BBA, MBA(Finance), London, UK Topic # 05 Cash Flow & Financial Planning Zulfiqar Hasan BBA, MBA(Finance), London, UK Associate Professor hasanzulfiqar@yahoo.co.uk

Contents Financial Planning and Forecasting, Definition of Financial planning, Short Term Financial Plan & Long-Term Financial Plan, Sales Forecasts, Pro Forma Financial Statements, Analyzing the firms cashflow, Depreciation and MACRS, Types of firm’s cash flows, Determination of different cash flows: Operating Cash Flows, NCAI, NFAI and FCF Zulfiqar Hasan

Financial Planning Steps in Financial Forecasting Forecast sales Financial Planning is the process of estimating the capital required and determining it’s competition. It is the process of framing financial policies in relation to procurement, investment and administration of funds of an enterprise. The projection of sales, income, and assets based on alternative production and marketing strategies, as well as the determination of the resources needed to achieve these projection is called financial planning. Steps in Financial Forecasting Forecast sales Project the assets needed to support sales Project internally generated funds Project outside funds needed Decide how to raise funds See effects of plan on ratios and stock price Zulfiqar Hasan

Objectives of Financial Planning Determining capital requirements- This will depend upon factors like cost of current and fixed assets, promotional expenses and long- range planning. Capital requirements have to be looked with both aspects: short- term and long- term requirements. Determining capital structure- The capital structure is the composition of capital, i.e., the relative kind and proportion of capital required in the business. This includes decisions of debt- equity ratio- both short-term and long- term. Framing financial policies with regards to cash control, lending, borrowings, etc. Maximum Utilization of Scares Resources: A finance manager ensures that the scarce financial resources are maximally utilized in the best possible manner at least cost in order to get maximum returns on investment. Zulfiqar Hasan

Importance of Financial Planning Ensuring Adequate Funds: Financial planning is important because it ensures the adequate funds available to meet the needs of future, and present. Preparing Good Budget: It helps to prepare a good budget Assessing Financial Situation: Financial planning assess business' financial situation Formulating Financial Strategies: It determines its objectives and formulating financial strategies of how to achieve them. Performance Evaluation: Financial planning should become a continuous activity where the plan is reviewed regularly and performance measured against specific devised targets Balance Between Outflow and Inflow of Funds: Financial Planning helps in ensuring a reasonable balance between outflow and inflow of funds so that stability is maintained. Zulfiqar Hasan

Importance of Financial Planning Easy Investment Environment for Fund Suppliers: Financial Planning ensures that the suppliers of funds are easily investing in companies which exercise financial planning. Making Growth and Expansion Programs: Financial Planning helps in making growth and expansion programs which helps in long-run survival of the company. Facing Market Challenges Easily: Financial Planning reduces uncertainties with regards to changing market trends which can be faced easily through enough funds. Reducing The Uncertainties: Financial Planning helps in reducing the uncertainties which can be a hindrance to growth of the company. This helps in ensuring stability an d profitability in concern. Zulfiqar Hasan

Financial Planner An investment professional who helps individuals set and achieve their long-term financial goals, through investments, tax planning, asset allocation, risk management, retirement planning, and estate planning. The role of a financial planner is to find ways to increase the client's net worth and help the client accomplish all of his/her financial objectives. Zulfiqar Hasan

Financial Planning Types Long-Term (Strategic) Financial Plans: An investment plan or strategy with a term of usually longer than one year. A long-term financial plan involves more uncertainty than anything short-term because, typically, market trends are more easily predictable in the short term. On the other hand, planning for the long-term is necessary in order to enjoy financial security in retirement. Thus, while planning for the long term is necessary, one's plan must be flexible to account for the uncertainty inherent to it. Operating (Short-Term) Financial Planning: A financial plan outlining investment and other financial goals for the coming fiscal year. Short-term financial plans involve less uncertainty than long-term financial plans because, generally speaking, market trends are more easily predictable in the short term. Likewise, short-term financial plans are more easily amendable as a result of the short time frame. Short-term financial plans usually invest in short-lived securities, such as T-bills. A short-term financial plan aims to achieve goals that would be beneficial for one's long-term financial plan. Zulfiqar Hasan

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 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. 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. Zulfiqar Hasan

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 1- to 2-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. 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 statement and cash budget are prepared—ultimately leading to the development of the pro forma balance sheet. Zulfiqar Hasan

Pro Forma Financial Statements Sales forecasts Percent of sales method Three important uses: Forecast the amount of external financing that will be required Evaluate the impact that changes in the operating plan have on the value of the firm Set appropriate targets for compensation plans Zulfiqar Hasan

Depreciation Depreciation: The systematic charging of a portion of the costs of fixed assets against annual revenues over time is called Depreciation. This is a historical cost of fixed assets over time. Depreciable life of an Asset :The time period over which an asset is depreciated is called depreciable life of that asset. The depreciable value of an asset (the amount to be depreciated) is its full cost, including outlays for installation. No adjustment is required for expected salvage value. Example: Orin Corporation acquired a new machine at a price of $38000 and installation costs of $2000. What is the depreciable value of the machine? Now, the Depreciable Value is: $40000 Zulfiqar Hasan

MACRS: What is it? One of the depreciation methods is MACRS which stands for Modified Accelerated Cost Recovery System. It is used to determine the depreciation of assets for tax purpose. Some other depreciation methods are: Straight-line; Double-Declining balance and sum-of-the-year-digits. First Four Property Classes Under MACRS 3 years: Research equipment and certain special tools. 5 years: Computers, typewriters, copiers, duplicating equipment, cars, light duty trucks, qualified technological equipment, and similar assets. 7 years: Office furniture, fixtures, most manufacturing equipment, railroad track, and single-purpose agricultural and horticultural structures. 10 years Equipment used in petroleum refining or in the manufacture of tobacco products and certain food products. Zulfiqar Hasan

Rounded Depreciation %age by recovery year using MACRS 3 years 5 years 7 years 10 years 1 33% 20% 14% 10% 2 45% 32% 25% 18% 3 15% 19% 4 7% 12% 5 9% 6 5% 8% 7 8 4% 6% 9 10 11 Total 100% Zulfiqar Hasan

Example 01: Calculating Depreciation using MACRS Year Cost %age Depreciation 1 $40000 20% $8000 2 32 12800 3 19 7600 4 12 4800 5 6 2000 Total 100% Boca Corporation purchased a machine having a cost of $40000 including installation cost and recovery period of 5 years. Find out the depreciation in each year. Zulfiqar Hasan

Practice 01: Calculating Depreciation On March 20, 2009, Norton Systems acquired two new assets. Asset A was research equipment costing $17000 and having a 3-year recovery period. Asset B was duplicating equipment having an installed cost of $45000 and a 5-year recovery period. Using MACRS depreciation percentages, Prepare a depreciation schedule for each of these assets. Prepare a yearly total depreciation schedule for the organization Zulfiqar Hasan

Practice 02: Calculating Depreciation On January, 2011, BIU acquired two new assets. Conference Table costing Tk 70000 with a carrying charge of Tk 1500 and having a 5-year recovery period. BIU Also purchased an AC from Singer costing Taka 55000 having an installed cost of Tk 3000 and a 5-year recovery period. Using MACRS depreciation percentages, Prepare a yearly total depreciation schedule for the organization Zulfiqar Hasan

Firm’s Cash Flows Operating Cash Flow Cashflow directly related to sale and production of the firm’s products and services. Investment Cash Flow Cashflow associated with purchase and sale of both fixed assets and business interests. Financing Cash Flows Cashflows that result from debt and equity financing transactions; includes incurrence and repayment of debt, cash inflow from the sale of stock, and cash outflows to pay cash dividends or repurchase stock. Free cash flows The amount of cashflow available to investors after the firm has met all operating needs and paid for investments in net fixed assets and not current assets. Zulfiqar Hasan

Baker Corporation Income Statement, 2010 Sales revenue $ 1700 Less: Cost of Goods Sold (1000) Gross Profit $ 700 Less: Operating Expenses: Selling Expenses ($ 110) Lease exp ($120) Depreciation exp ($100) Total Operating Exp ($ 330) Earnings Before Interest and Taxes (EBIT) $ 370 Less Interest Exp ($ 70) Earnings Before Taxes (EBT) $ 300 Less: Taxes @ 40% ($ 120) Net Profit After Taxes $180 Less: Preferred stock dividend ($ 10) Earnings Available to Common stockholders $170 Zulfiqar Hasan

Example 01: Calculating Operating Cashflow A firm’s operating cash flow (OCF) is the cash flow it generates from its normal operations—producing and selling its output of goods or services Calculate Baker Corporation’s Operating cashflow for 2008 from the given income statement. Solution: OCF = EBIT – Taxes + Depreciation OCF = $370 – $120 + $100 OCF = $350 Zulfiqar Hasan

FCF = OCF – NFAI – NCAI Free cash Flows The firm’s free cash flow (FCF) represents the amount of cash flow available to investors—the providers of debt (creditors) and equity (owners)—after the firm has met all operating needs and paid for investments in net fixed assets and net current assets. It represents the summation of the net amount of cash flow available to creditors and owners during the period. FCF = OCF – NFAI – NCAI Here, NFAI = Net Fixed Asset Investment NCAI = Net Current Asset Investment NFAI = Change in net fixed Assets + Depreciation NCAI = Change in Current Assets – Change in Accounts payable - Change in Accruals Zulfiqar Hasan

Example 02: Calculating NFAI The Baker Corporations 2009 fixed asset was $1000 and 2010 fixed asset was $1200 and the depreciation for 2010 was $100. Find out the Baker’s NFAI. Solution: Fixed Assets in 2010 = $ 1200 Fixed Assets in 2009 = $ 1000 Change in Net Fixed Asset = $200 So, NFAI = Change in net fixed Asset + Depreciation = $ 200 + $ 100 = $ 300 Zulfiqar Hasan

Example 03: Calculating NCAI The following information is available for Baker Company’s 2010 and 2009 Balance Sheet statement. 2010 2009 Change Current Asset $2000 $1900 ? Accounts Payable $700 $500 Accruals $100 $200 NCAI = Δ in Current Assets – Δ in A/P - Δ in Accruals) NCAI = $ 100 - $ 200-(-$100) = $ 0 Example 04: Calculating FCF From the previous example 01, 02 and 03, calculate the Free Cash Flow for Baker Company. Solution: FCF = OCF – NFAI – NCAI FCF = $350 - $ 300 - $ 0 = $ 50 Zulfiqar Hasan

A Sample Cash Flow Statement Cash Flow from Operating Activities Net profits after taxes (Net Income) $180 Depreciation 100 Decrease in accounts receivable 100 Decrease in inventories 300 Increase in accounts payable 200 Decrease in accruals (100) Cash provided by operating activities $780 Cash Flow from Investment Activities Increase in gross fixed assets ($300) Changes in business interests 0 Cash provided by investment activities ( 300) Cash Flow from Financing Activities Decrease in notes payable ($100) Increase in long-term debts 200 Changes in stockholders’ equity 0 Dividends paid (80) Cash provided by financing activities 20 Net increase in cash and marketable securities $500 Zulfiqar Hasan

Earnings before interests and Taxes (EBIT) 130 133.3 Practice: 01 Calculate FCF for 2010 from the following information: 2010 2009 Sales $1500 $1435 Cost of goods sold (1230) (1176.7) Depreciation (50) (40) Earnings before interests and Taxes (EBIT) 130 133.3 EBT 90 98.3 Taxes (40%) (36.0) (39.3) Net income 54.0 59.0 Total Current Assets $465.0 400.0 Total Fixed Assets 380.0 350.0 Total Assets $845.0 $750.0 ===== ===== Accounts payable $70.0 $60.0 Accruals 60.0 55.0 Long term bonds 300.0 255.0 Zulfiqar Hasan

Practice: 02 The Bangla-Longla Company has purchased an asset which cost Taka 50000 and an installation charge of Taka 10,000 in the year of 2007 with five years of working life. The following information are given for Bangla-Longla Company. Calculate the FCF from the given information for 2009. 2009 2008 EBIT Tk 27500 ------------ Depreciation Tk ?????? Current Assets Tk 8200 Tk 6800 Fixed Assets Tk 14800 Tk 15000 Accounts Payable Tk 1600 Tk 1500 Accruals Tk 200 Tk 300 Taxes Tk 933 Net Profit Tk 1400 Zulfiqar Hasan

Practice: 03 The Bangla-Longla Company has purchased an asset which cost Taka 60000 and an installation charge of Taka 10,000 in the year of 2008 with five years of working life. The following information are given for Bangla-Longla Company. Calculate the FCF from the given information for 2010. 2010 2009 EBIT Tk 27500 ------------ Depreciation Tk ?????? Current Assets Tk 8200 Tk 6800 Fixed Assets Tk 14800 Tk 15000 Accounts Payable Tk 1600 Tk 1500 Accruals Tk 200 Tk 300 Taxes Tk 933 Net Profit Tk 1400 Zulfiqar Hasan

Practice 04: FCF Calculation During the year, Xero, Ltd. Experienced an increase in net fixed assets of Tk 300000 and had depreciation of Tk 200000. It also experienced an increase in current assets of Tk 150000 and an increase in accounts payable of Tk 75000. If operating cash flow (OCF) for the year was Tk 700000, Calculate the firm’s free cash flow (FCF) for the year. NFAI = Change in net fixed Assets + Depreciation = Tk 300000 + Tk 200000 = Tk 500000 NCAI = Change in Current Assets – Change in Accounts payable - Change in Accruals) = Tk 150 000 – Tk 75000 – Tk 0 = Tk 75000 FCF = OCF – NFAI – NCAI So, FCF = Tk 700000 – Tk 500000 – Tk 75000 FCF = Tk 125000 Zulfiqar Hasan

Example 06: Accounting Cash Flow A firm had earnings after taxes of $50,000 in 2009. Depreciation charges were $28,000, and a $2,000 charge for amortization of a bond discount was incurred. What was the firm’s accounting cash flow from operations during 2009? Cash flow from operations = Net profits after taxes + Depreciation + other noncash charges Solutions: Earnings after taxes $50,000 Plus: Depreciation 28,000 Plus: Amortization 2,000 Cash flow from operations $80,000 Zulfiqar Hasan

Practice 05: Depreciation and accounting cash flow A firm in the third year of depreciating its only asset, which originally cost $180,000 and has a 5-year MACRS recovery period, has gathered the following data relative to the current year’s operations. Accruals $ 15,000 Current assets 120,000 Interest expense 15,000 Sales revenue 400,000 Inventory 70,000 Total costs before depreciation, interest, and taxes 290,000 Tax rate on ordinary income 40% Use the relevant data to determine the accounting cash flow from operations for the current year. Explain the impact that depreciation, as well as any other noncash charges, has on a firm’s cash flows. Zulfiqar Hasan

Solution: Depreciation and accounting cash flow a. Cash flow from operations: Sales revenue $400,000 Less: Total costs before depreciation, interest, and taxes -290,000 Depreciation expense -34,200 Interest expense -15,000 Net profits before taxes $ 60,800 Less: Taxes at 40% -24,320 Net profits after taxes $ 36,480 Plus: Depreciation +34,200 Cash flow from operations $ 70,680 b. Depreciation and other noncash charges serve as a tax shield against income, increasing annual cash flow. Zulfiqar Hasan

Home Practice 01 Consider the balance sheets and selected data from the income statement of Keith Corporation that follow. Calculate the firm’s accounting cash flow from operations for the year ended December 31, 2003, Calculate the firm’s operating cash flow (OCF) for the year ended December 31, 2003, Calculate the firm’s free cash flow (FCF) for the year ended December 31, 2003, Interpret, compare, and contrast your cash flow estimates in parts a, b, and c. Zulfiqar Hasan