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

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Cash Flow and Financial Planning

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Cash Flow and Financial Planning

FIL 240

Prepared by Keldon Bauer


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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.


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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.


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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.


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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


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Financial Statement Projections

  • If done correctly, cash budgets can be consistently projected by projecting pro-forma financial statements.

  • The cash in the projected cash account of the balance sheet is our expected cash.


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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.


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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.


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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.)


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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.


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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


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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.


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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.


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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


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1. Sales Forecast


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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.


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2. Projecting Income Statement

  • Usually, each line of the income statement can be projected as a percentage of sales.

  • These percentages come from the common-size income statement.

    • In a common-size income statement, all lines are restated as a percent of sales.


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Do you think Rocky will have sufficient financing based on their projected income statement

  • Yes

  • No

  • Maybe so!


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3. Projecting the Balance Sheet

  • Assets can also be estimated as a percent of sales.

    • In practice, these base estimates would have to be adjusted since some accounts don’t tend to rise and fall throughout the year with sales.


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3. Projecting the Balance Sheet

  • Liabilities can be made a percent of sales if they tend to rise and fall with sales (such as current liabilities).

  • For planning purposes, long-term debt and equity are left at last year’s levels.


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4. Analyzing Forecasts for Financial Planning

  • What current trends suggest will happen to the firm in the future.

  • What effect management’s current plans and budgets will have on the firm.

  • What actions to take to avoid problems revealed in the pro forma statements.


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