Finance Chapter 4 Cash Flow and Financial Planning

Coping with uncertainty in the cash budget

(1) Scenario analysis: when analysts prepare several cash budgets based on pessimistic, most likely, and optimistic forecasts. (2) Simulation: Use several cash budgets based on differing scenarios, which also give financial manager a sense of the riskiness of various alternatives.

What are the inputs required to develop pro forma statements?

- Financial statements from the preceding year (i.e. income statements and balance sheets) - Sales forecast for the coming year - Key assumptions about a number of factors

What topics would be considered for a long-term (strategic) financial plan?

- Proposed outlays for fixed assets - Research and development activities - Marketing and product development actions - Capital structure, and major sources of financing. Also included would be: - Termination of existing projects - Product lines, or lines of business - Repayment or retirement of outstanding debts; and any planned acquisitions.

What are the two key aspects of financial planning?

1. Cash planning 2. Profit planning

What are the three categories within a cash flow statement?

1. Operating flows 2. Investment flows 3. Financing flows

Steps in Short-term financial planning

1. SALES FORECAST 2. PRODUCTION PLANS: take into account lead (preparation) times and include estimates of the required raw materials. 3. EXPENSE ESTIMATES: Using the production plans, the firm can estimate direct labor requirements, factory overhead outlays, and operating expenses. 4. PRO FORMA INCOME STATEMENT and CASH BUDGET: based on estimations 5. PRO FORMA BALANCE SHEET: created from use of all of these basic inputs

Pro Forma Balance Sheet Judgmental Approach Example: Step 1) Understand Requirements

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 (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. 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. 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, long-term debt, and common stock. 10.) Retained earnings will change in accordance with the pro forma income statement.

For each of the following say whether it is an inflow or outflow of cash: 1.) Increase in an asset 2.) Increase in a liability 3.) Dividends paid 4.) Sale of stock 5.) Net loss after taxes 6.) Decrease in an asset 7.) Net profits after taxes 8.) Decrease in a liability 9.) Depreciation and other non cash charges 10.) Repurchase of retirement of stock 11.) Decrease in accrual

1.) Outflow; you are purchasing an item, this is an outflow of cash 2.) Inflow; you are borrowing funds 3.) Outflow; you are paying out dividends 4.) Inflow: you are selling an item which produces cash 5.) Outflow; you have paid out taxes 6.) Inflow; you are selling an item, which produces cash 7.) Inflow; you have retained profit 8.) Outflow; you are paying out what you owe 9.) Inflow; All non cash charges are inflows 10.) Outflow; You are paying to re-purchase stock 11.) Outflow; you are paying out the accrual

Which MACRS recovery period correlates with: equipment used in petroleum refining or in the manufacture of tobacco products and certain food products?

10 year recovery period.

What MACRS recovery period corresponds with research equipment and certain special tools

3 year recovery period

Which MACRS recovery period corresponds with office furniture, fixtures, and manufacturing equipment, and similar assets

7 year recovery period

Statement of Cash Flows

A financial statement that provides financial information about the cash receipts and cash payments of a business for a specific period of time.

What does a negative NFAI represent?

A negative NFAI represents a net cash inflow attributable to the firm selling more assets than it acquired during the year.

What are key outputs of short-term (operating) financial plans?

A number of operating budgets, the cash budget, and pro forma financial statements.

Downsides to pro forma statements constructed with percent of sales method

A pro forma income statement constructed using the percentage-of-sales method generally tends to understate profits when sales are increasing and overstate profits when sales are decreasing.

Judgmental approach to creating pro forma balance sheet

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.

Cash budget (Cash forecast)

A statement of the firm's planned inflows and outflows of cash that is used to estimate its short-term cash requirements, with particular attention being paid to planning for surplus cash and for cash shortages.

Total cash receipts

All of a firm's inflows of cash during a given financial period. The most common components of cash receipts are: cash sales collections of accounts receivables and other cash receipts.

Depreciation Example Using MACRS recovery period and percentages

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 (see image)

Personal Finance example of Evaluating the Cash Budget

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.

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. Note: generally, the short-term plans and budgets implement the firm's long term strategic objectives

How are the assets in the first four MARCS property classes depreciated?

By the Double-declining balance method, using a half-year convention (meaning that a half-year's depreciation is taken in the year the asset is purchased) and switching to Straight-line when advantageous.

Evaluating the Cash Budget (i.e. looking at shortages and surpluses)

Cash budgets indicate the extent to which cash shortages or surpluses are expected in the months covered by the forecast. In the example shown, the excess cash of $22,000 in October should be invested in marketable securities. Because the deficits in November and December need to be financed.

Investment flows

Cash flows associated with the purchase or sale of fixed assets

Operating flows

Cash flows directly related to sale and production of the firm's products and services

Financing flows

Cash flows 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 repurchase stock or pay cash dividends

Cash planning vs. Profit planning

Cash planning focuses on forecasting cash flows, profit planning relies on accrual concepts to project the firm's profit and overall financial position.

Schedule of Projected Cash Receipts Example (inflows)

Coulson Industries, a defense 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. Bad-debt expenses (uncollectible accounts) have been negligible. In December, Coulson will receive a $30,000 dividend from stock in a subsidiary.

Schedule of Projected Cash Disbursements (outflows)

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 follows

How to find required total financing or excess cash balance

Ending cash - desired minimum cash balance. If the ending cash is less than the minimum cash balance, financing is required. Such financing is typically viewed as short-term and is therefore represented by notes payable. If the ending cash is greater than the minimum cash balance, excess cash exists. Any excess cash is assumed to be invested in a liquid, short-term, interest-paying vehicle, that is, in marketable securities.

Example of percent of sales to create Pro Forma Income Statement: Step 1 use income statement to create percentages

Here the income statement for Vectra sales 2015 was used to create percentages. Specifically, every item such as, cost of goods sold and interest expenses, was divided by the revenue (100,000) to create a percentage. These percentages will be used to create the pro forma income statement in the next step.

Strengths of Pro forma statements

However pro forma statements are prepared, analysts must understand how to use them to make financial decisions. Both 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.

Total cash disbursements

Includes all outlays of cash by the firm during a given financial period. The most common cash disbursements are: Cash purchases Fixed-asset outlays Payments of accounts payable Interest payments Rent (and lease) payments Cash dividend payments Wages and salaries Principal payments (loans) Tax payments Repurchases or retirements of stock

A negative value for "external financing required"

Indicates that, based on its plans, the firm will generate more financing internally than it needs to support its forecast growth in assets. In this case, funds are available for use in repaying debt, repurchasing stock, or increasing dividends. Once the specific actions are determined, "external financing required" is replaced in the pro forma balance sheet with the planned reductions in the debt and/or equity accounts. Obviously, besides being used to prepare the pro forma balance sheet, the judgmental approach is frequently used specifically to estimate the firm's financing requirements.

What system is used for determining depreciation for tax purposes?

MACRS

What principle is used with depreciation?

Matching principle, where revenues are matched with expenses

A positive value for "external financing required"

Means that, based on its plans, the firm will not generate enough internal financing to support its forecast growth in assets. To support the forecast level of operation, the firm must raise funds externally by using debt and/or equity financing or by reducing dividends. Once the form of financing is determined, the pro forma balance sheet is modified to replace "external financing required" with the planned increases in the debt and/or equity accounts.

Indirect vs Direct method to cash flow statements

Most companies use indirect method to cash flow statements because it doesn't give away too much info.

Net fixed asset investment (NFAI)

Net investment that the firm makes in fixed assets and refers to purchases minus sales of fixed assets. Formula: NFAI - Change in net fixed assets + Depreciation Note: The NFAI is also equal to the change in gross fixed assets from one year to the next.

Is depreciation associated with cash outlays?

No because it is a non-cash charge. hen a firm deducts depreciation expense, it is allocating a portion of an asset's original cost (that the firm has already paid for) as a charge against that year's income. The net effect is that depreciation deductions increase a firm's cash flow because they reduce a firm's tax bill.

Are non-cash charges outflows of cash? Provide some examples of non-cash charges.

No they are inflows. Examples include: depreciation, amortization, and depletion.

Is there any adjustment required for expected salvage value under MACRS procedures to determine depreciation?

No, it does not matter. Remember, salvage value is how much a company expects to receive from selling an item. The only thing that matters is how much it cost to purchase the item.

General format of the Cash Budget

Notice how the ending cash of one month becomes the beginning cash of the next.

Long-term (strategic) financial plans

Plans that lay out a company's planned financial actions and the anticipated impact of those actions over periods ranging from 2 to 10 years. Most common are 5 year strategic plans. These plans are generally supported by a series of annual budgets and profit plans.

Pro forma financial statements (profit planning)

Projected, or forecast, income statements and balance sheets

Baker corporation acquired a new machine at a cost of $38,00, with installation costs of $2,000. When the machine is retired from service, Baker expects it will sell it for scrap metal and receive $1,000. What is the depreciable value of the machine?

Regardless of it's expected value, the depreciable value of the machine is $40,000, which is: The cost, $38,000 + the Installation cost $2,000

Net current asset investment (NCAI)

Represents the net investment made by the firm in its current (operating) assets. Formula: NCAI = Change in current assets - Change in (accounts payable + accruals) *Note: notes payables are not included in the NCAI calculation because they represent a negotiated creditor claim on the firm's free cash flow.

What MACRS recovery period correlates with three years?

Research equipment and certain special tools

What are key inputs of short-term (operating) financial plans?

Sales forecast and various forms of operating and financial data.

Internal forecast (sales forecast)

Sales forecast based on a buildup, or consensus, of sales forecasts through the firm's own sales channels.

External forecast (sales forecast)

Sales forecast based on the relationships observed between the firm's sales and certain key external economic indicators

Percent of sales method (used to develop pro forma income statement)

Starts with a sales forecast and then expresses the cost of goods sold, operating expenses, interest expense, and other accounts as a percentage of projected sales. The easiest way to do this is to recast the historical income statement as a percentage of sales.

Excess cash balance

The (excess) amount available for investment by the firm if the period's ending cash is greater than the desired minimum cash balance. Typically any excess cash balance is invested in marketable securities.

Cash Budget (based on projected cash disbursements and receipts given)

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 of $22,000 in October, and a deficit of cash in November and December. The resulting cash budget follows.

Free cash flow (FCF)

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) You generally want a positive FCF Most items for FCF are found on the balance sheet, the only thing from the income statement will be the depreciation expense

What is the best way to adjust for presence of fixed costs when preparing a pro forma statement?

The best way to adjust for the presence of fixed costs when preparing a pro forma income statement is to break the firm's historical costs and expenses into fixed and variable components. The potential returns as well as risks resulting from use of fixed (operating and financial) costs to create "leverage" are discussed in. The key point to recognize is that fixed costs make a firm's profits more variable than its revenues. That is, when both profits and sales are rising, profits tend to increase at a faster rate, but when profits and sales are in decline, the percentage drop in profits is often greater than the rate of decline in sales.

Sales forecast

The prediction of the firm's sales over a given period, based on external and/or internal data; used as the key input to the short-term financial planning process. Note: the sales forecast is then used as the basis for estimating the monthly cash flows that will result from projected sales and from cash outlays related to production, inventory, and sales. It sets the stage for the later steps of short term (operating) financial plans (i.e. production plans, expense estimates, pro forma income statement, cash budget)

Issues with Pro Forma Statement Methods

The weaknesses lie in two assumptions: (1) that the firm's past financial condition is an accurate indicator of its future and (2) that certain variables (such as cash, accounts receivable, and inventories) can be forced to take on certain "desired" values.

How does depreciation reduce taxes the firm must pay?

These expenses (like any other expenses) reduce the income that a firm reports on its income statement and therefore reduce the taxes that the firm must pay.

Example of percent of sales to create Pro Forma Income Statement: Step 2 use projected revenue from sales forecast and percentages calculated in step 1 to create pro forma income statement.

This step involves multiplying the percentages we calculated in step 1 by the projected revenue from the sales forecast, for each item. For example, the percent of sales for cost of goods sold was calculated as 80%. So we multiply $135,000 which is the projected revenue from the sales forecast, by 80% to get $108,000

Interpreting 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 (involving operating, investing, and financing) 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.

Net cash flow (based on cash budget)

Total inflows - total outflows: found by subtracting the cash disbursements from cash receipts in each period.

T/F: The sales forecast may be based on an analysis of external data, internal data, internal data, or a combination of the two.

True

T/F: Under the basic MACRS procedures, the depreciable value of an asset is its full cost, including outlays for installation.

True

T/F: When measuring the amount of cash flow generated by a firm, we have to add depreciation back to net income; if we don't, we will understate the cash that the firm has truly generated.

True

T/F: depreciation and other non-cash charges are NOT included in the cash budget because they merely represent a scheduled write-off of an earlier cash outflow.

True

T/F: the sales forecast may be based on an analysis of external data, internal data, or a combination of the two.

True

Cash budget intervals

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.

External financing required

Under the judgmental approach for developing a pro forma balance sheet, the amount of external financing needed to bring the statement into balance. It can be either a positive or a negative value.

MACRS Recovery Class

Used for determining depreciable value for tax purposes. Each type of asset has its own class or period in which it is to be depreciated.

Depreciation

a portion of the costs of fixed assets charged against annual revenues over time.

Required total financing (based on cash budget)

amount of funds needed by the firm if the ending cash for the period is less than the desired minimum cash balance; typically represented by notes payable

Profit planning

involves preparation of pro forma statements

Cash planning

involves the preparation of the firm's cash budget

Operating Cash Flow (OCF)

is the cash flow a firm generates from normal operations—from the production and sale of its goods and services. You generally want a positive OCF Requires knowing NOPAT (net operating profits after taxes) and Depreciation expense See image for how to calculate OCF

Short-term (operating) financial plans

specify short-term financial actions and the anticipated impact of those actions. Key inputs: include the sales forecast and various forms of operating and financial data. Key outputs: include a number of operating budgets, the cash budget, and pro forma financial statements.

Ending cash (based on cash budget)

the sum of the firm's beginning cash and its net cash flow for the period. i.e. NCF + Beginning Cash

Scenario Analysis (cash planning)

when analysts prepare several cash budgets based on pessimistic, most likely, and optimistic forecasts.