Download busn 5200 lesson notes – week 3 chapter 3

BUSN 5200 LESSON NOTES – WEEK 3 CHAPTER 3
Cash flow and Financial Planning
Introduction
- Financial analysts tend to concentrate on a firm’s cash flow rather than accounting profits.
The reasoning behind this is that cash is what is distributed to a firm’s shareholders in the
form of dividends and cash can be used to obtain new assets and to pay down debt.
Accounting profits cannot be used for any of these things.
- Therefore it is important for all managers in a firm to be able to analyze the flow of cash in
and out of their firms.
- The first tool that can be used to do this is the cash flow statement
The Statement of Cash Flows (See Baker Corporation Statement of Cash Flows on pg 100)
Note – This material was presented in chapter 2 in week 2. We repeat it here for
convenience.
- The statement of cash flows shows how much cash flowed in and out of the business
during a particular period
- Basically the statement of cash flows is developed by adding to earnings available to
common stockholders all the cash inflows and outflows that are not shown on the
income statement. Most of these are found by comparing balance sheets of two
successive dates. The changes in the balance sheet accounts are computed and recorded
on the statement of cash flows as follows:
-- An increase in an asset account is a use of funds
-- A decrease in an asset account is a source of funds
-- An increase in a liability or equity account is a source of funds
-- A decrease in a liability or equity account is a use of funds
Categories of Cash Flows:
Net Operating Profit After-Tax (NOPAT) (see page 99)
- Earnings available to common stockholders is often looked upon by managers as an
indicator of a firm’s performance. There is a problem with this measure, however, in that
it has interest expense subtracted out of it. Interest expense occurs as a result of a
company’s borrowing activity, and does not directly have anything to do with the
productivity of a firm’s assets. For this reason just looking at earnings available to
common stockholders doesn’t give you a true picture of how well the firm is operating
(two firm’s could be operating identically, but if one was using borrowed money and the
other was not, they would have different earnings available to common stockholders
figures).
- To get a better idea of how a company is operating, analysts turn to a measure called Net
Operating Profit After Tax (NOPAT). This is simply Operating Income, or Earnings
Before Interest and Taxes (EBIT), times 1 – the company’s effective income tax rate:
NOPAT = EBIT(1 – TR)
- Notice how this measure is essentially the same as Earnings available to common
stockholders, but interest expense has been backed out of the equation.
Operating Cash Flow (see page 100)
- Although NOPAT is useful, there is a problem with using it as a performance indicator,
however, in that it has Depreciation and Amortization expenses subtracted out of it.
- Operating Cash Flow (OCF) is simply NOPAT with these non-cash expenses added back
in:
OCF = NOPAT + Depreciation & Amortization
Free Cash Flow (see page 101)
- Although NOPAT and OCF are useful, some analysts don’t think they go far enough
because they do not include cash expenditures for new plant and equipment, increases in
inventory, and so on.
- To overcome this problem, analysts turn to a measure called Free Cash Flow (FCF). Free
cash flow is calculated by any required investment in operating capital (new plant and
equipment, etc.) and net working capital from Operating Cash Flow (OCF)
Note: in the business world investments in capital equipment are usually referred to as
capital expenditures, abbreviated as CapEx. In the textbook (see page 101) Capex is
called Net Fixed Asset Investment (NFAI)
FCF = OCF – Net Fixed Asset Investment (NFAI) – Net current Asset
Investment (NCAI)
- NFAI is calculated by taking the change in net fixed assets on the balance sheet from one
date to the next and adding depreciation expense for the period in between.
Example: (Net fixed assets for Dec 31, 2007 - net fixed assets for Dec 31, 2006) +
Depreciation for 2007
- NCAI is calculated by taking the change in current assets on the balance sheet from one
date to the next and subtracting the change in accounts payable plus accruals for the same
dates.
Example: (Current assets for Dec 31, 2007 - current assets for Dec 31, 2006) [ (Accounts payable + accruals for Dec 31, 2007) (Accounts payable + accruals for Dec 31, 2006) ]
Depreciation and Cash Flow:
- Accounting depreciation is the allocation of an asset's initial cost over time. Depreciation
expense on an income statement for a certain year is the portion of the asset’s initial cost
allocated to the year covered by the income statement.
- See table 3.2 on page 94 for the percentages of assets’ initial costs to be charged in
depreciation expense each year. The example at the bottom of the page shows how the
depreciation expense for each year is calculated form the percentages.
- The important thing to remember is that depreciation expense is not a cash flow.
Depreciation expense affects cash flow, however, because it is tax-deductible.
Depreciation expense lowers a company’s taxable income and, therefore its income tax
liability. In this way depreciation reduces cash outflows.
Cash Budgeting:
-- Even though the financial statements for many companies they're making money (on the
income statement) they don't have enough cash to support their growth
-- They either have to slow down growth because they can't get enough money, or they
default on some obligation
-- Therefore it is important that you know how to forecast a company’s cash needs
accurately.
-- Forecasting cash needs is done with a cash budget
- Cash budgeting is normally done on a spreadsheet, by adding up all expected cash inflows
and subtracting all expected cash outflows
- What’s left after subtracting cash outflows from cash inflows is the net cash balance,
which can be positive or negative
- If the net cash balance is negative, you know you need to obtain that amount from outside
sources (by borrowing it from a bank, for example)
- If the net cash balance is positive, and exceeds your minimum requirement, you could plan
on using the excess to pay down debt, or investing it.
- Creating a cash budget is essentially a mechanical exercise. See pages 105 – 110 in the
text for the procedure.
Forecasting
Introduction:
- Why you need to know how to forecast:
In business that's what game is about; trying to predict the future and act accordingly
-- In finance, the forecasting task involves generating financial statements for future times
(called “Pro Forma” financial statements), calculating ratios, etc, off of them, and
deciding what to do as a result
-- The task generally comes down to estimating how much money the company is going to
need (or not need) in the next year or two.
The forecasting task:
- Note that if you knew how many widgets you were going to sell in the future, your
forecasting task would be easy!
-- You could match that figure against how much it will cost you to produce them, add in
other expenses, and you'd be done.
-- It follows, then, that the critical task in forecasting is to forecast sales.
NOTE: Forecasting sales is not strictly a function of finance—it’s more of a marketing
task. Usually, the finance department’s job is to analyze what will happen to the firm’s
finances given a certain sales forecast. So, I admit you will be generally given a sales
forecast to work from, but not always, so you do need to be able to do it yourself in a
rudimentary sort of way:
Ways to forecast sales (nothing fancy; just some basic thoughts):
(1) Use someone else's forecast. Better yet, find three or four and average them together.
(Note--there's nothing wrong with doing this. After all, people who publish earnings
forecasts have been following the company longer than you have, and their information
is probably as good as yours.)
(2) Extend a past trend. Look at sales for the past 5 or 6 years and see if there's any
pattern, or trend developing. Draw a graph and extend it into the future.
NOTE--you certainly don't want to do this blindly. You would modify your guess for
the future according to anything you know about--example, market share information,
population shifts, new laws, etc. (that is, the QUALITATIVE information you have)
Example: you are an analyst at a company called Vectra manufacturing and you want to
make a sales forecast for 2007. Looking back over the past five years you observe that
sales were as follows:
2002……….. $ 30,100
2003……….. 48,000
2004……….. 52,000
2005……….. 86,000
2006……….. 100,000
On a graph:
Vectra Mfg. Sales Record
$120,000
$100,000
$100,000
$71,000
$80,000
$61,000
$60,000
$40,000
$32,300
$35,000
2002
2003
$20,000
$0
2001
2004
2005
2006
2007
- By “eyeballing” the sales trend, and assuming there are no external factors that would
cause you to modify your opinion, you might estimate that 2007 sales would be in the
neighborhood of $135,000.
- Refining the forecast:
-- If you needed more justification for your forecast than an “eyeball” estimate you
could calculate the average growth rate in sales during the past four years and then
use that growth rate to make your forecast for 2006:
 FV 
g

 PV 
 100,000 
g

 32,300 
1/n
-1
1/4
-1
g  3.095975 .25 - 1
g  .3265, or 32.65% per year
2007 sales = 2006 sales x (1 + g)
2007 sales = 100,000 x (1 + .3265)
2007 sales = $132,648, rounded off to $132,600
(You would generally round off to an even number because forecasting a very precise
number implies you had very precise input data which is generally not the case)
-- If you needed even more justification for your forecast, you might conduct a regression
analysis on the sales record and estimate 2007 sales by extending the regression line
Producing Pro Forma Financial Statements
OK, Once you have a Sales Forecast, the finance person's task is to extend the rest of the income
statement and the balance sheet into the future accordingly (these projected financial statements
are called pro forma after the Latin “as a matter of form”):
- To extend the income statement and balance sheet accounts into the future, you must
make judgments about how each item on the financial statements behaves
--example (based on Vectra Manufacturing, pages 114-119):
Historical 2006
Sales
COGS
100,000
80,000
Estimated 2007
135,000 (Forecast)
?
- Suppose through careful observation and analysis you determine that COGS tends to
fluctuate with sales over the years, tending to remain a constant percent of sales.
Therefore, you believe you can forecast COGS in the future by maintaining this trend
(that is, by always keeping COGS the same percentage of sales that it is now).
- In 2006 COGS was 80,000 / 100,000 = .80, or 80% of Sales.
- Therefore, according to your assumption, COGS in 2007 ought to remain 80% of Sales:
2007 COGS = 135,000 x .80 = 108,000
Note: Can you see why this forecasting method is often called the percent of
sales method?
- In this manner, you can extend the whole income statement and the balance sheet into the
future. Remember, you do it by making judgments about how each account on the
financial statements behaves. If, in your judgment, the account varies directly with sales
you can use the percent of sales method as outlined above. If the account does not
behave that way, then you must make other judgments and forecast the account
accordingly. (For example, you might forecast Notes Payable by assuming that all shortterm debts will be paid off during the coming year. In that case projected Notes payable
will be zero.)
Forecasting Retained Earnings
- Remember, the retained earnings account represents the sum of all net income not paid
out in the form of dividends to stockholders.
- At the end of 2007, Vectra’s retained earnings will be the retained earnings at the end of
2006 plus that portion of 2007’s net income not paid out in dividends
Example:
Retained earnings at the end of 2006……..$23,000
Forecasted Net Income for 2007……...…..$10,327
Forecasted Dividends for 2007………...…- 4,000
2007 Addition to Retained Earnings……...$ 6,327
Retained earnings at the end of 2007 = $23,000 + $6,327 = $29,327
External Financing Required (EFR)
- When the pro forma balance sheet is completed, total assets and total liabilities and equity
will rarely match. The discrepancy between forecasted assets and forecasted liabilities
and equity results because either too little or too much financing is projected for the
amount of asset growth expected.
- The discrepancy is called external financing required (EFR) when forecasted assets
exceed forecasted liabilities and equity.
- It is called excess financing when forecasted liabilities and equity exceed forecasted
assets.
- The determination of external financing required is one of the most important reasons for
producing pro forma financial statements. Armed with the knowledge of how much
additional external funding is needed, financial managers can make the necessary
financing arrangements in the financial markets before a crisis occurs.
Vectra’s EFR for 2007 = Forecast Total Assets………...............$105,875
- Forecast Total Liabilities & Equity… 97,582
EFR = $ 8,293
What to do with the Pro Forma (forecast) financial statements:
- Once the pro forma financial statements have been developed, managers can do some
ratio analysis on the forecast to see if they like the results
-- If they do like the results, they simply let the future take its course
-- If they don't like the results, they take management action to change things
- Also, don't forget, when the forecast is done, managers must plan on how to raise the
External Financing Required (EFR) if any
An Important Observation:
As the growth rate in sales goes up, so does External Financing Required
- As a result, many businesses can get into trouble by "growing too fast". Even though
they're making money (on the income statement) they don't have enough cash to support
their growth
End of Notes