Chapter 4

Cash Flow and Financial Planning

Learning Goals
This chapter introduces the student to the financial planning process, with
the emphasis on short-term (operating) financial planning and its two key
components: cash planning and profit planning. Cash planning requires
preparation of the cash budget, while profit planning involves preparation of
a pro forma income statement and balance sheet. The text illustrates through
example how these budgets and statements are developed. The distinction
between operating cash flow and free cash flow is presented and discussed.
Current tax law regarding the depreciation of assets and the effect on cash
flow are also described. The firm’s cash flow is analyzed through
classification of sources and uses of cash. The student is guided in a step-by-
step preparation of the statement of cash flows and the interpretation of this
statement. This chapter ties in every person’s need to set goals, estimate
income, and budget expenditures to the firm’s need to effectively engage in
these activities.

Analyzing the Firm’s Cash Flow

An old saying in finance is “Cash is king.” Cash flow, the lifeblood of the
firm, is the primary ingredient in any financial valuation model. Whether an
analyst wants to put a value on an investment that a firm is considering or
the objective is to value the firm itself, estimating cash flow is central to the
valuation process.
DEVELOPING THE STATEMENT OF CASH FLOWS
The statement of cash flows summarizes the firm’s cash flow over a given
period.
The firm’s cash flows fall into three categories:
1) Operating flows ‫تدفقات تشغيليه‬: Cash flows directly related to sale and
production of the firm’s products and services.
‫تتعلق التدفقات النقدية مباشرة ببيع وإنتاج منتجات وخدمات الشركة‬

Relates to the firm’s production cyclefrom the purchase of raw materials to

the finished product. Any expenses incurred directly related to this
process are considered operating flows.
‫ أي مصروفات@ يتم تكبدها‬.‫ من شراء المواد الخام إلى المنتج النهائي‬- ‫يتعلق بدورة إنتاج الشركة‬
‫تتعلق مباشرة بهذه العملية تعتبر تدفقات تشغيلية‬
2) Investment flows ‫ تدفقات استثماريه‬: Cash flows associated with purchase
and sale of both fixed assets and equity investments in other firms.
‫التدفقات النقدية المرتبطة بشراء وبيع األصول الثابتة واالستثمارات@ في األسهم في شركات أخرى‬
3) Financing flows ‫دفقات تمويليه‬JJ‫ ت‬: 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.
‫التدفقات النقدية الناتجة عن معامالت تمويل الديون واألسهم ؛ تشمل تح ّمل وسداد الديون والتدفقات‬
‫النقدية من بيع األسهم والتدفقات النقدية الخارجة إلعادة شراء األسهم أو دفع أرباح نقدية‬
Preparing the Statement of Cash Flows
The statement of cash flows uses data from the income statement, along with
the beginning- and end-of-period balance sheets.
Classifying Inflows and Outflows of Cash ‫تصنيف التدفقات النقدية الداخلة‬
‫والخارجة‬
Table 4.3
Inflows and
Outflows of Cash

 Depreciation 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.
INCOME STATEMENT
Sales revenue
_ Cost of goods sold
= Gross profit
_operating expenses (administrative and marketing expenses + depreciation)
= EBIT (Earnings before Interest and Tax)
_Interest
= income before tax
_tax
Net income after tax
  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 reduction in net
(rather than gross) fixed assets, we would be double counting
depreciation.
Part of the balance sheet ‫جزء من الميزانية العمومية‬
Total gross fixed assets (at cost) ‫إجمالي األصول الثابتة‬
Less: Accumulated depreciation ‫االستهالك المتراكم‬
Net fixed assets ‫صافي األصول الثابتة‬
Operating Cash Flow (OCF) ‫التدفق النقدي التشغيلي‬
The cash flow a firm generates from its normal operations of producing and
selling its output of goods and services.
‫التدفقات النقدية التي تنتجها الشركة من عملياتها العادية إلنتاج وبيع منتجاتها من السلع والخدمات‬
Calculated as net operating profits after taxes (NOPAT) plus depreciation.
‫يتم حسابه كصافي أرباح تشغيل بعد الضرائب باإلضافة إلى االستهالك‬

NOPAT_ Net operating profit after tax

EBIT_ earnings before interest and tax
T_ tax rate
To convert NOPAT to operating cash flow (OCF), we merely add back depreciation:
 Operating cash flows take net profits after tax and add in depreciation.
The net profits after tax figure is obtained after interest expense is
deducted from operating income. Because interest expense is not an
operating account, the calculation of operating cash flows excludes
the impact of interest by taking EBIT and multiplying it by 1 less tax
rate. We exclude the effects of interest expense and taxes because we
want a measure that captures the cash flow generated by the firm’s
operations, not by how those operations are financed and taxed.

Substituting for Baker Corporation, we get:

OCF = [$370 × (1.00 – 0.40] + $100 = $222 + $100 = $322
Thus, we can conclude that Baker’s operations are generating positive operating cash
flows.
Free Cash Flow (FCF) ‫التدفق النقدي الحر‬
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).
‫هو مقدار التدفق النقدي المتاح للمستثمرين (الدائنين والمالكين) بعد أن تلبي الشركة جميع‬
‫( االحتياجات التشغيلية وتدفع@ لالستثمارات في صافي األصول الثابتة‬NFAI) ‫وصافي@ األصول‬
‫( الجارية‬NCAI)

• Where:
The 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.
You can calculate the NFAI as:

The NFAI is also equal to the change in gross fixed assets from one year to
the next.

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.
 Example: The following is information related to Nablus Corporation
2018 2019
Total Current
$6,800 $8,200
Assets
Net Fixed Assets 15,000 14,800
Accounts Payable 1,500 1,600
Accruals 300 200
Depreciation
1,600
Expense
EBIT 2,700
Interest Expense 500
Net Profits After
1,400
Taxes
Tax Rate 40%

1-Calculate the operating cash flow (OCF) for 2019.

OCF= EBIT * (1- T) + Depreciation
OCF= 2700 * (1- 40%) + 1600
OCF = 2700 * .60% + 1600
OCF = 1620+ 1600 = $3220
2-Calculate the free cash flow (FCF) for 2019.
FCF = OCF - NFAI – NCAI
NFAI = change in net fixed assets + Depreciation
NFAI = (net fixed assets in 2019 – net fixed assets in 2018) + depreciation
NFAI = (14800 – 15,000) + 1600
NFAI = - 200 + 1600 = 1400
NCAI = change in current assets – change in (accounts payable +
accruals)
NCAI = ( current assets in 2019 – current assets in 2018) – ( accounts payable
+ accruals in 2019) – ( accounts payable + accruals in 2018)
NCAI = (8200-6800) – ( 1800- 1800)
NCAI = 1400 – 0 = 1400
FCF = OCF – NFAI – NCAI
FCF = 3220 – 1400 – 1400 = $ 420

The Financial Planning Process

Financial planning is an important aspect of the firm’s operations because it
provides road maps for guiding, coordinating, and controlling the firm’s
actions to achieve its objectives.
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.
(Planning for surplus cash and for cash shortages.)
 Profit planning involves preparation of pro forma statements.
Short-term (operating) financial
• short-term financial planning begins with a sales forecast.
• From this sales forecast, production plans are developed that consider
lead times and raw material requirements.
• From the production plans, direct labor, 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 sheet.
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.
 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.
o An external forecast is a sales forecast based on the
relationships observed between the firm’s sales and certain key
external economic indicators.
o An internal forecast is a sales forecast based on a buildup, or
consensus, of sales forecasts through the firm’s own sales
channels.
The General Format of the Cash Budget

Ending cash: The sum of the firm’s beginning cash and its net cash flow for
the period.
Required total financing ‫ إجمالي التمويل المطلوب‬:Amount of funds needed by
the firm if the ending cash for the period is less than the desired minimum
cash balance; typically represented by notes payable.
‫مبلغ األموال التي تحتاجها@ الشركة إذا كان النقد النهائي للفترة أقل من الحد األدنى المطلوب للرصيد‬
‫النقدي ؛ يتم تمثيلها عادةً بمالحظات مستحقة الدفع‬
Excess cash balance ‫فائض الرصيد النقدي‬: The (excess) amount available for
investment by the firm if the period’s ending cash is greater than the desired
minimum cash balance; assumed to be invested in marketable securities.
‫المبلغ (الزائد) المتاح لالستثمار@ من قبل الشركة إذا كانت نقد نهاية الفترة أكبر من الحد األدنى‬
@‫المطلوب للرصيد النقدي ؛ يفترض أن تستثمر في األوراق@ المالية القابلة للتسويق‬

PREPARING THE CASH BUDGET

Cash Receipts ‫ النقدية‬J‫ المقبوضات‬: 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.
Example: Coulson Industries, a defense contractor, is developing a cash
budget for October, November, and December. Coulson’s sales in August
and September were $100,000 and $200,000 respectively. Sales of
$400,000, $300,000 and $200,000 have been forecast for October,
November, and December. Historically, 20% of the firm’s sales have been
for cash, 50% have been collected after 1 month, and the remaining 30%
after 2 months. Bad-debt expenses (uncollectible accounts) have been
negligible. In December, Coulson will receive a $30,000 dividend from
stock in a subsidiary.

Terms of sales:
-Cash sales: 20% of the firm’s sales.
-50% have been collected after 1 month.
-30% have been collected after 2 month.
A Schedule of Projected Cash Receipts for Coulson Industries ($000)

Cash Disbursements

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 noncash charges are NOT
included in the cash budget, because they merely represent a scheduled
write-off of an earlier cash outflow. The impact of depreciation, as we noted
earlier, is reflected in the reduced cash outflow for tax payments.

Example: Coulson Industries has gathered the following data needed for the
preparation of a cash disbursements schedule for October, November, and
December. Purchases The firm’s purchases represent 70% of sales. Of this
amount, 10% is paid in cash, 70% is paid in the month immediately
following the month of purchase, and the remaining 20% is paid 2 months
following the month of purchase.

Term of purchases:
-10% is paid in cash,
-70% is paid after 1 the month
-20% is paid after 2 months
-Rent payments Rent of $5,000 will be paid each month.
- Wages and salaries Fixed salaries for the year are $96,000, or $8,000 per
month. In addition, wages are estimated as 10% of monthly sales.
-Tax payments Taxes of $25,000 must be paid in December.
-Fixed-asset outlays New machinery costing $130,000 will be purchased and
paid for in November. Interest payments
-An interest payment of $10,000 is due in December.
-Cash dividend payments Cash dividends of $20,000 will be paid in
October. Principal payments (loans) A $20,000 principal payment is due in
December.
A Schedule of Projected Cash Disbursements for Coulson Industries ($000)

A Cash Budget for Coulson Industries ($000)

The beginning cash balance for October is $50,000. The firm desires to
maintain 25,000 as minimum cash each month.
Evaluating the Cash Budget
Cash budgets indicate the extent to which cash shortages or surpluses are
expected in the months covered by the forecast.
@‫تشير الميزانية النقدية إلى مدى توقع@ حدوث نقص أو فائض نقدي في األشهر التي تغطيها التوقعات‬

The excess cash of $22,000 in October should be invested in marketable

securities. The deficits in November and December need to be financed.
Q:A firm has actual sales of $65,000 in April and $60,000 in May. It expects
sales of $70,000 in June and $100,000 in July and in August. Assuming that
sales are the only source of cash inflows and that half of them are for cash
and the remainder are collected evenly over the following 2 months, what
are the firm’s expected cash receipts for June, July, and August?

Solution:

April May June July August

Sales $65,000 $60,000 $70,000 $100,000 $100,000
Cash sales (0.50) $32,500 $30,000 $35,000 $ 50,000 $ 50,000
Collections:
Lag 1 month (0.25) 16,250 15,000 17,500 25,000
Lag 2 months (0.25) 16,250 15,000 17,500
Total cash receipts $66,250 $ 82,500 $ 92,500
Profit Planning:
Two inputs are required for preparing pro forma statements: (1) financial
statements for the preceding year and (2) the sales forecast for the coming
year.

)2( ‫) القوائم المالية للسنة السابقة و‬1( :‫هناك حاجة إلى مدخلين إلعداد القوائم الماليه التقديريه‬
‫توقعات المبيعات للسنة القادمة‬

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.

‫تبدأ هذه الطريقة بتنبؤات المبيعات ثم تعبر عن تكلفة السلع المباعة ونفقات التشغيل‬
‫ومصروفات الفوائد والحسابات األخرى كنسبة مئوية من المبيعات المتوقعة‬

• This method assumes that all costs and expenses are variable ( when
sales increase expenses increase by the same percentage and vice
versa).

‫تفترض هذه الطريقة أن جميع التكاليف والنفقات متغيرة (عندما زيادة المبيعات تزيد نفقات‬
)‫بنفس النسبة المئوية والعكس صحيح‬
Example: Vectra Manufacturing’s Income Statement for the Year Ended
December 31, 2015:

Sales revenue $100,000

Less: Cost of goods sold $80,000

Gross profits 20,000

Less: Operating expenses 10, 000

Operating profits $ 10,000

Less: Interest expense 1000

Net profits before taxes $ 9,000

Less: Taxes (0.15 $9,000) 1350

Net profits after taxes $ 7,650

Develop the Pro forma income statement for the year 2016, using Percent –
of sales method, if the forecasted sales in 2016 is $ 135,000.

Solution: By using dollar values taken from Vectra’s 2015 income

statement, we find that these percentages are
A Pro Forma Income Statement, Using the Percent-of-Sales Method, for
Vectra Manufacturing for the Year Ended December 31, 2016

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.

-Assume that half of the costs and expenses are variable and the rest are
fixed.