Chapter 4. Cash Flow and Financial Planning. Copyright 2012 Pearson Prentice Hall. All rights reserved.

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1 Chapter 4 Cash Flow and Financial Planning Copyright 2012 Pearson Prentice Hall. All rights reserved.

2 Analyzing the Firm s Cash Flow Cash flow (as opposed to accounting profits ) is the primary ingredient in any financial valuation model. From an accounting perspective, cash flow is summarized in a firm s statement of cash flows. Firms often focus on operating cash flow, which is used in managerial decisionmaking free cash flow, which is closely monitored by participants in the capital market Pearson Prentice Hall. All rights reserved. 4-2

3 Depreciation Depreciation is the portion of the costs of fixed assets charged against annual revenues over time. Amortization write-off of intangible assets Depletion write-off natural resources Depreciation for tax purposes is determined by using the modified accelerated cost recovery system (MACRS) Pearson Prentice Hall. All rights reserved. 4-3

4 Depreciation: Depreciation & Cash Flow 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. non-cash expenses create a tax shield and enhance cash flow Pearson Prentice Hall. All rights reserved. 4-4

5 Table 4.1 First Four Property Classes under MACRS 2012 Pearson Prentice Hall. All rights reserved. 4-5

6 Table 4.2 Rounded Depreciation Percentages by Recovery Year Using MACRS for First Four Property Classes 2012 Pearson Prentice Hall. All rights reserved. 4-6

7 Depreciation Depreciabl e Basis = Asset Cost + Installation Cost Depreciati on Expense = Basis * % Book Value = Deprec. Basis- Accum. Depr 2012 Pearson Prentice Hall. All rights reserved. 4-7

8 Depreciation schedule Basis = yr asset yr % Depr Acc BV Depr Pearson Prentice Hall. All rights reserved. 4-8 CB Cash Flows

9 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 Pearson Prentice Hall. All rights reserved. 4-9

10 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 = EBIT Taxes + Depreciation Slightly different formula than in the textbook. This formula matches the formula in the spreadsheet Pearson Prentice Hall. All rights reserved. 4-10

11 Free Cash Flow Free cash flow (FCF) is the amount of cash flow available to investors (creditors and owners) after the firm has met all operating needs and paid for investments in net fixed assets (NFAI) and net current assets (NCAI). FCF = OCF NFAI NCAI Where: NFAI = Change in net fixed assets + Depreciation NCAI = Change in CA Change in (A/P + Accruals) Pearson Prentice Hall. All rights reserved. 4-11

12 The Financial Planning Process The financial planning process begins with long-term, or strategic, financial plans that in turn guide the formulation of short-term, or operating, plans and budgets. 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 preparation of pro forma statements Pearson Prentice Hall. All rights reserved. 4-12

13 FCF Calculation Notes Payable are not included as a Current Liability in this technique 2012 Pearson Prentice Hall. All rights reserved. 4-13

14 Net Income $180 Non-Cash Expenses $100 CFAT $280 Taxes ($) $120 EBIT $370 OCF $350 Change in CA (if given) CA (beg) $1,900 NCAI $0 CA (end) $2,000 Change in CL (if given) NFAI $300 A/P and Accruals (beg) $700 A/P and Accruals (end) $800 FCF $50 Change in FA (if given) Fixed Assets (beg) $1,000 Fixed Assets (end) $1,200 OCF (if given) OCF = EBIT Taxes + Depreciation = $370 $120 + $100 = $350 NCAI = CA A /P and Accruals NFAI = Net Fixed Assets + Depreciation = [($2,000 - $1,900) - ($800 - $700)] = $0 = [($1,200- $1,000) + $100 = $300 FCF = OCF NFAI NCAI = $350 $300 $0 = Pearson Prentice Hall. All rights reserved. Free Cash Flow Calculation 4-14

15 The Financial Planning Process: Long-Term (Strategic) Financial Plans 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 subject to high degrees of operating uncertainty, relatively short production cycles, or both, tend to use shorter planning horizons. 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 Pearson Prentice Hall. All rights reserved. 4-15

16 The Financial Planning Process: Short-Term (Operating) Financial Plans Short-term (operating) financial plans specify shortterm financial actions and the anticipated impact of those actions. 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 on the following slide Pearson Prentice Hall. All rights reserved. 4-16

17 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 Pearson Prentice Hall. All rights reserved. 4-17

18 Profit Planning: Pro Forma Statements Pro forma financial statements are projected, or forecast, financial statements income statements and balance sheets. A simple method for developing a pro forma income statement is the percent-of-sales method. Probably the best approach to use in developing the pro forma balance sheet is the judgmental approach. The accounting balance sheet is created using the debit-credit system This balance sheet will not balance One of the outcomes is the external funding required to finance asset growth A deficit requires external funds to be gathered A surplus requires temporary investment or a payback 2012 Pearson Prentice Hall. All rights reserved. 4-18

19 Evaluation of Pro Forma Statements (cont.) However pro forma statements are prepared, analysts must understand how to use them to make financial decisions. Financial managers and lenders can use pro forma statements to analyze the firm s inflows and outflows of cash, as well as its liquidity, activity, debt, profitability, and market value. Various ratios can be calculated from the pro forma income statement and balance sheet to evaluate performance. Cash inflows and outflows can be evaluated by preparing a pro forma statement of cash flows. After analyzing the pro forma statements, the financial manager can take steps to adjust planned operations to achieve short-term financial goals Pearson Prentice Hall. All rights reserved. 4-19