Bba 2204 fin mgt week 4 cashflow & financial planning

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Cashflow Cashflow and and Financial Planning Financial Planning BBA 2204 FINANCIAL MANAGEMENT BBA 2204 FINANCIAL MANAGEMENT by by Stephen Ong Stephen Ong Visiting Fellow, Birmingham City Visiting Fellow, Birmingham City University Business School, UK University Business School, UK Visiting Professor, Shenzhen Visiting Professor, Shenzhen University University

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Cashflow, Depreciation, Financial Planning, Pro-forma statements

Transcript of Bba 2204 fin mgt week 4 cashflow & financial planning

Page 1: Bba 2204 fin mgt week 4 cashflow & financial planning

Cashflow Cashflow and and

Financial PlanningFinancial Planning

Cashflow Cashflow and and

Financial PlanningFinancial Planning

BBA 2204 FINANCIAL MANAGEMENTBBA 2204 FINANCIAL MANAGEMENT

bybyStephen OngStephen Ong

Visiting Fellow, Birmingham City Visiting Fellow, Birmingham City University Business School, UKUniversity Business School, UK

Visiting Professor, Shenzhen UniversityVisiting Professor, Shenzhen University

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Today’s Overview Today’s Overview

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Learning GoalsLearning Goals1. Understand tax depreciation procedures and the effect of

depreciation on the firm’s cash flows.2. Discuss the firm’s statement of cash flows, operating cash

flow, and free cash flow.3. Understand the financial planning process, including long-

term (strategic) financial plans and short-term (operating) financial plans.

4. Discuss the cash-planning process and the preparation, evaluation, and use of the cash budget.

5. Explain the simplified procedures used to prepare and evaluate the pro forma income statement and the pro forma balance sheet.

6. Evaluate the simplified approaches to pro forma financial statement preparation and the common uses of pro forma statements.

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Analyzing the Firm’s Analyzing the Firm’s Cash FlowCash Flow

• Cash flow Cash flow (as opposed to accounting “profits”)(as opposed to accounting “profits”) is the primary ingredient in any financial is the primary ingredient in any financial valuation model.valuation model.

• From an accounting perspective, cash flow is From an accounting perspective, cash flow is summarized in a firm’s statement of cash flows.summarized in a firm’s statement of cash flows.

• From a financial perspective, firms often focus on From a financial perspective, firms often focus on both operating cash flow, which is used in both operating cash flow, which is used in managerial decision-making, and free cash flow, managerial decision-making, and free cash flow, which is closely monitored by participants in the which is closely monitored by participants in the capital market.capital market.

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DepreciationDepreciation• Depreciation is the portion of the costs of

fixed assets charged against annual revenues over time.

• Depreciation for tax purposes is determined by using the modified accelerated cost recovery system (MACRS).

• On the other hand, a variety of other depreciation methods are often used for reporting purposes.

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Depreciation: An Depreciation: An ExampleExample

Baker Corporation acquired a new machine at a cost of $38,000, with installation costs of $2,000. When the machine is retired from service, Baker expects that it will sell it for scrap metal and receive $1,000. What is the depreciable value of the machine?

Regardless of its expected salvage value, the depreciable value of the machine is $40,000: $38,000 cost + $2,000 installation cost.

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Depreciation: Depreciable Depreciation: Depreciable Value and Depreciable LifeValue and Depreciable Life• Under the basic MACRS procedures, the

depreciable value of an asset is its full cost, including outlays for installation.

• No adjustment is required for expected salvage value.

• For tax purposes, the depreciable life of an asset is determined by its MACRS recovery predetermined period.

• MACRS property classes and rates are shown in Table 4.1 and Table 4.2 on the following slides.

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Table 4.1 First Four Table 4.1 First Four Property Classes under Property Classes under

MACRSMACRS

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Table 4.2 Rounded Depreciation Table 4.2 Rounded Depreciation Percentages by Recovery Year Percentages by Recovery Year

Using MACRS for First Four Using MACRS for First Four Property ClassesProperty Classes

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Depreciation: An Depreciation: An ExampleExample

Baker Corporation acquired, for an installed cost of Baker Corporation acquired, for an installed cost of $40,000, a machine having a recovery period of 5 $40,000, a machine having a recovery period of 5 years. Using the applicable MACRS rates, the years. Using the applicable MACRS rates, the depreciation expense each year is as follows:depreciation expense each year is as follows:

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Developing the Developing the Statement of Cash Statement of Cash

FlowsFlows• The statement of cash flows summarizes the firm’s cash flow over a given period of time.

• Firm’s cash flows fall into three categories: Operating flows: cash flows directly related to sale

and production of the firm’s products and services. Investment flows: cash flows associated with

purchase and sale of both fixed assets and equity investments in other firms.

Financing 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.

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Table 4.3 Table 4.3 Inflows and Outflows of Inflows and Outflows of

CashCash

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Table 4.4 Baker Table 4.4 Baker Corporation 2012 Corporation 2012 Income Statement Income Statement

($000)($000)

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Table 4.5a Baker Table 4.5a Baker Corporation Balance Corporation Balance

Sheets ($000)Sheets ($000)

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Table 4.5b Baker Table 4.5b Baker Corporation Balance Corporation Balance

Sheets ($000)Sheets ($000)

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Table 4.6 Baker Corporation Table 4.6 Baker Corporation Statement of Cash Flows Statement of Cash Flows ($000) for the Year Ended ($000) for the Year Ended

December 31, 2012December 31, 2012

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Interpreting Interpreting Statement of Statement of

Cash FlowsCash 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.

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Operating Cash Operating Cash FlowFlow

• A firm’s A firm’s operating Cash Flow (OCF)operating Cash Flow (OCF) is the cash flow is the cash flow a firm generates from normal operations—from the a firm generates from normal operations—from the production and sale of its goods and services.production and sale of its goods and services.

• OCF may be calculated as follows:OCF may be calculated as follows:

NOPAT = EBIT NOPAT = EBIT (1 – T) (1 – T)

OCF = NOPAT + DepreciationOCF = NOPAT + Depreciation

OCF = [EBIT OCF = [EBIT (1 – T)] + Depreciation(1 – T)] + Depreciation

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Operating Cash Flow Operating Cash Flow (cont.)(cont.)

• Substituting for Baker Corporation, we get:Substituting for Baker Corporation, we get:

• Thus, we can conclude that Baker’s Thus, we can conclude that Baker’s operations are generating positive operations are generating positive operating cash flows.operating cash flows.

OCF = [$370 OCF = [$370 (1 – .40)] + $100 = $322 (1 – .40)] + $100 = $322

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Free Cash FlowFree Cash Flow• Free cash flow (FCF)Free cash flow (FCF) is the amount of cash flow is the amount of cash flow

available to investors (creditors and owners) after the available to investors (creditors and owners) after the firm has met all operating needs and paid for firm has met all operating needs and paid for investments in net fixed assets (NFAI) investments in net fixed assets (NFAI) and and net net current assets (NCAI).current assets (NCAI).

• Where:Where:FCF = OCF – NFAI – NCAIFCF = OCF – NFAI – NCAI

NFAI = Change in net fixed assets + NFAI = Change in net fixed assets + DepreciationDepreciation

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

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Free Cash Flow Free Cash Flow (cont.)(cont.)

• Using Baker Corporation we get:Using Baker Corporation we get:

• Thus, the firm generated adequate cash flow to Thus, the firm generated adequate cash flow to cover all of its operating costs and investments cover all of its operating costs and investments and had free cash flow available to pay and had free cash flow available to pay investors.investors.

FCF = $322 – $300 – $0 = $22FCF = $322 – $300 – $0 = $22

NFAI = [($1,200 – $1,000) + $100] = $300NFAI = [($1,200 – $1,000) + $100] = $300

NCAI = [($2,000 – $1,900) + ($800 - $700)] = $0NCAI = [($2,000 – $1,900) + ($800 - $700)] = $0

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Focus on Focus on PracticePractice Free Cash Flow at Cisco SystemsFree Cash Flow at Cisco Systems

On May 13, 2010, Cisco Systems reported earnings per share of On May 13, 2010, Cisco Systems reported earnings per share of $0.42 for the most recent quarter, ahead of the expectations of $0.42 for the most recent quarter, ahead of the expectations of Wall Street experts who had projected EPS of $0.39. Wall Street experts who had projected EPS of $0.39.

In subsequent analysis, one analyst observed that of the three In subsequent analysis, one analyst observed that of the three cents by which Cisco beat the street’s forecast, one cent could be cents by which Cisco beat the street’s forecast, one cent could be attributed to the fact that the quarter was 14 weeks rather than attributed to the fact that the quarter was 14 weeks rather than the more typical 13 weeks. Another penny was attributable to the more typical 13 weeks. Another penny was attributable to unusual tax gains, and the third was classified with the somewhat unusual tax gains, and the third was classified with the somewhat vague label, “other income.” vague label, “other income.”

Free cash flow is often considered a more reliable measure of a Free cash flow is often considered a more reliable measure of a company’s income than reported earnings. What are some possible company’s income than reported earnings. What are some possible ways that corporate accountants might be able to change their ways that corporate accountants might be able to change their earnings to portray a more favorable earnings statement?earnings to portray a more favorable earnings statement?

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The Financial Planning The Financial Planning ProcessProcess

• 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.

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The Financial Planning The Financial Planning Process: Process:

Long-Term (Strategic) Long-Term (Strategic) Financial PlansFinancial 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.

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The Financial Planning The Financial Planning Process: Process:

Long-Term (Strategic) Long-Term (Strategic) Financial PlansFinancial Plans• Long-term financial plans consider a

number of financial activities including: Proposed fixed asset investments Research and development activities Marketing and product development Capital structure Sources of financing

• These plans are generally supported by a series of annual budgets and profit plans.

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Focus on EthicsFocus on Ethics How Much Is a CEO Worth?How Much Is a CEO Worth?

Bob Nardelli abruptly resigned his position as Home Depot CEO Bob Nardelli abruptly resigned his position as Home Depot CEO on on January 3, 2007.January 3, 2007.

Nardelli’s total severance package amounted to $210 million, Nardelli’s total severance package amounted to $210 million, including including $55.3 million of life insurance coverage, reimbursement of $1.3 $55.3 million of life insurance coverage, reimbursement of $1.3 million of personal taxes related to the life insurance, $50,000 million of personal taxes related to the life insurance, $50,000 to cover his legal fees, $33.8 million in cash due July 3, 2007, an to cover his legal fees, $33.8 million in cash due July 3, 2007, an additional $18 million over 4 years for abiding by the terms of additional $18 million over 4 years for abiding by the terms of the deal, and the balance of the package from accelerated the deal, and the balance of the package from accelerated vesting of stock options. vesting of stock options.

In addition, Nardelli and his family would receive health-care In addition, Nardelli and his family would receive health-care benefits from the company for the next 3 years.benefits from the company for the next 3 years.

What are some possible activities that Nardelli must avoid in What are some possible activities that Nardelli must avoid in order to reap the additional $18 million over 4 years?order to reap the additional $18 million over 4 years?

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The Financial Planning The Financial Planning Process: Process:

Short-Term (Operating) Short-Term (Operating) Financial PlansFinancial 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.

• This process is described graphically on the following slide.

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Figure 4.1 Figure 4.1 Short-Term Financial Short-Term Financial

PlanningPlanning

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The Financial Planning The Financial Planning Process: Process:

Short-Term (Operating) Short-Term (Operating) Financial PlansFinancial Plans• As indicated in the previous exhibit, short-term

financial planning begins with a sales forecastsales forecast..• From this sales forecast, production plans are

developed that consider lead times and raw material requirements.

• From the production plans, direct labour, factory overhead, and operating expense estimates are developed.

• From this information, the pro forma income statement and cash budget are prepared—ultimately leading to the development of the pro forma balance sheetpro forma balance sheet.

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Personal Finance Personal Finance ExampleExample

First step – define your goals. Short-term (1 year) Intermediate-term (2–5 years) Long-term (6+ years) Each goal should be clearly defined and have a

priority, time frame, and cost estimate. For example, a college senior’s intermediate-term

goal in 2012 might include earning a master’s degree at a cost of $40,000 by 2012, and his or her long-term goal might be to buy a condominium at a cost of $125,000 by 2016.

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Cash Planning: Cash Cash Planning: Cash BudgetsBudgets

• The 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.

• The more seasonal and uncertain a firm’s cash flows, the greater the number of intervals.

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Cash Planning: Cash Cash Planning: Cash Budgets (cont.)Budgets (cont.)• A sales forecast is a prediction of the sales activity

during a given period, based on external and/or internal data.

• The sales forecast is then used as a basis for estimating the monthly cash flows that will result from projected sales and from outlays related to production, inventory, and sales.

• The sales forecast may be based on an analysis of external data, internal data, or a combination of the two. An external forecast is a sales forecast based on the

relationships observed between the firm’s sales and certain key external economic indicators.

An internal forecast is a sales forecast based on a buildup, or consensus, of sales forecasts through the firm’s own sales channels.

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Table 4.7 The General Table 4.7 The General Format of the Cash Format of the Cash

BudgetBudget

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Cash Planning: Cash Cash Planning: Cash Budgets Budgets

An Example: Coulson An Example: Coulson IndustriesIndustriesCoulson Industries, a defence contractor, is Coulson Industries, a defence contractor, is

developing a cash budget for October, November, developing a cash budget for October, November, and December. Coulsonand December. Coulson’’s sales in August and s sales in August and September were $100,000 and $200,000 September were $100,000 and $200,000 respectively. Sales of $400,000, $300,000 and respectively. Sales of $400,000, $300,000 and $200,000 have been forecast for October, $200,000 have been forecast for October, November, and December. Historically, 20% of the November, and December. Historically, 20% of the firmfirm’’s sales have been for cash, 50% have been s sales have been for cash, 50% have been collected after 1 month, and the remaining 30% collected after 1 month, and the remaining 30% after 2 months. In December, Coulson will receive a after 2 months. In December, Coulson will receive a $30,000 dividend from stock in a subsidiary.$30,000 dividend from stock in a subsidiary.

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Table 4.8 A Schedule of Table 4.8 A Schedule of Projected Cash Receipts for Projected Cash Receipts for Coulson Industries ($000)Coulson Industries ($000)

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Cash Planning: Cash Budgets Cash Planning: Cash Budgets An Example: Coulson An Example: Coulson

Industries (cont.)Industries (cont.)Coulson has also gathered the relevant information Coulson has also gathered the relevant information for the development of a cash disbursement for the development of a cash disbursement schedule. Purchases will represent 70% of sales—schedule. Purchases will represent 70% of sales—10% will be paid immediately in cash, 70% is paid the 10% will be paid immediately in cash, 70% is paid the month following the purchase, and the remaining month following the purchase, and the remaining 20% is paid two months following the purchase. The 20% is paid two months following the purchase. The firm will also expend cash on rent, wages and firm will also expend cash on rent, wages and salaries, taxes, capital assets, interest, dividends, and salaries, taxes, capital assets, interest, dividends, and a portion of the principal on its loans. The resulting a portion of the principal on its loans. The resulting disbursement schedule thus follows.disbursement schedule thus follows.

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Table 4.9 A Schedule of Projected Table 4.9 A Schedule of Projected Cash Disbursements for Coulson Cash Disbursements for Coulson

Industries ($000)Industries ($000)

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Cash Planning: Cash Budgets Cash Planning: Cash Budgets An Example: Coulson An Example: Coulson

Industries (cont.)Industries (cont.)The Cash Budget for Coulson Industries can be derived by combining the receipts budget with the disbursements budget. At the end of September, Coulson’s cash balance was $50,000, notes payable was $0, and marketable securities balance was $0. Coulson also wishes to maintain a minimum cash balance of $25,000. As a result, it will have excess cash in October, and a deficit of cash in November and December. The resulting cash budget follows.

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Table 4.10 A Cash Table 4.10 A Cash Budget for Coulson Budget for Coulson Industries ($000)Industries ($000)

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Evaluating the Cash Evaluating the Cash BudgetBudget

• Cash budgets indicate the extent to which cash Cash budgets indicate the extent to which cash shortages or surpluses are expected in the months shortages or surpluses are expected in the months covered by the forecast.covered by the forecast.

• The excess cash of $22,000 in October should be The excess cash of $22,000 in October should be invested in marketable securities. The deficits in invested in marketable securities. The deficits in November and December need to be financed. November and December need to be financed.

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Personal Finance Personal Finance ExampleExample

• Because individuals receive only a finite amount of income (cash inflow) during a given period, they need to prepare budgets in order to make sure they can cover their expenses (cash outflows) during the period.

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Coping with Coping with Uncertainty in the Uncertainty in the

Cash BudgetCash Budget• One way to cope with cash budgeting uncertainty is to prepare several cash budgets based on several forecasted scenarios (e.g., pessimistic, pessimistic, most likely, optimisticmost likely, optimistic).

• From this range of cash flows, the financial manager can determine the amount of financing necessary to cover the most adverse situation.

• This method will also provide a sense of the riskiness of alternatives.

• An example of this sort of “sensitivity analysis” for Coulson Industries is shown on the following slide.

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Table 4.11 A Scenario Analysis Table 4.11 A Scenario Analysis of Coulson Industries’ Cash of Coulson Industries’ Cash

Budget ($000)Budget ($000)

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Profit Planning: Profit Planning: Pro Forma StatementsPro Forma Statements

• Pro forma financial statements are projected, or forecast, income statements and balance sheets.

• The inputs required to develop pro forma statements using the most common approaches include: Financial statements from the preceding year The sales forecast for the coming year Key assumptions about a number of factors

• The development of pro forma financial statements will be demonstrated using the financial statements for Vectra Manufacturing.

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Table 4.12 Vectra Table 4.12 Vectra Manufacturing’s Manufacturing’s

Income Statement for the Year Income Statement for the Year Ended Ended

December 31, 2012December 31, 2012

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Table 4.13 Vectra Table 4.13 Vectra Manufacturing’s Balance Manufacturing’s Balance

Sheet, December 31, 2012Sheet, December 31, 2012

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Table 4.14 2010 Sales Table 4.14 2010 Sales Forecast for Vectra Forecast for Vectra

ManufacturingManufacturing

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Profit Planning: Pro Profit Planning: Pro Forma Financial Forma Financial

Statements (cont.)Statements (cont.)Step 1: Start with a Sales Forecast (cont.)The previous sales forecast is based on an

increase in price from $20 to $25 per unit for Model X and from $40 to $50 per unit for Model Y.

These increases are required to cover anticipated increases in various costs, including labour, materials, & overhead.

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Profit Planning: Pro Profit Planning: Pro Forma Financial Forma Financial

Statements (cont.)Statements (cont.) Step 2: Preparing the Pro Forma Income Statement A simple method for developing a pro forma income

statement is the percent-of-sales method. This method starts with the sales forecast and then

expresses the cost of goods sold, operating expenses, interest expense, and other accounts as a percentage of projected sales.

Using the Vectra example, the easiest way to do this is to recast the historical income statement as a percentage of sales.

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Profit Planning: Pro Profit Planning: Pro Forma Financial Forma Financial

Statements (cont.)Statements (cont.) Step 2: Preparing the Pro Forma Income Statement (cont.) By using dollar values taken from Vectra’s 2012 income

statement (Table 4.12), we find that these percentages are

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Table 4.15 A Pro Forma Income Statement, Table 4.15 A Pro Forma Income Statement, Using the Percent-of-Sales Method, for Using the Percent-of-Sales Method, for

Vectra Manufacturing for the Year Ended Vectra Manufacturing for the Year Ended December 31, 2013December 31, 2013

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Profit Planning: Pro Profit Planning: Pro Forma Financial Forma Financial

Statements (cont.)Statements (cont.) Step 2: Preparing the Pro Forma Income Statement (cont.) Clearly, some of the firm’s expenses will increase with

the level of sales while others will not. the use of past cost and expense ratios generally the use of past cost and expense ratios generally tends to tends to

understate profits when sales are increasing.understate profits when sales are increasing. (Likewise, (Likewise, it it tends to overstate profits when sales are decreasing.tends to overstate profits when sales are decreasing.) )

The best way to generate a more realistic pro forma income statement is to segment the firm’s expenses into fixed and variable components, as illustrated in the following example.

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Profit Planning: Pro Profit Planning: Pro Forma Financial Forma Financial

Statements (cont.)Statements (cont.)Step 3: Preparing the Pro Forma Balance Sheet The judgmental approach is 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.

To apply this method to Vectra Manufacturing, a number of simplifying assumptions must be made.

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Profit Planning: Pro Profit Planning: Pro Forma Financial Forma Financial

Statements (cont.)Statements (cont.) Step 3: Preparing the Pro Forma Balance Sheet Step 3: Preparing the Pro Forma Balance Sheet (cont.)(cont.)

1.1. A minimum cash balance of $6,000 is desired.A minimum cash balance of $6,000 is desired.2.2. Marketable securities will remain at their current level of Marketable securities will remain at their current level of

$4,000.$4,000.3.3. Accounts receivable will be approximately $16,875 which Accounts receivable will be approximately $16,875 which

represents 45 days of sales (about 1/8represents 45 days of sales (about 1/8thth of a year) on average of a year) on average [(45/365) [(45/365) $135,000]. $135,000].

4.4. Ending inventory will remain at about $16,000. 25% ($4,000) Ending inventory will remain at about $16,000. 25% ($4,000) represents raw materials and 75% ($12,000) is finished goods.represents raw materials and 75% ($12,000) is finished goods.

5.5. A new machine costing $20,000 will be purchased. Total A new machine costing $20,000 will be purchased. Total depreciation will be $8,000. Adding $20,000 to existing net fixed depreciation will be $8,000. Adding $20,000 to existing net fixed assets of $51,000 and subtracting the $8,000 depreciation yields assets of $51,000 and subtracting the $8,000 depreciation yields a net fixed assets figure of $63,000.a net fixed assets figure of $63,000.

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Profit Planning: Pro Profit Planning: Pro Forma Financial Forma Financial

Statements (cont.)Statements (cont.) Step 3: Preparing the Pro Forma Balance Sheet Step 3: Preparing the Pro Forma Balance Sheet (cont.)(cont.)6.6. Purchases will be $40,500 which represents 30% of annual Purchases will be $40,500 which represents 30% of annual

sales (30% sales (30% $135,000). Vectra takes about 73 days to pay $135,000). Vectra takes about 73 days to pay on its accounts payable. As a result, accounts payable will on its accounts payable. As a result, accounts payable will equal $8,100 [(73/365) equal $8,100 [(73/365) $40,500]. $40,500].

7.7. Taxes payable will be $455 which represents one-fourth of Taxes payable will be $455 which represents one-fourth of the 1998 tax liability.the 1998 tax liability.

8.8. Notes payable will remain unchanged at $8,300.Notes payable will remain unchanged at $8,300.9.9. There will be no change in other current liabilities, long-There will be no change in other current liabilities, long-

term debt, and common stock.term debt, and common stock.10.10. Retained earnings will change in accordance with the pro Retained earnings will change in accordance with the pro

forma income statement.forma income statement.

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Table 4.16 A Pro Forma Balance Table 4.16 A Pro Forma Balance Sheet, Sheet,

Using the Judgmental Approach, Using the Judgmental Approach, for for

Vectra Manufacturing (December Vectra Manufacturing (December 31, 2013)31, 2013)

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Evaluation of Pro Evaluation of Pro Forma StatementsForma Statements

• The major weaknesses of the approaches to pro forma statement development outlined above lie in two assumptions: That the firmThat the firm’’s past financial performance will be s past financial performance will be

replicated in the futurereplicated in the future That certain variables (such as cash, accounts That certain variables (such as cash, accounts

receivable, and inventories) can be forced to take on receivable, and inventories) can be forced to take on certain certain ““desireddesired”” values. values.

• These assumptions cannot be justified solely on the basis of their ability to simplify the calculations involved.

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Evaluation of Pro Evaluation of Pro Forma Statements Forma Statements

(cont.)(cont.)However pro forma statements are prepared, analysts must However pro forma statements are prepared, analysts must understand how to use them to make financial decisions. understand how to use them to make financial decisions.

Financial managers and lenders can use pro forma statements to Financial managers and lenders can use pro forma statements to analyze the firm’s inflows and outflows of cash, as well as its analyze the firm’s inflows and outflows of cash, as well as its liquidity, activity, debt, profitability, and market value. liquidity, activity, debt, profitability, and market value.

Various ratios can be calculated from the pro forma income Various ratios can be calculated from the pro forma income statement and balance sheet to evaluate performance. statement and balance sheet to evaluate performance.

Cash inflows and outflows can be evaluated by preparing a pro Cash inflows and outflows can be evaluated by preparing a pro forma statement of cash flows. forma statement of cash flows.

After analyzing the pro forma statements, the financial manager After analyzing the pro forma statements, the financial manager can take steps to adjust planned operations to achieve short-term can take steps to adjust planned operations to achieve short-term financial goals. financial goals.

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Review of Learning Review of Learning GoalsGoalsUnderstand tax depreciation procedures and the effect of

depreciation on the firm’s cash flows. •Depreciation is an important factor affecting a firm’s cash flow. An asset’s depreciable value and depreciable life are determined by using the MACRS standards in the federal tax code.

Discuss the firm’s statement of cash flows, operating cash flow, and free cash flow. The statement of cash flows is divided into operating, investment,

and financing flows. It reconciles changes in the firm’s cash flows with changes in cash and marketable securities for the period. From a strict financial point of view, a firm’s operating cash flow is defined to exclude interest. Of greater importance is a firm’s free cash flow, which is the amount of cash flow available to creditors and owners.

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Review of Learning Goals Review of Learning Goals (cont.)(cont.)

Understand the financial planning process, including long-term Understand the financial planning process, including long-term (strategic) financial plans and short-term (operating) financial plans. (strategic) financial plans and short-term (operating) financial plans. The two key aspects of the financial planning process are cash planning and profit The two key aspects of the financial planning process are cash planning and profit planning. Long-term (strategic) financial plans act as a guide for preparing short-planning. Long-term (strategic) financial plans act as a guide for preparing short-term (operating) financial plans. Long-term plans tend to cover periods ranging term (operating) financial plans. Long-term plans tend to cover periods ranging from 2 to 10 years; short-term plans most often cover a 1- to 2-year period.from 2 to 10 years; short-term plans most often cover a 1- to 2-year period.

Discuss the cash-planning process and the preparation, evaluation, Discuss the cash-planning process and the preparation, evaluation, and use of the cash budget. and use of the cash budget. The cash-planning process uses the cash budget, based on a sales forecast, to The cash-planning process uses the cash budget, based on a sales forecast, to estimate short-term cash surpluses and shortages. The cash budget nets cash estimate short-term cash surpluses and shortages. The cash budget nets cash receipts and disbursements for each period to calculate net cash flow. Ending cash receipts and disbursements for each period to calculate net cash flow. Ending cash is estimated by adding beginning cash to the net cash flow. By subtracting the is estimated by adding beginning cash to the net cash flow. By subtracting the desired minimum cash balance from the ending cash, the firm can determine desired minimum cash balance from the ending cash, the firm can determine required total financing or the excess cash balance. required total financing or the excess cash balance.

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Review of Learning Goals Review of Learning Goals (cont.)(cont.)

Explain the simplified procedures used to prepare and evaluate Explain the simplified procedures used to prepare and evaluate the pro forma income statement and the pro forma balance the pro forma income statement and the pro forma balance sheet. sheet. A pro forma income statement can be developed by A pro forma income statement can be developed by calculating past percentage relationships between certain cost calculating past percentage relationships between certain cost and expense items and the firmand expense items and the firm’’s sales and then applying these s sales and then applying these percentages to forecasts. percentages to forecasts. Under the judgmental approach, the values of certain balance Under the judgmental approach, the values of certain balance sheet accounts are estimated and the firmsheet accounts are estimated and the firm ’’s external financing is s external financing is used as a balancing, or used as a balancing, or ““plug,plug,”” figure. figure.

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Review of Learning Goals Review of Learning Goals (cont.)(cont.)

Evaluate the simplified approaches to pro forma financial Evaluate the simplified approaches to pro forma financial statement preparation and the common uses of pro forma statement preparation and the common uses of pro forma statements. statements. Simplified approaches for preparing pro forma statements Simplified approaches for preparing pro forma statements assume that the firmassume that the firm’’s past financial condition is an accurate s past financial condition is an accurate indicator of the future. Pro forma statements are commonly indicator of the future. Pro forma statements are commonly used to forecast and analyze the firmused to forecast and analyze the firm ’’s level of profitability s level of profitability and overall financial performance so that adjustments can and overall financial performance so that adjustments can be made to planned operations to achieve short-term be made to planned operations to achieve short-term financial goals.financial goals.

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Gitman, Lawrence J. and Gitman, Lawrence J. and Zutter ,Chad J.(2013) Zutter ,Chad J.(2013) Principles of Managerial Principles of Managerial Finance, Pearson,13Finance, Pearson,13thth Edition Edition

Brooks,Raymond (2013) Brooks,Raymond (2013) Financial Management: Core Financial Management: Core Concepts , Pearson, 2Concepts , Pearson, 2thth edition edition

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Further ReadingFurther Reading

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Questions?Questions?