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Chapter (3)
Cash Flow and
Financial Planning
Objectives to be achieved
Understand tax depreciation & effect of
depreciation on cash flow
 Discuss the statement of cash flows,
operating cash flow, & free cash flow
 Understand the financial planning process,
incl. long-term (strategic) financial plans &
short-term (operating) financial plans

Objectives to be achieved
Discuss the cash-planning process & the
preparation, evaluation, & use of cash
budget
 Explain the simplified procedures used to
prepare and evaluate the pro forma
income statement/pro forma balance
sheet
 Evaluate the simplified approaches to pro
forma financial statement preparation &
common uses of pro forma statements

Analyzing the Firm’s Cash Flow
Cash flow (as opposed to accounting “profits”) is the
primary 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 managerial
decision-making, and free cash flow, which is closely
monitored by participants in the capital market.

Analyzing the Firm’s Cash Flow
Depreciation is the systematic charging of a
portion of the costs of fixed assets against
annual revenues over time.
• Depreciation for tax purposes is determined by
using the Modified Accelerated Cost
Recovery System (MACRS).
• On the other hand, a variety of other
depreciation methods are often used for
reporting purposes (e.g. straight-line, doubledeclining balance…etc)

Analyzing the Firm’s Cash Flow
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 charges
should be added back to net profit after taxes.
 By lowering taxable income, depreciation and
other non-cash expenses create a tax shield
and enhance cash flow.

Analyzing the Firm’s Cash
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 Flow
Depreciable Value/Life


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

Under the basic MACRS procedures, the depreciable
value of an asset is its full cost, including outlays
for 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.
Depreciation
Depreciation
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 Statement
of Cash Flows
The statement of cash flows summarizes the
firm’s cash flow over a given period of time.
 The statement of cash flows is divided into
three sections:
– Operating flows
– Investment flows
– Financing flows
 The nature of these flows is shown in Figure 3.1
page 107 (have a look at it)

Developing the Statement
of Cash Flows
The operating flows are cash inflows and
outflows directly related to the sale & production
of the firm’s products and services.
 The investment flows are cash flows
associated with the purchase & sale of both
fixed assets and business interests
 The financing flows are generated from debt
and equity financing transactions. Incurring (or
repaying) either short-term or long-term debt
would result in a corresponding 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 Cash
Flows: Balance Sheet (cont.)
Preparing the Statement of Cash
Flows:
Statement of cash flows is developed
using the income statement & balance
sheet
 All cash inflows, net profits after taxes &
depreciation are treated as positive values
 All cash outflows, any losses, and
dividends paid are treated as negative
values

Preparing the Statement of Cash
Flows: Cash Flows Statement
Preparing the Statement of Cash
Flows: Cash Flows Statement (con)
Interpreting Statement of Cash
Flows
The 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 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.

Interpreting Statement of Cash
Flows (cont.)
Financial managers should pay special attention
both to the major categories of cash flows and
to the individual items of cash inflow and
outflow, to assess whether any developments
have occurred that are contrary to the
company’s financial policies
 The statement is used to evaluate progress
towards projected goals or to isolate
inefficiencies (e.g. increases in A/Rec. or Inv.
resulting in major cash outflows which indicate
at forthcoming problems)

Cash Flow (Lifeblood of the 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) When a firm has no interest expense, the accounting
definition and the finance definition of 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 - NCAI
Where:
 NFAI = Change in net fixed assets +
Depreciation
 NCAI = Change in CA – Change in A/P and
Accruals

Accruals
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accruals are liabilities to pay for goods or services that have been
received or supplied but have not been paid, invoiced or formally
agreed with the supplier, including amounts due to employees (for
example, amounts relating to accrued vacation pay). Although it is
sometimes necessary to estimate the amount or timing of accruals,
the uncertainty is generally much less than for provisions.
"Accruals are often reported as part of trade and other payables,
whereas provisions are reported separately."
To add to the confusion, some legalistic accounting systems take a
simplistic view of “’accrued revenue”’ and “’accrued expenses”’,
defining each as revenue / expense that has not been formally
invoiced. This is primarily due to tax considerations, since the act of
issuing an invoice creates, in some countries, taxable revenue, even
if the customer does not ultimately pay and the related receivable
becomes uncollectible.
What is the difference between Notes
Payable and Accounts Payable?
While both of these are liabilities, Notes Payable involves a written
promissory note. For example, if your company wishes to borrow $100,000
from its bank, the bank will require company officers to sign a formal loan
agreement before the bank provides the money. (The bank might also
require your company to pledge collateral and for the company owners to
personally guarantee the loan.) Perhaps the loan paperwork will be a half
inch high. Your company will record this loan in its general ledger account,
Notes Payable. (The bank will record the loan in its general ledger account
Notes Receivable.)
 Contrast the bank loan with phoning one of your company’s suppliers and
asking for a delivery of products or supplies. On the next day the products
arrive and you sign the delivery receipt. A 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. This transaction did not involve a promissory
note. As a result, this transaction is recorded in your company’s general
ledger account Accounts Payable. The supplier will record the transaction
with a debit to its asset account Accounts Receivable (and a credit to its
account Sales).

Free Cash Flow (cont.)

Using Baker Corporation we got:

NFAI = [($1,200 yr 06 - $1,000 yr 05) + $100] = $300
i.e. Baker Corp. invested $300K in fixed assets during
2006 which represents a net cash outflow to acquire
fixed assets
And, 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 adequate cash flow to
cover all of its operating costs & investments & had free
cash flow available 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
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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: LongTerm (Strategic) Financial Plans (cont.)
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.

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 other
operating and financial data.
 Key outputs include operating budgets, the cash
budget, 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 the
timing of cash inflows and outflows during a given
period.
 Typically, monthly budgets are developed covering
a 1-year time period.

Cash Planning: Cash Budgets (cont.)
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

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 the
economy, the industry, the company and other
external (GDP, consumer confidence, Disposable PI, unemployment 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 estimating
the monthly cash inflows that will result from projected
sales—and outflows related to production, overhead and
other expenses.
* The internal data provide insight into sales expectations, and
external data provide a means of adjusting these expectations to
take into 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 net cash flow is found by subtracting the
cash disbursement from cash receipts in each
period.
 Adding the beginning cash to the firm’s net cash
flow determine the ending cash for each
period.
 Subtracting the desired minimum cash balance
from ending cash results in either the required
total financing or the excess cash balance.

Cash Receipts &
Cash Disbursements
The common components of cash receipts are
cash sales, collections of A/Rs, and other cash
receipts (e.g. interest received, dividends
received, proceeds from the sale of equip., stock
& bond sale proceeds, and lease receipts
 As for disbursements, it includes cash
purchases, payments of A/Ps, rent (& lease)
payments, wages/salaries, tax payments, FA
outlays, interest payments, cash dividend
payments, principal payments (loan) &
repurchases/retirements of stock

Cash Planning: Cash Budgets
An 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 $100,000
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 (this assumes no bad debts!). In December,
Coulson will receive a $30,000 dividend from stock in a
subsidiary.
Cash Planning: Cash Budgets
An 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 Budgets
An Example: Coulson Industries (cont.)

Coulson Company 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
thus follows.
Cash Planning: Cash Budgets
An Example: Coulson Industries (cont.)
Cash Planning: Cash Budgets
An Example: Coulson Industries (cont.)

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 in
October, and a deficit of cash in November and
December. The resulting cash budget follows.
Cash Planning: Cash Budgets
An Example: Coulson Industries (cont.)
Cash Planning: Cash Budgets
An 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 Budgets
An Example: Coulson Industries (cont.)

We can summarize the financial activities
for each month as follows:
– October: invest $22K excess cash balance in
marketable securities.
– November: liquidate the $22K of market.
Securities and borrow $76K (notes payables)
– December: Repay $35K of N/Ps to leave $41K
of outstanding required total financing
– FM’ll seek to borrow > the max. financing
indicated because of uncertainty of ECVs
Coping with Uncertainty
in the Cash Budget




One way to cope with cash budgeting uncertainty
is to prepare several cash budgets based on several
forecasted scenarios (e.g., pessimistic, most
likely, optimistic).
From this range of cash flows, the financial manager can
determine the amount of financing necessary to cover
the most adverse situation.
This method will also provide a sense of the riskiness
of 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 Uncertainty
in the Cash Budget
A second & more sophisticated way of coping
with uncertainty in cash budget is Simulation.
 By simulating the occurrence of sales and other
uncertain events, the firm can develop a
probability distribution of its ending cash flows
for each month.
 The financial decision maker can then use the
probability distribution to determine the amount
of financing needed to protect the firm
adequately against any expected cash shortage.
 This will be discussed in details in Ch.10.

Cash Flow within the Month
The information provided by the cash budget is
not necessarily adequate for ensuring Solvency
 A firm must look more closely at its pattern of
daily cash receipts and cash disbursements to
ensure that adequate cash is available for paying
bills as they come due.
 Because a firm’s cash flows are quite variable
when viewed on a daily basis, effective cash
planning requires a look beyond the cash budget
 Therefore, the FM should plan and monitor cash
flow more frequently than on a monthly basis.

Profit Planning:
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:
Pro Forma Statements



Pro forma financial statements are projected, or
forecast, financial statements – income statements and
balance sheets.
The inputs required to develop pro forma statements
using 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 will
be demonstrated using the financial statements for
Vectra 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.)
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.
Profit Planning:
Pro Forma Financial Statements (cont.)

Step 1: Start with a Sales Forecast (cont.)
– The previous sales forecast is based on an
increase in price from $20 to $25 per unit for
Model X and from $40 to $50 per unit for
Model Y.
– These increases are required to cover
anticipated 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 income
statement is the “percent-of-sales” method.
– This method starts with the sales forecast and then
expresses the cost of goods sold, operating
expenses, and other accounts as a percentage of
projected sales.
– Using the Vectra example, the easiest way to do this
is to recast the historical income statement as a
percentage of sales.
Profit Planning:
Pro Forma Financial Statements (cont.)
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)
Profit Planning:
Pro Forma Financial Statements (cont.)
Step 2:Preparing the
Pro Forma Income
Statement (cont.)
* The expected
contribution to
retained earnings is
$6,327 which
represents a
considerable increase
over $3,650 in the
preceding year

Profit Planning:
Pro Forma Financial Statements (cont.)
– 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.
Profit Planning:
Pro Forma Financial Statements (cont.)

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.
Profit Planning:
Pro Forma Financial Statements (cont.)
Step 2:Preparing the
Pro Forma Income
Statement (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 developing
the 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, a
number of simplifying assumptions must be made
Profit Planning:
Pro Forma Financial Statements (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.
Profit Planning:
Pro Forma Financial Statements (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.
Profit Planning:
Pro Forma Financial Statements (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 required
– of $8,293 is needed to bring the statement into
balance
 This means the firm needs to obtain $8,293 of add.
External financing to support the increased level of sales
of $135,000 in yr 2007
 A positive value for “external financing required” means
that the firm will not generate enough internal financing
to support its forecast growth in assets. i.e. it must raise
funds externally by using debt and/or equity or by
reducing dividends
 Once the form of financing is determined, the pro forma
balance sheet is modified to replace ‘ext. fin. Required’
with the planned increases in debt &/or equity accounts.

Profit Planning: Pro Forma Financial
Statements (cont.) – Results Analysis
A negative value for “external financing required”
indicates the firm will generate more financing internally
than it needs to support its forecast growth in assets.
 The expected savings can be used to repay debt,
repurchasing stock, or increasing dividends.
 Once action is determined, the ‘ext. fin. Required’ is
replaced in the pro forma bal. sheet with the planned
reduction in the debt &/or equity accounts
 Beside being used for the preparation of the pro forma
balance sheet, the Judgemental Approach is frequently
used to estimate the firm’s financing requirements.

Evaluation of Pro Forma Statements:
Weaknesses of Simplified Approaches


The major weaknesses of the approaches to pro
forma statement development outlined above lie
in two assumptions:
– That the firm’s past financial performance will be
replicated 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.