 the preparation of both cash budgets and pro forma financial statements. Profit planning relies on accrual concepts to project the firm’s profit & overall financial position The approaches for estimating the pro forma statements are all based on the belief that the firm’s past financial statements will not change in the coming period.

Profit Planning: Pro Forma Statements Pro forma financial statements are projected, or forecast, financial statements – 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 with 2 product models X & Y which are produced by the same process.

Profit Planning:Pro forma financial statements

Profit Planning: Pro Forma Financial Statements (cont.)

Profit Planning: Pro Forma Financial Statements (cont.) Step 1: Start with a Sales Forecast – The first and key input for developing pro forma financial statements is the sales forecast for Vectra Manufacturing.

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 labor, materials, & overhead.

Profit Planning: Pro Forma Financial Statements (cont.) 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, 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.

Profit Planning: Pro Forma Financial Statements (cont.) Step 2: Preparing the Pro Forma Income Statement (cont.) – Using these percentages and the sales forecast we developed, the entire income statement can be projected. – The results are shown in Table 3.15 (following slide – page 128)

Profit Planning: Pro Forma Financial Statements (cont.) Step 2:Preparing the Pro Forma Income Statement (cont.) * The expected contribution to retained earnings is $6,327 which represents a considerable increase over $3,650 in the preceding year

Profit Planning: Pro Forma Financial Statements (cont.) – It is important to note that this method implicitly assumes that all costs are variable and that all increase or decrease in proportion to sales. - This approach implies that the firm will not receive the benefits (increased profit) that result from fixed costs when sales are increasing! – Therefore, this will understate profits when sales are increasing and overstate them when sales are decreasing. The key point to recognize here is that when the firm’s revenue is increasing, fixed costs can magnify/maximize returns.

Profit Planning: Pro Forma Financial Statements (cont.) Step 2: Preparing the Pro Forma Income Statement (cont.) – Clearly, some of the firm’s expenses will increase with sales level while others will not. – As a result, the strict application of the percent-of sales method is a bit naïve. – The best way to generate a more realistic pro forma income statement is to segment the firm’s expenses into fixed and variable components. – This may be demonstrated as follows.

Profit Planning: Pro Forma Financial Statements (cont.) Step 2:Preparing the Pro Forma Income Statement (cont.) * By assuming all costs are variable, NPBT equals 9% of sales ($9K/$100K). So, 2007 NPBT would’ve been $12,150 (9% of $135K) instead of $28,250 obtained by using the fixed-cost-variable cost breakdown.

Profit Planning: Pro Forma Financial Statements (cont.) Step 3: Preparing the Pro Forma Balance Sheet – Probably the best approach to use in developing the pro forma balance sheet is the judgmental approach. – Under this simple method, the values of some balance sheet accounts are estimated and the company’s external financing requirement is used as the balancing account. – To apply this method to Vectra Manufacturing, a number of simplifying assumptions must be made

Profit Planning: Pro Forma Financial Statements (cont.) Step 3: Preparing the Pro Forma Bal 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 which represents 45 days of sales on average [(45/365) x $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. 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.

Profit Planning: Pro Forma Financial Statements (cont.) Step 3: Preparing the Pro Forma Bal Sheet (cont.) 6. Purchases will be $40,500 which represents 30% of annual sales (30% x $135,000). Vectra takes about 73 days to pay on its accounts payable. As a result, accounts payable will equal $8,100 [(73/365) x $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, long-term debt, and common stock. 10.Retained earnings will change in accordance with the pro forma income statement.

Profit Planning: Pro Forma Financial Statements (cont.) Step 3: Preparing the Pro Forma Balance Sheet (cont.): Based on the previous assumption, the 2007 pro forma balance sheet is presented in table 3.16 – page 131.

Profit Planning: Pro Forma Financial Statements (cont Profit Planning: Pro Forma Financial Statements (cont.) – Results Analysis The ‘Plug’ figure – called the external financing required – of $8,293 is needed to bring the statement into balance This means the firm needs to obtain $8,293 of add. External financing to support the increased level of sales of $135,000 in yr 2007 A positive value for “external financing required” means that the firm will not generate enough internal financing to support its forecast growth in assets. i.e. it must raise funds externally by using debt and/or equity or by reducing dividends Once the form of financing is determined, the pro forma balance sheet is modified to replace ‘ext. fin. Required’ with the planned increases in debt &/or equity accounts.

Profit Planning: Pro Forma Financial Statements (cont Profit Planning: Pro Forma Financial Statements (cont.) – Results Analysis A negative value for “external financing required” indicates the firm will generate more financing internally than it needs to support its forecast growth in assets. The expected savings can be used to repay debt, repurchasing stock, or increasing dividends. Once action is determined, the ‘ext. fin. Required’ is replaced in the pro forma bal. sheet with the planned reduction in the debt &/or equity accounts Beside being used for the preparation of the pro forma balance sheet, the Judgemental Approach is frequently used to estimate the firm’s financing requirements.

Evaluation of Pro Forma Statements: Weaknesses of Simplified Approaches 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 accounts can be forced to take on “desired” values For these reasons, it is imperative to first develop a forecast of the overall economy and make adjustments to accommodate other facts or events.