Cash Flow and Financial Planning

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Cash Flow and Financial Planning

• FIL 240
• Prepared by Keldon Bauer

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Income versus Cash Flow

• The goal of the income statement is to report on
  the status of stockholders equity in the firm.
• Income may have little to do with cash flow.
• Cash is the lifeblood of the firm.
• All debts must be paid in cash (or the firm can
  be forced in to bankruptcy).
• All investors expect to be repaid in cash.

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Depreciation

• To adjust reported income to reflect period cash
  flow, financial analysts should adjust for
  non-cash charges.
• The largest of these non-cash charges is usually
  depreciation.
• Although depreciation is not paid in cash, it
  usually does have a cash effect, since it acts as
  a tax shield.

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Depreciation

• Modified accelerated cost recovery system
  (MACRS).
• Double declining balance, using the half-year
  convention.

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Understanding Cash Flow

• Operating Cash Flows
• Cash generation and use through regular operation
  of the business.
• Investment Cash Flows
• Cash generation and use through purchase and sale
  of company assets.
• Financing Cash Flows
• Cash generation and use through financial markets.

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Operating Cash Flow

• Net Operating Profit After Taxes (NOPAT)
• An estimate of profit (not cash flow) to all
  investors, both debt and equity.
• NOPAT EBIT(1-T)
• Operating Cash Flow (OCF)
• An estimate of cash flow to all investors.
• OCF NOPAT Depreciation
• OCF EBIT(1-T) Depreciation

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Free Cash Flow

• Free Cash Flow (FCF)
• The amount of cash generated and available for
  all investors after the firm has met all
  operating needs, and investment needs.
• FCF OCF NFAI NCAI
• 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 payables and accruals

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Cash Planning

• Cash budget (forecast)
• Projection of inflows and outflows used to
  estimate cash needs or surpluses.
• Forecast Sales
• Project Cash Receipts
• Project Cash Disbursements
• Project Net Cash Flow, Ending Cash, Financing or
  Surplus Cash

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1. Sales Forecast

• External Forecast
• A sales projection based on the relationship
  observed between the firms sales and external
  indicators.
• Statistics can be very helpful here.
• However, you may have to make assumptions about
  future market/economic indicators

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1. Sales Forecast
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1. Sales Forecast

• Internal forecast
• Forecast based on a information generated through
  the firms own channels, and a consensus of
  internal agents.
• Both internal and external methods should be
  used, and assessed over time for effectiveness.

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2. Project Cash Receipts

• Forecasting a firms inflow of cash during a
  particular period.
• Take into account
• Forecasted sales
• Cash advances
• Cash sales
• Collections of accounts receivables
• Cash from sources other than sales

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3. Cash Disbursements

• All outlays of cash by the firm over a given
  period.
• Take into account

• Cash purchases
• Payments of AP
• Rent/lease Payment
• Wages/salaries
• Tax Payments

• Fixed-asset outlays
• Interest payments
• Cash dividends
• Principal payment
• Stock repurchases

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4. Summarize

• Net Cash Flow The difference between cash
  receipts and disbursements.
• Ending Cash Adding net cash flow to the
  beginning cash balance.
• If the difference between ending cash and
  necessary cash is negative, then the absolute
  value of that difference is the financing
  required.
• Otherwise the difference is the surplus.

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Dealing with Uncertainty

• The projection we just made may be our best
  guess, but it is almost certainly wrong.
• Many financial managers will borrow more than is
  indicated by this base estimate.

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Dealing with Uncertainty

• Financial managers can deal with uncertainty by
  using
• Sensitivity analysis
• Scenario analysis
• Simulation

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Pro Forma Statements

• Pro forma statements project financial statements
  based on the accrual method.
• They focus on income (profits) not cash flow.
• It is impossible to hit the correct figures, but
  it is imperative that we plan
• Assets must be planned,
• Returns must be forecasted for all investors,
• Financing for additional needs must be found.

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Pro Forma Income Statement

• Consider the past income statement
• Either use the most recent, an average of the
  past two or three years, or any other period
  which seems representative.
• Apply a commonsize income statement of the
  representative period.
• Adjust costs using a fixed versus variable
  cost framework.

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Pro Forma Balance Sheet

• Balance Sheet Projections are much more complex.
• Some accounts will change with sales
• Accounts receivable,
• Inventory,
• Accounts Payable.
• Some will change with capacity
• Fixed assets
• Some accruals (wages payable, etc.)

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Pro Forma Balance Sheet

• Start with the assets necessary to achieve the
  income statement projections.
• Current assets might well be tied to sales.
• Fixed assets depend on capacity (depreciate).
• Project the current liabilities
• Some are tied to sales.
• Others might be tied to capacity.
• Others might be tied to contracts.
• Others might be relatively fixed.

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Pro Forma Balance Sheet

• Project long-term liabilities.
• These are mainly contractual (e.g. bonds, loans)
• Projections can be amortizations.
• Others might be based on tax considerations.
• Others are rather fixed.
• Project Equity.
• Except for retained earnings adjustments, you
  should usually hold this constant

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Pro Forma Balance Sheet

• The balance sheet should balance (hence the
  name)
• If your pro forma balance sheet has more assets
  than liabilities and equity, more financing is
  required.
• If your pr forma balance sheet has more
  liabilities and equity than assets, then you are
  projecting excess cash.

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Evaluating the Pro Formas

• It is usually advisable to conduct a reality
  check on the pro forma statements.
• Ratio analysis
• How far off recent results are we projecting?
• Internal and external users of projections.