Cash Flow and Financial Planning

Chapter 4 Cash Flow and Financial Planning
Chapter 4
Cash Flow
and Financial
Planning
Copyright © 2014 Pearson

Copyright © 2009 All rightsPrentice
Pearson reserved.
Hall. All rights reserved. 4-1
Learning Outcomes
• Understand the procedures behind the preparation of a statement of

cash flow and the effect that transactions have on the firm’s cash
flows.
• Discuss the concepts of operating cash flow and free cash flow.
• Understand the financial planning process, including long-term
(strategic) financial plans and short-term (operating) plans.
• Explain the simplified procedures used to prepare and evaluate the
pro forma statement of comprehensive income and the pro forma
statement of financial position.
• Evaluate the simplified approaches to pro forma financial statement
preparation and the common uses of pro forma statements.
Copyright © 2014 Pearson All rights reserved. 4-2

Analysing the Firm’s Cash Flows
• Cash flow (as opposed to accounting “profits”) is the

primary focus of the financial manager.
• From an accounting perspective, cash flow is

summarised 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.

Developing the Statement of Cash Flows
• The statement of cash flows summarises the firm’s cash flow

over a given period of time.
• Its purpose is to reconcile the cash and cash equivalents of the
firm at the beginning of the financial year with the balance at the
end of the financial year

Developing the Statement of Cash Flows
• 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
4.1 on the following slide.

Figure 4.1 Cash Flows

Operating activities
• Cash flows from operating activities are those that relate

to the principal revenue-generating activities of the firm.
e.g.
– A manufacturer’s principle activities will be the
purchase of raw materials, the process of manufacturing
and then the sale of the manufactured product.
• The main transactions in this category of activities are cash
receipts from customers and cash paid to suppliers for
goods and services

Investing activities
• Cash flows from investing activities are those

associated with the purchase and sale of non-
current assets and equity investments in other
firms.
– For investing activities relating to the non-current
assets, a distinction must be made between those
activities that maintain the operating capacity and
those that expand the operating capacity of the firm.

Financing activities
• Financing activities are those that result in

changes in the equity or capital of a firm, as well
as changes in its borrowings.
• Incurring ST or LT debt or selling company
shares would result in cash inflows, whilst
repaying debt or buying back company shares
would constitute cash outflows.

Preparing the statement of cash flows

A note on Depreciation
• Depreciation is the systematic allocation of the cost of

an asset (less residual value, if any) over its useful life.
• Depreciation for tax purposes is determined by using the
wear and tear allowances (WTA).
• Depreciation per se has no effect on the cash or bank
balances. The charge every year is an accounting
expense shown in the statement of comprehensive
income.
• It is however a tax-deductible expense and as such it
reduces the tax payable by a firm which does affect cash.


Table 4.4 Tugela Company Statement of financial position

(R000) (cont.)

Statement of changes in equity for Tugela Company


Free Cash Flow
• Free Cash Flow (FCF) is the amount of cash flow available to debt and equity holders after meeting all
operating needs (OCF) and paying for its Net non-current asset investments (NFAI) and net current asset
investments (NCAI).
• Where:
FCF = OCF – NFAI - NCAI
OCF = [EBIT x (1 – T)] + Depreciation

NFAI = Change in net non-current assets + Depreciation
NCAI = Change in CA – Change in A/P and Accruals

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 as follows:
OCF = NOPAT + Depreciation
NOPAT = EBIT x (1 – T)
OCF = [EBIT x (1 – T)] + Depreciation

Operating cash flow for Tugela Company
OCF = [R370 000 x (1 - 0.30)] + R100

= R259 000 + R100 = R359 000
• During 2012, Tugela generated R359 000 from
producing and selling its output
• Tugela’s operations are generating positive
operating cash flows.

Free cash flow for Tugela Company

(R000’s)
OCF = R359 (inflow)
NFAI = Change in net non-current assets + Depr.
= (R1 200 – R1 000) + R100 = R300 (outflow)
NCAI = Change in current assets – change in A/P and
accruals
= (R2 000 – R1 900) – (800 – 700) = 0
FCF = R359 – R300 – 0 = R59
During 2012 Tugela generated R59 000 of FCF, with which
to pay its creditors (interest) and owners (dividends)
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 and ST financial plan.
– Profit planning involves the preparation of pro forma
financial statements.

Profit Planning: Pro Forma Statements
• Pro forma financial statements are projected, or forecast, financial

statements – statements of comprehensive income and statements of
financial position.
• 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 is demonstrated
using the financial statements for Vectra Manufacturing.

Profit Planning:
Pro Forma Financial Statements


Profit Planning: Pro Forma Financial

Statements (cont.)
• Step 1: Start with a Sales Forecast
Table 4.13 2013 Sales Forecast for Vectra Manufacturing


Statements (cont.)
• Step 1: Start with a Sales Forecast (cont.)

– The sales forecast is based on an increase in price
from R200 to R250 per unit for Model X and from
R400 to R500 per unit for Model Y.
– These increases are required to cover anticipated
increases in various costs, including labor, materials,
& overhead.


Statements (cont.)
• Step 2: Preparing the Pro Forma Statement of

comprehensive income
– A simple method for developing a pro forma statement of
comprehensive income is the “percent-of-sales” method.
– This method starts with the sales forecast and then expresses the
cost of sales, operating expenses, and other accounts as a
percentage of projected sales, as per the previous period’s SOCI.
– Using the Vectra example, we look to the 2012 statement of
comprehensive income to apply the percentage of sales method.


Statements (cont.)
• Step 2: Preparing the Pro Forma Statement of comprehensive

income (cont.)
– Using the 2012 percentages and the sales forecast for 2013 we developed,
the entire statement of comprehensive income can be projected.
– The results are shown on the following slide.
– 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. Tax
is applied at the tax rate, dividends may be governed by dividend policy.
– This will understate profits when sales are increasing and overstate them
when sales are decreasing.


Statements (cont.)


Statements (cont.)
• Step 2: Preparing the Pro Forma Statement of comprehensive

income (cont.)
– Clearly, some of the firm’s expenses will increase with the level of
sales 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 statement of
comprehensive income is to segment the firm’s expenses into fixed
and variable components.
– This may be demonstrated as follows.


Statements (cont.)


Statements (cont.)
• Step 3: Preparing the Pro Forma Statement of Financial Position
– Probably the best approach to use in developing the pro forma statement of
financial position is the judgmental approach.
– The percent-of-sales approach can also be used, or a combination of the two.
– Under the judgemental method, the values of some statement of financial
position accounts are estimated
– Using either method, the company’s external financing requirement (EFN)
is used as the balancing account.
– To apply the judgemental method to Vectra Manufacturing, a number of
simplifying assumptions must be made.


Statements (cont.)
• Step 3: Preparing the Pro Forma Statement of financial position:

Assumptions:
1. A minimum cash balance of R60 000 is desired.
2. Marketable securities will remain at their current level of R40 000.
3. Accounts receivable will be approximately R168 750 which
represents 45 days of sales on average [(45/365) x R1 350 000].
4. Ending inventory will remain at about R160 000: 25% (R40 000)
represents raw materials and 75% (R120 000) is finished goods.
5. A new machine costing R200 000 will be purchased. Total
depreciation will be R80 000. Adding R200 000 to existing net fixed
assets of R510 000 and subtracting the R80 000 depreciation yields a
net fixed asset figure of R630 000.


Statements (cont.)
• Step 3: Preparing the Pro Forma Statement of financial position:

6. Purchases will be R405 000 which represents 30% of annual sales (30% x
R1 350 000). Vectra takes about 73 days to pay on its accounts payable. As
a result, accounts payable will equal R81 000 [(73/365) x R405 000].
7. Taxes payable will be R14 580 which represents 40% of the current year’s
tax liability.
8. Short-term borrowings will remain unchanged at R83 000.
9. There will be no change in other current liabilities, long-term debt, and
ordinary shares.
10. Retained earnings will change in accordance with the pro forma statement of
comprehensive income.

Table 4.15 A Pro Forma Statement of financial position, using

the Judgmental Approach, for Vectra Manufacturing (31
December 2013)

Table 4.15 (cont.) A Pro Forma Statement of financial position, using the
Judgmental Approach, for Vectra Manufacturing (31 December 2013)

External Finance Needed (EFN)
• TA may be > TE + TL and this shortfall = EFN. Management need to

choose a plug variable:
– Borrow more short-term debt
– Borrow more long-term debt
– Sell more shares
– Decrease dividends paid out, which will increase RE.
• Which of these the firm chooses will depend on their D to E ratio and
other factors.
• TA may also be < TE + TL, and then have to do the opposite to these
procedures.
• This process is thus extremely useful as it shows the external financing
that may be needed in order to increase sales.

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. We will discuss
sensitivity analysis further in third year.

Example 2: Using % of sales approach

to establish EFN
Tasha’s Toy Emporium Tasha’s Toy Emporium
Income Statement, 2017 Pro Forma Income Statement,
% of Sales 2018
Sales 5 500
Sales 5 000
Costs (3 300)
Costs (3 000) 60%
PBT 2 200
PBT 2 000 40%
Taxes (880)
Taxes (40%) (800) 16%
Net Profit 1 320
Net Profit 1 200 24%
Dividends 600 Dividends 660
Add. To RP 600 Add. To RP 660
Assume Sales grow at 10% Dividend Payout Rate = 50%

Example 2: EFN
Tasha’s Toy Emporium – Statement of Financial Position
Current % of Sales Pro Current % of Pro Forma
Forma Sales
ASSETS Liabilities & Owners’ Equity
Current Assets Current Liabilities
Cash R500 10% R550 A/P R900 18% R990
A/R 2 000 40 2 200 ST Debt 2 500 n/a 2 500

Inventory 3 000 60 3 300 Total 3 400 n/a 3 490
Total 5 500 110 6 050 LT Debt 2 000 n/a 2 000
Non-Current Assets Owners’ Equity
Net NCA 4 000 80 4 400 Share capital 2 000 n/a 2 000
Total Assets 9 500 190 10 450 RP 2 100 n/a 2 760
Total 4 100 n/a 4 760
Note that these don’t Total L & OE 9 500 10 250
balance! The
difference is the EFN!
Example 2: EFN
• The firm needs to come up with an additional R200

in debt or equity to make the statement of financial
position balance
TA – (TL + OE) = 10 450 – 10 250 = 200
• Choose plug variable (in other words, how can me
make this balance?)
–Borrow more short-term (ST Debt)
–Borrow more long-term (LT Debt)
–Sell more shares (Share Capital)
–Decrease dividend payout, which increases the
additions to Retained Profits
Example 2 : EFN
Operating at Less than Full Capacity: Scenario 1
• Suppose that Tasha’s is currently operating at only 80% capacity.

– Full Capacity sales = 5 000 / 0.8 = 6 250
– Estimated sales = R5 500 (5 000 + the 10% predicted increase)
– This means the firm would only be operating at 88%
88% = 5 500 / 6 250
– Therefore, no additional non-current assets would be required.
– Pro forma Total Assets = 6 050 + 4 000 = 10 050
– Total Liabilities and Owners’ Equity = 10 250

Example 2: EFN
• THERE IS STILL EFN: 10 250 DOES NOT EQUAL 10 050

• What is it now?
• TA – (TL + TE)
• 10 050 – (10 250) = -200
– Choose plug variable (how will we deal with this?)
• Repay some short-term debt (decrease ST Debt)
• Repay some long-term debt (decrease LT Debt)
• Buy back shares (decrease Share Capital)
• Pay more in dividends (reduces additions to RP)
• Increase cash account

Example 2: EFN
• Suppose that Tasha’s is currently operating at 95% capacity.

– Full Capacity sales = 5 000 / 0.95 = 5 263
– Estimated sales = R5 500 (5 000 + the 10% predicted increase)
– Your estimated sales are MORE than what you can do with your
current capacity.
– Therefore, need additional non-current assets!
– New NCA = 4 000 / 5 263 * 5 500 = 4 180
– Pro forma Total Assets = 10 230
– Total Liabilities and Owners’ Equity = 10 250

Example 2: EFN
Operating at Less than Full Capacity: Scenario
2
• THERE IS STILL EFN: 10 230 DOES NOT EQUAL 10 250
• What is it now?
• TA – (TL + TE)
• 10 230 – (10 250) = -20
– Choose plug variable (how will we deal with this?)
• Repay some short-term debt (decrease ST Debt)
• Repay some long-term debt (decrease LT Debt)
• Buy back shares (decrease Share Capital)
• Pay more in dividends (reduces additions to RP)
• Increase cash account

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Chapter 4 Cash Flow and Financial Planning

Copyright © 2014 Pearson

• Understand the procedures behind the preparation of a statement of

Copyright © 2014 Pearson All rights reserved. 4-2

Analysing the Firm’s Cash Flows

• Cash flow (as opposed to accounting “profits”) is the

• From an accounting perspective, cash flow is

• From a financial perspective, firms often focus on both

Copyright © 2014 Pearson All rights reserved. 4-3

Developing the Statement of Cash Flows

• The statement of cash flows summarises the firm’s cash flow

Copyright © 2014 Pearson All rights reserved. 4-4

Developing the Statement of Cash Flows

• The statement of cash flows is divided into

Copyright © 2014 Pearson All rights reserved. 4-5

Figure 4.1 Cash Flows

Copyright © 2014 Pearson All rights reserved. 4-6

• Cash flows from operating activities are those that relate

Copyright © 2014 Pearson All rights reserved. 4-7

• Cash flows from investing activities are those

Copyright © 2014 Pearson All rights reserved. 4-8

• Financing activities are those that result in

Copyright © 2014 Pearson All rights reserved. 4-9

Preparing the statement of cash flows

Copyright © 2014 Pearson All rights reserved. 4-10

• Depreciation is the systematic allocation of the cost of

Copyright © 2014 Pearson All rights reserved. 4-12

Copyright © 2014 Pearson All rights reserved. 4-13

Table 4.4 Tugela Company Statement of financial position

Copyright © 2014 Pearson All rights reserved. 4-14

Statement of changes in equity for Tugela Company

Copyright © 2014 Pearson All rights reserved. 4-15

Copyright © 2014 Pearson All rights reserved. 4-16

Free Cash Flow

FCF = OCF – NFAI - NCAI

OCF = [EBIT x (1 – T)] + Depreciation

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

Copyright © 2014 Pearson All rights reserved. 4-17

Operating Cash Flow

• A firm’s Operating Cash Flow (OCF) is the cash flow

OCF = NOPAT + Depreciation

OCF = [EBIT x (1 – T)] + Depreciation

Operating cash flow for Tugela Company

OCF = [R370 000 x (1 - 0.30)] + R100

Copyright © 2014 Pearson All rights reserved. 4-19

Free cash flow for Tugela Company

The Financial Planning Process

• Financial planning involves guiding,

Copyright © 2014 Pearson All rights reserved. 4-21

Profit Planning: Pro Forma Statements

• Pro forma financial statements are projected, or forecast, financial

Copyright © 2014 Pearson All rights reserved. 4-22

Copyright © 2014 Pearson All rights reserved. 4-23

Copyright © 2014 Pearson All rights reserved. 4-24

Profit Planning: Pro Forma Financial

• Step 1: Start with a Sales Forecast

Table 4.13 2013 Sales Forecast for Vectra Manufacturing

Copyright © 2014 Pearson All rights reserved. 4-25

Profit Planning: Pro Forma Financial