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. • All debts must be paid in cash (or the firm can be forced in to bankruptcy). • All investors expect to be repaid in cash.
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.
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.
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
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.
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.
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.
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.)
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.
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
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.
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.
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
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.
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.
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.
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.
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.