Cash Flows, Financial Planning and Budgeting

I.​ Nature and Purpose of Cash Flow Analysis

●​ “Cash -not profit- is King”
●​ Cash flow (as opposed to accounting “profits”) is the primary ingredient in any
financial valuation model. It is the life blood of the firm.
●​ Cash flow is the amount of cash moving in and out of a business during a specific
period.
○​ Positive Cash Flow - Indicates more money entering than leaving.
○​ Negative Cash Flow- Indicated more money leaving than entering.
●​ Cash flow is summarized in a firm’s statement of cash flows.
●​ The Statement of Cash Flows required by PAS 7 provides information about cash
inflows and outflows during an accounting period as well as the net change in
cash from the operating, investing and financing activities in a manner that
reconciles the beginning and ending cash balances.
●​ The statement of cash flows is a valuable analytical tool for managers as well as
for investors and creditors because it answers questions that cannot be answered
by the income statement and statement of financial position. Some such vital
questions are:
1.​ Is the company generating sufficient positive cash flows from its ongoing
operations to remain variable?
2.​ Will the company be able to meet its financial obligations to the creditor?
3.​ What expansion activities took place and how were those financed?
4.​ Will the company be able to pay its customary dividend:
5.​ Why did cash decrease even though a net income was reported?
6.​ To what extent will the company have to borrow money in order to make
needed investments
7.​ What happened to the proceeds received from the issuance of capital
stock?
●​ The primary purpose of a cash flow statement is to provide relevant information
about a company's cash receipts and cash payments during an accounting period.

II.​ Cash Flow Activities

●​ Operating Cash Flows
○​ Cash flows directly related to sale and production of the firm’s products
and services.
○​ is the cash flow it generates from its normal operations—producing and
selling its output of goods or services.
●​ Investment Cash Flows
○​ Cash flows associated with purchase and sale of both fixed assets and
equity investments in other firms.
 Cash Flows, Financial Planning and Budgeting

●​ Financing Cash Flows

○​ Cash flows that result from debt and equity financing transactions; include
incurrence and repayment of debt, cash inflow from the sale of stock, and
cash outflows to repurchase stock or pay cash dividends.

III.​ Inflows and Outflows of Cash

1.​ A decrease in an asset, such as the firm’s cash balance, is an inflow of cash. Why?
Because cash that has been tied up in the asset is released and can be used for
some other purpose, such as repaying a loan. On the other hand, an increase in the
firm’s cash balance is an outflow of cash because additional cash is being tied up
in the firm’s cash balance.
2.​ Depreciation (like amortization and depletion) is a noncash charge—an expense
that is deducted on the income statement but does not involve an actual outlay of
cash. Therefore, when measuring the amount of cash flow generated by a firm, we
have to add depreciation back to net income or we will understate the cash that
the firm has truly generated.
3.​ Because depreciation is treated as a separate cash inflow, only gross rather than
net changes in fixed assets appear on the statement of cash flows. The change in
net fixed assets is equal to the change in gross fixed assets minus the depreciation
charge. Therefore, if we treated depreciation as a cash inflow as well as the
 Cash Flows, Financial Planning and Budgeting

reduction in net (rather than gross) fixed assets, we would be double counting
depreciation.
4.​ Direct entries of changes in retained earnings are not included on the statement of
cash flows. Instead, entries for items that affect retained earnings appear as net
profits or losses after taxes and dividends paid.

IV.​ Preparing Statement of Cash Flows

Statement of Cash Flow is a financial statement that summarizes a company's cash
inflows and outflows over a specific period.

Classification:
1.​ Operating Activities - Cash flows related to a company’s core business operations.
2.​ Investing Activities - Cash flows from the purchase or sale of long-term assets.
3.​ Financing Activities - Cash flows from borrowing, repaying debt, or issuing
dividends.

Methods:
1.​ Direct Method - Directly lists all actual cash receipts and payments from
operations. May be preferred by companies that want to provide greater
transparency about their cash flows, particularly for smaller businesses with
simpler transactions.
2.​ Indirect Method - It starts with net income from the income statement and adjusts
for non-cash items and changes in balance sheet accounts to arrive at the cash
flow from operations. Most companies use the indirect method as it is simpler to
prepare and provides a good overview of cash flow adjustments from non-cash
items.

Example 1. Direct Method Statement of Cash Flows

Japheth established her own service company. She invested 2,000,000 to open the
business and has purchased some computer equipment worth 120,000 and office furniture
worth 80,000. During the year, 500,000 revenues were earned, 200,000 of which were on
account. Salaries paid to employees amounted to 150,000, office rent payment is 40,000,
and utilities paid amounted to 30,000. Receivables collected amounted to 70,000. The
owner withdrew 100,000 for a personal emergency. At the time when the carrying value
of the furniture was 70,000, Madam Lisa sold it for 75,000 cash.

1. How much is the entity’s cash flow from operating activities?

2. How much is the entity’s cash flow from investing activities?
3. How much is the entity’s cash flow from financing activities?
4. How much is the cash balance at the end of the year?
Cash Flows, Financial Planning and Budgeting
 Cash Flows, Financial Planning and Budgeting

Example 2. Indirect Method Statement of Cash Flows

 Cash Flows, Financial Planning and Budgeting

Operating Cash Flow is the cash flow the firm generates from its normal operations,
producing, and selling its output of goods or services. It is calculated as net operating
profits after taxes (NOPAT) plus depreciation.
OCF = NOPAT + Depreciation

NOPAT is calculated as follows:

NOPAT = EBIT x (1- T)

We can substitute the expression for NOPAT from the first equation into equation 2 to get
a single equation for OCF:
​ OCF = [EBIT x (1- T)] + Depreciation

Substituting the values for Baker Corporation

from its income statement into Equation 3,
we get
OCF = [$370 x (1.00 - 0.40)] + $100
= $222 + $100
= $322

V.​ 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).

​ FORMULA: FCF=OCF-NFAI-NCAI

WHERE:

NFAI = Change in net fixed assets + Depreciation

NCAI = Change in CA – Change in (A/P + Accruals)

Net Fixed Asset Investment (NFAI) is the net investment that the firm makes in fixed
assets and refers to purchases minus sales of fixed assets.
 Cash Flows, Financial Planning and Budgeting

NFAI= $200 + $100= $300

The Net Current Asset Investment (NCAI) represents the net investment made by the
firm in its current (operating) assets. “Net” refers to the difference between current assets
and the sum of accounts payable and accruals.
 Cash Flows, Financial Planning and Budgeting

NCAI= $100- $100= $0

THEREFORE:

FCF= $322- $300- $0= $22

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VI.​ 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

●​ Cash Planning
●​ Profit Planning
A.​ 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.

B.​ Short-term (Operating) Financial Plans

​ Short-term (operating) financial plans specify short-term 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.

SHORT-TERM FINANCIAL PLANNING PROCESS

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VII.​ Cash Planning

●​ Cash Budget or cash forecast is a statement of the firm's planned inflows and
outflows of cash that is used to estimate its short-term cash
requirements.Typically, the cash budget is designed to cover a 1-year period,
divided into smaller time intervals
●​ Sale Forecast is a prediction of the sales activity during a given period, based on
external and/or internal data
-​ External Forecast
-​ Internal Forecast

●​ Cash receipts include all of a firm’s inflows of cash during a given financial
period. The most common components of cash receipts are cash sales, collections
of accounts receivable, and other cash receipts.
●​ Cash disbursements include all outlays of cash by the firm during a given
financial period. The most common cash disbursements are;
-​ Cash purchases Fixed-asset outlays
-​ Payments of accounts payable Interest payments
-​ Rent (and lease) payments Cash dividend payments
-​ Wages and salaries Principal payments (loans)
-​ Tax payments Repurchases or retirements of stock
It is important to recognize that depreciation and other non-cash charges are
NOT included in the cash budget
●​ The firm’s net cash flow is found by subtracting the cash disbursements from
cash receipts in each period. Then we add beginning cash to the firm’s net cash
flow to determine the ending cash for each period.
●​ Finally, we subtract the desired minimum cash balance from ending cash to find
the required total financing or the excess cash balance.---------
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●​ The personal budget is a short-term financial planning report that helps

individuals or families achieve short-term financial goals. Personal budgets
typically cover a 1-year period, broken into months.
●​ Coping with Uncertainty in the Cash Budget
-​ To manage uncertainty, financial managers can:
1.​ Prepare Multiple Cash Budgets – Create forecasts based on:
○​ Pessimistic scenarios (expecting unfavorable outcomes, such as low sales
or high expenses).
○​ Most likely scenarios (expected normal conditions).
○​ Optimistic scenarios (expecting favorable outcomes, such as high sales or
cost savings).​
This helps assess financing needs for worst-case situations.
2.​ Use Scenario Analysis – A “what-if” approach to analyze cash flows under
different conditions and evaluate risk.

E.g.

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●​ The optimal cash balance is the ideal amount of cash a company should maintain
to cover daily expenses while minimizing costs.
1.​ Baumol Model
-​ Best for businesses with predictable cash flows. It works like inventory
management, where firms withdraw cash periodically to balance needs
and costs.
-​ minimizes total cost by balancing transaction costs and opportunity
costs, ensuring an efficient cash management strategy.

( TOTAL COST = TRANSACTION COST + OPPORTUNITY COST)

 Cash Flows, Financial Planning and Budgeting

BAUMOL MODEL FORMULA:

C* - OPTIMAL CASH BALANCE

2.​ Miller-Orr Model

-​ Suitable for businesses with fluctuating or uncertain cash flows. It sets
upper and lower cash limits to determine when to invest or withdraw
funds.

Z - Optimal cash return point

F - Trading transaction cost (Marketable Security)
o - Net daily cash flow
i - Daily interest rate on marketable security
L - Lower Limit (Most likely given)
H - Higher Limit

When cash drops below the lower limit, the firm transfers funds from investment into
the account to bring the balance back to the optimal cash return point. When cash
 Cash Flows, Financial Planning and Budgeting

exceeds the upper limit, the firm moves excess cash into investments, reducing the
balance back to the return point

●​ Cash Flow Within the Month

-​ A monthly cash budget alone may not ensure solvency. Firms must
monitor daily cash receipts and disbursements to meet obligations on
time. Since cash flows vary daily, financial managers should plan and
track cash flow more frequently, especially when variability is high.

VIII.​ Preparing the Pro Forma Income Statement

Profit Planning: Pro Forma Statements
●​ Cash planning focuses on forecasting cash flows.
●​ Profit planning relies on accrual concepts to project the firm’s profit and overall
financial position.
Pro forma statements- projected, or forecast, income statements and balance sheets.​
Two inputs are required for preparing pro forma statements:
(1) Financial statements for the preceding year and
(2) Sales forecast for the coming year.
A simple method for developing a pro forma income statement is the
percent-of-sales method.
Percent-of-sales method - it forecasts sales and then expresses the various
income statement items as percentages of projected sales

Illustrative Example:
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CONSIDERING TYPES OF COSTS AND EXPENSES

The technique that is used to prepare the pro forma income statement in Table 4.15
assumes that all the firm’s costs and expenses are variable.

Because this approach assumes that all costs are variable, it may understate the increase
in profits that will occur when sales increase if some of the firm’s costs are fixed. Similarly, if
sales decline, the percentage-of-sales method may overstate profits if some costs are fixed and do
not fall when revenues decline​
​ Therefore, a pro forma income statement constructed using the percentage-of sales
method generally tends to understate profits when sales are increasing and overstate profits when
sales are decreasing.
The best way to adjust for the presence of fixed costs when preparing a pro forma income
statement is to break the firm’s historical costs and expenses into fixed and variable components
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Clearly, when using a simplified approach to prepare a pro forma income statement, we should
break down costs and expenses into fixed and variable components.

IX.​ Preparing the Pro Forma Statement of Financial Position

●​ Judgmental Approach - A simplified approach for preparing the pro forma balance
sheet under which the firm estimates the values of certain balance sheet accounts and
uses its external financing as a balancing, or “plug,” figure.

●​ External Financing Required (“plug” figure) - Under the judgmental approach for
developing a pro forma balance sheet, the amount of external financing needed to bring
the statement into balance. It can be either a positive or a negative value.

●​ A positive value for “external financing required,” like that shown in Table 4.16,
means that, based on its plans, the firm will not generate enough internal
financing to support its forecast growth in assets.
●​ A negative value for “external financing required” indicates that, based on its
plans, the firm will generate more financing internally than it needs to support its
forecast growth in assets. In this case, funds are available for use in repaying debt,
repurchasing stock, or increasing dividends.