The document discusses financial planning and cash flow analysis. It covers topics such as analyzing a firm's cash flow, developing the statement of cash flows, operating cash flow, free cash flow, and the financial planning process. The financial planning process involves long-term strategic planning as well as short-term operating plans and budgets, including cash budgets which forecast expected cash inflows and outflows. Cash flow analysis is important for valuation and financial decision making.

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All rights reserved.
Chapter 4
Cash Flow
and
Financial
Planning

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Analyzing the Firm’s Cash Flow
• Cash flow (as opposed to accounting “profits”) is the
primary ingredient in any financial valuation model.
• From an accounting perspective, cash flow is summarized
in a firm’s statement of cash flows.
• From a financial perspective, firms often focus on both
operating cash flow, which is used in managerial
decision-making, and free cash flow, which is closely
monitored by participants in the capital market.

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Depreciation
• 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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Developing the Statement of
Cash Flows
• 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
Inflows and Outflows of Cash

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Interpreting Statement of
Cash 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 Flow
• A firm’s operating Cash Flow (OCF) is the cash flow
a firm generates from normal operations—from the
production and sale of its goods and services.
• OCF may be calculated as follows:
NOPAT = EBIT × (1 – T)
OCF = NOPAT + Depreciation
OCF = [EBIT × (1 – T)] + Depreciation

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Operating Cash Flow (cont.)
• Substituting for Baker Corporation, we get:
• Thus, we can conclude that Baker’s operations are
generating positive operating cash flows.
OCF = [$370 × (1 – .40)] + $100 = $322

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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).
• Where:
FCF = OCF – NFAI – NCAI
NFAI = Change in net fixed assets + Depreciation
NCAI = Change in CA – Change in (A/P + Accruals)

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Free Cash Flow (cont.)
• Using Baker Corporation we get:
• Thus, the firm generated adequate cash flow to cover all
of its operating costs and investments and had free cash
flow available to pay investors.
FCF = $322 – $300 – $0 = $22
NFAI = [($1,200 – $1,000) + $100] = $300
NCAI = [($2,000 – $1,900) + ($800 - $700)] = $0

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The 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 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 Process:
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.

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The Financial Planning Process:
Long-Term (Strategic) Financial 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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The Financial Planning Process:
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.
• This process is described graphically on the following
slide.

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Figure 4.1
Short-Term Financial Planning

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Cash Planning: Cash Budgets
• 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 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.