Cash Flow and Financial Planning

1. Cash Flow and Financial Planning FIL 240 Prepared by Keldon Bauer

2. Income versus Cash Flow • The goal of the income statement is to report on the status of stockholder’s 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.

3. 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.

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

5. 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.

6. 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

7. 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

8. 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

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

10. 1. Sales Forecast

11. 1. Sales Forecast • Internal forecast: • Forecast based on a information generated through the firm’s own channels, and a consensus of internal agents. • Both internal and external methods should be used, and assessed over time for effectiveness.

12. 2. Project Cash Receipts • Forecasting a firm’s 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

13. 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

14. 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.

15. 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.

16. Dealing with Uncertainty • Financial managers can deal with uncertainty by using: • Sensitivity analysis • Scenario analysis • Simulation

17. 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.

18. 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.

19. 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.)

20. 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.

21. 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

22. 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.

23. 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.