Gitman Ch03-01

BFA281 Financial Management
Tony Stanger
Week 2 Cash Flow and Financial Planning (Chapter 3)

Gitman, Juchau, Flanagan, Principles of Managerial Finance 5e: 2008 Pearson Education Australia 1
Learning Objectives
Importance of cash flow to business survival Describe the firms cash flow statement, operating cash flow and free cash flow Understand the financial planning process Discuss cash planning process and budgets Prepare pro forma financial statements Evaluate the approaches to pro forma financial statement preparation
Gitman, Juchau, Flanagan, Principles of Managerial Finance 5e: 2008 Pearson Education Australia
Importance of a firms cash flow

What is cash flow?
the actual net cash (not net income or accounting profit) that flows in or out of a firm during a specified period
The importance of cash flow

lifeblood of the firm - payment for inventory and other current assets (CA), non-current assets (NCA), wages/salaries (CL), interest on debt (repayment of principal) (CL & NCL), dividends must all be paid with cash and on time
Gitman, Juchau, Flanagan, Principles of Managerial Finance 5e : 2008 Pearson Education Australia
Importance of a firms cash flow

The importance of cash flow (cont.)
a firm can be profitable, but have poor (or negative) cash flow, leading to insolvency a firm can fail the day it misses paying a creditor, due to legal action leading to receivership/ bankruptcy e.g. Hartz Mineral Water
Analysing the firms cash flow

Tools for analysing a firms cash flow include
Past - statement of cash flows Future financial planning can involve
Cash budgeting Pro forma financial statements
Income statement Balance sheet
Statement of cash flows

Three types of cash flow
Operating cash flow
associated with the production (outflow) and sale of goods and services (inflow) i.e. normal operations
Investing cash flow

arise from the purchase (outflow) and sale of NCA like property, plant and equipment (inflow)
Financing cash flow

result from the issue of debt and equity securities (inflow), and payment of interest/ dividends, repayment/ repurchase of principal/ shares (outflow)

Step one:
Classifying transaction as inflows and outflows of cash inflows decrease in asset increase in liability net profits after tax depreciation sale of shares outflows increase in asset decrease in liability net loss dividends paid repurchase of shares
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Step two: Involves categorising inflows and outflows of cash into operating, investing and financing flows
Covered in Financial Accounting units Students not required to prepare a statement of cash flows in BFA281, rather to understand and interpret

Step three: Interpreting the statement of cash flows by answering 3 questions
What were the sources of funds during the year? How did the firm use available funds? Did operations during the year tend to increase or decrease the firms liquidity, as measured by cash and marketable securities balance
Operating cash flow (OCF)

Reconciling OCF from the Income Statement
Alternative definitions of OCF exist Accounting definition
cash flow from operations (CFO) = net profits after tax + depreciation and other non cash charges (amortisation & depletion) [3.1]
Includes interest as an operating expense This assumes no change in CA (debtors, inventory) and CL (creditors, accrued expenses)

Reconciling OCF from the Income Statement (cont.)
Finance definition
OCF = net operating profits after tax + depreciation and other non-cash charges ( amortisation & depletion) [3.4]
= NOPAT + (deprec, amort & depletion) = [EBIT x (1-T)] + (deprec, amort & depletion) Interest is excluded as an operating cash flow as it is a financing cash flow

Why allow for (add back) depreciation?
Definition: annual non-cash charge against income for the portion of non-current assets used up i production d in d ti Depreciation expense determined by
depreciable value of NCA depreciable life of NCA depreciation method used i.e. prime cost (straight line) or diminishing value (reducing balance)
Free cash flow (FCF)

FCF is the cash available to owners (shareholders and creditors) after meeting all operating needs and paying for investments in NNCA and NCA
Some firms count essential maintenance of e.g. gas transmission and distribution pipelines as an operating need e.g. Envestra
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Free cash flow (FCF)

FCF = OCF NNCAI NCAI
Where
NNCAI = net non-current asset investment = change in net non-current assets + depreciation [3.6]
[3.5]
NCAI = net current asset investment = change in current assets change in (accounts payable and accruals)
[3.7]
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Examples of CFO, OCF & FCF

Using the Baker Corporation example in Gitman
CFO = net profit after tax + depreciation expense = $180 + $100 = $280 OCF = EBIT (1 Tax rate) + depreciation = $370 (1 0.4) + $100 = $322 FCF = OCF NNCAI NCAI = $322 (1,200 1,000 + 100) [(2,000 1,900)* - (800 700)**] = $322 - $300 -$0 = $22 * current assets cash, marketable securities, debtors, invent. ** current liabilities accounts payable, accruals
Financial planning process

What is financial planning? Sets financial goals Formulates strategies for achieving goals Statement of what is to be done in the future
Most decisions involve long lead times and therefore decisions must be made far in advance of their implementation
e.g. to build a factory in 2012 we may need to arrange contractors and financing in 2010

Growth as a financial management goal? Growth rates are commonly used in the planning process as it is convenient in summarising aspects a firms financial and investment policies But, growth may not guarantee an increase in share price

Growth as a financial management goal?
Example: Is sales growth of 15% with constant net profit margin of 6% preferred over increased profit margin to 7% on constant sales and reduced costs?
In this case firm value is enhanced more by the latter e.g. let original sales = $100
$100 x 1.15 x 0.06 = $6.90 net profit, which is less than the alternative goal $100 x 0.07 = $7.00 net profit
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Dimensions of financial planning Planning horizon
long run = strategic
2 to 10 years, depending on uncertainty and production cycles e.g. cars v fashion
short run = operating

1 to 2 years

Dimensions of financial planning (cont.) Aggregation
smaller investment proposals of each operational unit are added up to and treated as one big project
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Dimensions of financial planning (cont.) Establish inputs in form of alternative sets of assumptions for important variables
Pessimistic or worst case Normal case most likely assumptions about company and economy Optimistic or best case

Benefits of financial planning Interactions
Linkages between investment and financing
Options
Develop, analyse and compare different scenarios in a consistent way
Avoiding surprises
Develop contingency plans in case assumptions about the future seriously wrong
Feasibility and internal consistency

Prioritise conflicting goals e.g. growth over debt reduction
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Cash planning
Components of the cash budget Sales forecast
external f t l forecast t
observable relationships between sales and e.g. GDP, new housing starts, unemployment rate
internal forecast
firms view on sales as per sales manager and production limitations
Cash planning
Components of the cash budget (cont.)
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Cash planning
cash receipts - forecast sales - cash sales - collections of A/R - lagged - other
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Cash planning
cash disbursements - cash dividends - purchases - rent - wages - tax - non current assets - interest/principal
Cash planning
Interpreting the cash budget
net cash flow
combined effect of operating, investing and financing activities
ending cash
beginning balance + net cash flow = ending balance
excess cash balance

Repay debt, invest or return to shareholders?
required total financing

raise funds how, where, amount, terms?
Cash planning
Evaluating the cash budget
meeting a cash shortfall
issue debt or equity, short or long term?
coping with uncertainty

run simulations; or pessimistic, most likely and optimistic scenarios
cash flow within the month (intra month)

day to day cash flows and solvency
Profit planning
Profit planning: projecting the firms overall financial position
pro forma statements are used (p j p (projections) )
estimations involved and assume relationships in past FS will apply this period
two ingredients needed

previous years financial statements sales forecast for coming year
accuracy important and marketing department input necessary
Profit planning
Preparing the pro forma income statement
percent-of-sales method, e.g. Vectra Manufacturing 31/12/2007 (pp.117-20)
( (cost of goods sold) / ( l ) t f d ld) (sales) (operating expenses) / (sales) (interest expense) / (sales) = 80% = 10% = 1%
Vectra example assumes all expenses variable

understates Net Profit when sales grow validity of this assumption?
Profit planning
Preparing the pro forma income statement (cont.)
fixed costs may exist in reality
fixed over a relevant range of sales e.g. depreciation, administrative and sales staff?
variable costs
factory labour, materials, power, taxes
existence of fixed costs creates operating leverage

Profit planning
Preparing the pro forma balance sheet to determine external funds required
Judgmental approach most popular and incorporates:
percent-of-sales method which assumes
Most BS accounts tied directly to sales The current levels of all assets are optimal for the current sales level
calculation of items that change spontaneously

CA - e.g. inventory, debtors CL- e.g. creditors, accruals, taxes SHE - retained profits (for a given dividend policy/payout ratio) CL and Retained Earnings are sources of spontaneous financing
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Profit planning
Preparing the pro forma balance sheet to determine external funds required (cont.)
Judgmental approach most popular and incorporates:
estimation of others specific management action or discretion required
NCA if no excess capacity, but investment lumpy NCL will long-term debt (e.g. notes payable, bonds, term loans) change? SHE will Issued Capital change? NCL and Issued Capital are sources of discretionary financing used to maintain the accounting equation A = L + OE
Profit planning
Preparing the pro forma balance sheet to determine external funds required (cont.)
If A > L+OE additional financing needed (AFN) is the plug figure in the Balance Sheet p g g
AFN can be sourced from
CL e.g. bank bills, overdraft NCL e.g. notes payable, bonds, term loans
If A < L+OE, suggests sales contraction and excess financing exists
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Profit planning
Evaluating the pro forma statements/ limitations of the percent-of-sales method
Benefit of method is its simplicity But assumes we can accurately forecast future financial items like assets as a given % of sales
This may be valid assumption where e.g. inventory levels rise and fall in direct proportion to sales volume But, depending on nature of firm operations and types of assets used, this 1-to-1 relationship may not hold
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Profit planning
Non-current assets
Large-scale equipment may need to be purchased or built well beyond the capacity required i.e. lumpy assets y p y q py Where excess capacity exists, investment may not increase for a given level of sales
Current assets
Are assumed values of some variables realistic?
Cash, debtors and inventories may be hard to control
e.g. interest rates reduce business optimism and affect debtor payments huge price rises for commodities in mining sector
Profit planning
Current assets
Relationships between sales and other accounts may change beyond a relevant range e.g.
quantity discounts impacting inventory and COGS Some firms purchase finished goods inventories daily on demand, while others maintain a base level which grows less rapidly than sales, so the ratio of inventory to sales declines
Profit planning
Determinants of a sustainable growth rate Profit margin Dividend policy Financial policy Total asset turnover
Quiz
1. If EBIT = $2,700, taxes = $200 and depreciation = $500, then operating cash flow equals: A) $2,900 B) $2,500 C) $2,200 D) $3,000 2. 2 All of the following are used in cash planning EXCEPT: A) internal forecasts B) external forecasts C) accruals D) sales forecasts 3. A pro forma statement summarises: A) the firm's projected income and/or balance sheet B) the current level of retained earnings C) inventory holdings D) the balance sheet
Quiz
4. When preparing the pro forma income statement, the use of past ratios: A) maximises net profits after taxes B) is legally compulsory C) tends to overstate profits when sales are falling D) cannot distinguish between fixed and variable costs 5. Under the judgemental approach to pro forma statements: A) a t e items a e eco o et ca y modelled ) all the te s are econometrically ode ed B) some of the items are set by the governing authorities C) none of the revenue items can be entered D) some values are estimated and others are calculated 6. The firm will often use different methods of depreciation for tax reporting than for internal reporting because: A) it wants to avoid triple taxation on dividends B) the objectives of financial reporting are different from those of tax legislation C) there is no incentive to encourage investors to increase their shareholding D) to lower the cost of equity financing for the company
Week 3 Tutorial
Review Questions and Problems from Chapter 3 to be covered in the Week 3 Tutorial:
Review Questions 3.4, 3.11, 3.13, 3.14 & 3.17 Problems 3.10, 3.14 & 3.24
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BFA281 Financial Management

Week 2 Cash Flow and Financial Planning (Chapter 3)

Importance of a firms cash flow

The importance of cash flow

Importance of a firms cash flow

Analysing the firms cash flow

Statement of cash flows

Investing cash flow

Financing cash flow

Statement of cash flows

Statement of cash flows

Statement of cash flows

Operating cash flow (OCF)

Operating cash flow (OCF)

Operating cash flow (OCF)

Free cash flow (FCF)

Free cash flow (FCF)

Examples of CFO, OCF & FCF

Financial planning process

Financial planning process

Financial planning process

Financial planning process

short run = operating

Financial planning process

Financial planning process

Financial planning process

Feasibility and internal consistency

Financial planning process

excess cash balance

required total financing

coping with uncertainty

cash flow within the month (intra month)

two ingredients needed

Vectra example assumes all expenses variable

existence of fixed costs creates operating leverage

calculation of items that change spontaneously

If A < L+OE, suggests sales contraction and excess financing exists

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