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

Chapter (3)Chapter (3)

CashCash Flow and Flow and

Financial PlanningFinancial Planning

Objectives to be Objectives to be achievedachieved

Understand tax depreciation & effect Understand tax depreciation & effect of depreciation on cash flowof depreciation on cash flow

Discuss the statement of cash flows, Discuss the statement of cash flows, operating cash flow, & free cash flowoperating cash flow, & free cash flow

Understand the financial planning Understand the financial planning process, incl. long-term (strategic) process, incl. long-term (strategic) financial plans & short-term financial plans & short-term (operating) financial plans(operating) financial plans

Objectives to be Objectives to be achievedachieved

Discuss the cash-planning process & the Discuss the cash-planning process & the preparation, evaluation, & use of cash preparation, evaluation, & use of cash budgetbudget

Explain the simplified procedures used to Explain the simplified procedures used to prepare and evaluate the pro forma prepare and evaluate the pro forma income statement/pro forma balance income statement/pro forma balance sheetsheet

Evaluate the simplified approaches to pro Evaluate the simplified approaches to pro forma financial statement preparation & forma financial statement preparation & common uses of pro forma statementscommon uses of pro forma statements

Analyzing the Firm’s Cash Analyzing the Firm’s Cash FlowFlow

Cash flow (as opposed to accounting “profits”) is theprimary 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 managerialdecision-making, and free cash flow, which is closelymonitored by participants in the capital market.

Analyzing the Firm’s Cash Analyzing the Firm’s Cash FlowFlow

Depreciation is the systematic charging of aportion of the costs of fixed assets againstannual revenues over time.

• Depreciation for tax purposes is determined byusing the Modified Accelerated Cost Recovery System (MACRS).

• On the other hand, a variety of other depreciation methods are often used forreporting purposes (e.g. straight-line, double-declining balance…etc)

Analyzing the Firm’s Cash Analyzing the Firm’s Cash FlowFlowDepreciation: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 chargesshould be added back to net profit after taxes.

By lowering taxable income, depreciation andother non-cash expenses create a tax shield and enhance cash flow.

Analyzing the Firm’s Cash Analyzing the Firm’s Cash Flow: Depreciation: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 Analyzing the Firm’s Cash FlowFlowDepreciable Value/Life Under the basic MACRS procedures, the depreciable

value of an asset is its full cost, including outlaysfor 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.

DepreciationDepreciation

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 Statementof Cash Flows The statement of cash flows summarizes

thefirm’s cash flow over a given period of time.

The statement of cash flows is divided intothree sections:– Operating flows– Investment flows– Financing flows

The nature of these flows is shown in Figure 3.1page 107 (have a look at it)

Developing the Statementof Cash Flows The operating flows The operating flows are cash inflows and are cash inflows and

outflows directly related to the sale & outflows directly related to the sale & production of the firm’s products and production of the firm’s products and services.services.

The investment flowsThe investment flows are cash flows are cash flows associated with the purchase & sale of both associated with the purchase & sale of both fixed assets and business interestsfixed assets and business interests

The financing flows The financing flows are generated from are generated from debt and equity financing transactions. debt and equity financing transactions. Incurring (or repaying) either short-term or Incurring (or repaying) either short-term or long-term debt would result in a long-term debt would result in a corresponding cash inflows/outflowscorresponding 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 Preparing the Statement of Cash Flows: Balance Sheet Cash Flows: Balance Sheet (cont.)(cont.)

Preparing the Statement of Cash Flows: Statement of cash flows is developed Statement of cash flows is developed

using the income statement & using the income statement & balance sheetbalance sheet

All cash inflows, net profits after taxes All cash inflows, net profits after taxes & depreciation are treated as positive & depreciation are treated as positive valuesvalues

All cash outflows, any losses, and All cash outflows, any losses, and dividends paid are treated as dividends paid are treated as negative valuesnegative values

Preparing the Statement of Preparing the Statement of Cash Flows: Cash Flows Cash Flows: Cash Flows StatementStatement

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

Interpreting Statement of Cash Flows The statement of cash flows ties the balance

sheet at the beginning of the period with thebalance sheet at the end of the period afterconsidering the performance of the firm duringthe period through the income statement.

The net increase (or decrease) in cash andmarketable securities should be equivalent tothe difference between the cash and marketablesecurities on the balance sheet at the beginningof the year and the end of the year.

Interpreting Statement of Cash Flows (cont.) Financial managers should pay special Financial managers should pay special

attention both to the major categories of attention both to the major categories of cash flows and to the individual items of cash flows and to the individual items of cash inflow and outflow, to assess whether cash inflow and outflow, to assess whether any developments have occurred that are any developments have occurred that are contrary to the company’s financial policiescontrary to the company’s financial policies

The statement is used to evaluate progress The statement is used to evaluate progress towards projected goals or to isolate towards projected goals or to isolate inefficiencies (e.g. increases in A/Rec. or inefficiencies (e.g. increases in A/Rec. or Inv. resulting in major cash outflows which Inv. resulting in major cash outflows which indicate at forthcoming problems)indicate at forthcoming problems)

Cash Flow (Lifeblood of the Cash Flow (Lifeblood of the Firm)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:1) 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.

2)2) When a firm has no interest expense, the When a firm has no interest expense, the accounting definition and the finance definition of accounting definition and the finance definition of operating cash flow would be the same.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 - NCAIWhere:

NFAI = Change in net fixed assets + Depreciation

NCAI = Change in CA – Change in A/P and Accruals

AccrualsAccruals

accruals are liabilities to pay for goods or services that have accruals are liabilities to pay for goods or services that have been received or supplied but have not been paid, invoiced been received or supplied but have not been paid, invoiced or formally agreed with the supplier, including amounts due or formally agreed with the supplier, including amounts due to employees (for example, amounts relating to accrued to employees (for example, amounts relating to accrued vacation pay). Although it is sometimes necessary to vacation pay). Although it is sometimes necessary to estimate the amount or timing of accruals, the uncertainty estimate the amount or timing of accruals, the uncertainty is generally much less than for provisions.is generally much less than for provisions.

"Accruals are often reported as part of trade and other "Accruals are often reported as part of trade and other payables, whereas provisions are reported separately."payables, whereas provisions are reported separately."

To add to the confusion, some legalistic accounting systems To add to the confusion, some legalistic accounting systems take a simplistic view of “’accrued revenue”’ and “’accrued take a simplistic view of “’accrued revenue”’ and “’accrued expenses”’, defining each as revenue / expense that has expenses”’, defining each as revenue / expense that has not been formally invoiced. This is primarily due to tax not been formally invoiced. This is primarily due to tax considerations, since the act of issuing an invoice creates, considerations, since the act of issuing an invoice creates, in some countries, taxable revenue, even if the customer in some countries, taxable revenue, even if the customer does not ultimately pay and the related receivable becomes does not ultimately pay and the related receivable becomes uncollectible.uncollectible.

What is the difference between What is the difference between Notes Payable and Accounts Notes Payable and Accounts Payable?Payable? While both of these are liabilities, While both of these are liabilities, Notes PayableNotes Payable involves a written involves a written

promissory note. For example, if your company wishes to borrow promissory note. For example, if your company wishes to borrow $100,000 from its bank, the bank will require company officers to $100,000 from its bank, the bank will require company officers to sign a formal loan agreement before the bank provides the sign a formal loan agreement before the bank provides the money. (The bank might also require your company to pledge money. (The bank might also require your company to pledge collateral and for the company owners to personally guarantee the collateral and for the company owners to personally guarantee the loan.) Perhaps the loan paperwork will be a half inch high. Your loan.) Perhaps the loan paperwork will be a half inch high. Your company will record this loan in its general ledger account, company will record this loan in its general ledger account, Notes Notes PayablePayable. (The bank will record the loan in its general ledger . (The bank will record the loan in its general ledger account account Notes ReceivableNotes Receivable.).)

Contrast the bank loan with phoning one of your company’s Contrast the bank loan with phoning one of your company’s suppliers and asking for a delivery of products or supplies. On the suppliers and asking for a delivery of products or supplies. On the next day the products arrive and you sign the delivery receipt. A next day the products arrive and you sign the delivery receipt. A few days later your company receives an invoice from the supplier 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. and it states that the payment for the products is due in 30 days. This transaction didThis transaction did not not involve a promissory note. As a result, involve a promissory note. As a result, this transaction is recorded in your company’s general ledger this transaction is recorded in your company’s general ledger account account Accounts PayableAccounts Payable. The supplier will record the transaction . The supplier will record the transaction with a debit to its asset account with a debit to its asset account Accounts ReceivableAccounts Receivable (and a credit (and a credit to its account to its account SalesSales).).

Free Cash Flow (cont.)

Using Baker Corporation we got:

NFAI = [($1,200 yr 06 - $1,000 yr 05) + $100] = $300i.e. Baker Corp. invested $300K in fixed assets during 2006 which represents a net cash outflow to acquire fixed assetsAnd, 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.)

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 Therefore, we can say that the firm generated adequate cash flow to cover all of its operating adequate cash flow to cover all of its operating costs & investments & had free cash flow available costs & investments & had free cash flow available to pay investors.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

offinancial 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 seriesof 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 otheroperating and financial data.

Key outputs include operating budgets, the cashbudget, 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 thetiming of cash inflows and outflows during a given period.

Typically, monthly budgets are developed coveringa 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 theeconomy, the industry, the company and otherexternal (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 estimatingthe monthly cash inflows that will result from projectedsales—and outflows related to production, overhead andother expenses.

* * The internal data provide insight into sales expectations, and external The internal data provide insight into sales expectations, and external data provide a means of adjusting these expectations to take into data provide a means of adjusting these expectations to take into account general economic factors.account general economic factors.

Cash Planning: Preparing the Cash Budget (cont.)

Cash Planning: Preparing the Cash Budget (cont.) – Net cash flow, Ending cash, Financing, and Excess Cash The The net cash flownet cash flow is found by subtracting is found by subtracting

the cash disbursement from cash receipts in the cash disbursement from cash receipts in each period.each period.

Adding the beginning cash to the firm’s net Adding the beginning cash to the firm’s net cash flow determine the cash flow determine the ending cashending cash for for each period.each period.

Subtracting the desired minimum cash Subtracting the desired minimum cash balance from ending cash results in either balance from ending cash results in either the the required total financingrequired total financing or the or the excess cash balanceexcess cash balance..

Cash Receipts &Cash Receipts &Cash DisbursementsCash Disbursements The common components of The common components of cash receiptscash receipts

are cash sales, collections of A/Rs, and other are cash sales, collections of A/Rs, and other cash receipts (e.g. interest received, cash receipts (e.g. interest received, dividends received, proceeds from the sale of dividends received, proceeds from the sale of equip., stock & bond sale proceeds, and lease equip., stock & bond sale proceeds, and lease receiptsreceipts

As for As for disbursementsdisbursements, it includes cash , it includes cash purchases, payments of A/Ps, rent (& lease) purchases, payments of A/Ps, rent (& lease) payments, wages/salaries, tax payments, FA payments, wages/salaries, tax payments, FA outlays, interest payments, cash dividend outlays, interest payments, cash dividend payments, principal payments (loan) & payments, principal payments (loan) & repurchases/retirements of stockrepurchases/retirements of stock

Cash Planning: Cash BudgetsAn 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 $100,000and $200,000 respectively. Sales of $400,000,$300,000 and $200,000 have been forecast for October,November, and December. Historically, 20% of thefirm’s sales have been for cash, 50% have beencollected after 1 month, and the remaining 30% after 2months (this assumes no bad debts!). In December, Coulson will receive a $30,000 dividend from stock in a subsidiary.

Cash Planning: Cash BudgetsAn 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 BudgetsAn Example: Coulson Industries (cont.) Coulson Company has also gathered the relevant

information for the development of a cash disbursementschedule. Purchases will represent 70% of sales—10%will be paid immediately in cash, 70% is paid the monthfollowing the purchase, and the remaining 20% is paidtwo months following the purchase. The firm will alsoexpend cash on rent, wages and salaries, taxes, capitalassets, interest, dividends, and a portion of the principalon its loans. The resulting disbursement schedulethus follows.

Cash Planning: Cash BudgetsAn Example: Coulson Industries (cont.)

Cash Planning: Cash BudgetsAn Example: Coulson Industries (cont.) The Cash Budget for Coulson Industries can be

derived by combining the receipts budget withthe disbursements budget. At the end ofSeptember, Coulson’s cash balance was$50,000, notes payable was $0, and marketablesecurities balance was $0. Coulson also wishesto maintain a minimum cash balance of$25,000. As a result, it will have excess cash inOctober, and a deficit of cash in November andDecember. The resulting cash budget follows.

Cash Planning: Cash BudgetsAn 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 BudgetsAn Example: Coulson Industries (cont.) We can summarize the financial We can summarize the financial

activities for each month as follows:activities for each month as follows:– October: invest $22K excess cash balance in October: invest $22K excess cash balance in

marketable securities.marketable securities.– November: liquidate the $22K of market. November: liquidate the $22K of market.

Securities and borrow $76K (notes payables)Securities and borrow $76K (notes payables)– December: Repay $35K of N/Ps to leave December: Repay $35K of N/Ps to leave

$41K of outstanding required total financing$41K of outstanding required total financing– FM’ll seek to borrow > the max. financing FM’ll seek to borrow > the max. financing

indicated because of uncertainty of ECVsindicated because of uncertainty of ECVs

Coping with Uncertaintyin the Cash Budget One way to cope with cash budgeting uncertainty

is to prepare several cash budgets based on severalforecasted scenarios (e.g., pessimistic, mostlikely, optimistic).

From this range of cash flows, the financial manager candetermine the amount of financing necessary to coverthe most adverse situation.

This method will also provide a sense of the riskinessof 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 Uncertaintyin the Cash Budget A second & more sophisticated way of A second & more sophisticated way of

coping with uncertainty in cash budget is coping with uncertainty in cash budget is Simulation. Simulation.

By simulating the occurrence of sales and By simulating the occurrence of sales and other uncertain events, the firm can other uncertain events, the firm can develop a develop a probability distributionprobability distribution of its of its ending cash flows for each month.ending cash flows for each month.

The financial decision maker can then use The financial decision maker can then use the probability distribution to determine the the probability distribution to determine the amount of financing needed to protect the amount of financing needed to protect the firm adequately against any expected cash firm adequately against any expected cash shortage.shortage.

This will be discussed in details in Ch.10.This will be discussed in details in Ch.10.

Cash Flow within the MonthCash Flow within the Month The information provided by the cash budget is The information provided by the cash budget is

not necessarily adequate for ensuring not necessarily adequate for ensuring SolvencySolvency A firm must look more closely at its pattern of A firm must look more closely at its pattern of

daily cash receipts and cash disbursements to daily cash receipts and cash disbursements to ensure that adequate cash is available for ensure that adequate cash is available for paying bills as they come due.paying bills as they come due.

Because a firm’s cash flows are quite variable Because a firm’s cash flows are quite variable when viewed on a daily basis, effective cash when viewed on a daily basis, effective cash planning requires a look beyond the cash planning requires a look beyond the cash budgetbudget

Therefore, the FM should plan and monitor Therefore, the FM should plan and monitor cash flow more frequently than on a monthly cash flow more frequently than on a monthly basis.basis.

Profit Planning:Profit Planning: Pro Forma Statements 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:Profit Planning: Pro Forma Statements Pro Forma Statements

Pro forma financial statements are projected, orforecast, financial statements – income statements andbalance sheets.

The inputs required to develop pro forma statementsusing 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 willbe demonstrated using the financial statements forVectra 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.)


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.


Step 1: Start with a Sales Forecast (cont.)– The previous sales forecast is based on anincrease in price from $20 to $25 per unit forModel X and from $40 to $50 per unit forModel Y.– These increases are required to coveranticipated 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 incomestatement is the “percent-of-sales” method.– This method starts with the sales forecast and thenexpresses the cost of goods sold, operatingexpenses, and other accounts as a percentage ofprojected sales.– Using the Vectra example, the easiest way to do thisis to recast the historical income statement as apercentage of sales.


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)


Step 2:Preparing the Pro Forma IncomeStatement (cont.)

* The expected contribution to retained earnings is $6,327 which represents a considerable increase over $3,650 in the preceding year


– 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.


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.


Step 2:Preparing the Pro Forma IncomeStatement (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 developingthe 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, anumber of simplifying assumptions must be made


(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.


(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.


(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.) –

Results Analysis The ‘Plug’ figure – called the external financing The ‘Plug’ figure – called the external financing

required – of $8,293 is needed to bring the required – of $8,293 is needed to bring the statement into balancestatement into balance

This means the firm needs to obtain $8,293 of add. This means the firm needs to obtain $8,293 of add. External financing to support the increased level of External financing to support the increased level of sales of $135,000 in yr 2007sales of $135,000 in yr 2007

A positive value for “external financing required” A positive value for “external financing required” means that the firm will not generate enough means that the firm will not generate enough internal financing to support its forecast growth in internal financing to support its forecast growth in assets. i.e. it must raise funds externally by using assets. i.e. it must raise funds externally by using debt and/or equity or by reducing dividendsdebt and/or equity or by reducing dividends

Once the form of financing is determined, the pro Once the form of financing is determined, the pro forma balance sheet is modified to replace ‘ext. fin. forma balance sheet is modified to replace ‘ext. fin. Required’ with the planned increases in debt &/or Required’ with the planned increases in debt &/or equity accounts.equity accounts.

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

Results Analysis A negative value for “external financing required” A negative value for “external financing required”

indicates the firm will generate more financing indicates the firm will generate more financing internally than it needs to support its forecast internally than it needs to support its forecast growth in assets.growth in assets.

The expected savings can be used to repay debt, The expected savings can be used to repay debt, repurchasing stock, or increasing dividends.repurchasing stock, or increasing dividends.

Once action is determined, the ‘ext. fin. Required’ Once action is determined, the ‘ext. fin. Required’ is replaced in the pro forma bal. sheet with the is replaced in the pro forma bal. sheet with the planned reduction in the debt &/or equity accountsplanned reduction in the debt &/or equity accounts

Beside being used for the preparation of the pro Beside being used for the preparation of the pro forma balance sheet, the Judgemental Approach is forma balance sheet, the Judgemental Approach is frequently used to estimate the firm’s financing frequently used to estimate the firm’s financing requirements.requirements.

Evaluation of Pro Forma Statements:Weaknesses of Simplified Approaches

The major weaknesses of the approaches to proforma statement development outlined above liein two assumptions:– That the firm’s past financial performance will bereplicated 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.

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

Documents

Transcript of Chapter (3) Cash Flow and Financial Planning Financial Planning.