CASH FLOW, FINANCIAL PLANNING, AND BUDGETING

I. Statement of Cash Flows

i. Classification of Cash Flow Activities
a. Operating Activities – The amount of cash flows arising from
operating activities is a key indicator of the extent to which the operations
of the enterprise have generated sufficient cash flows to repay loans,
maintain the operating capability of the enterprise, pay dividends and
make new investments without recourse to external sources of financing.
Operating activities include cash inflows and outflows directly related to
the sale and production of the firm's products and services. Examples are:
Inflows
o Sales of goods
o Revenue from services
o Returns on interest earnings assets (interest)
o Returns on equity securities (dividends)
o Receipts from contracts held for dealing and trading purposes
o Tax refunds unless identified with financing and investing
activities
Outflows
o Payments for purchases of inventories
o Payments for operating expenses (salaries, rent, insurance, etc.)
o Payments for purchases from suppliers other than inventory
o Payments for lenders (interest)
o Payments for taxes unless identified with financial and investing
activities
b. Investing Activities - The separate disclosure of cash flows arising from
investing activities is important because the cash flows represent the extent to
which expenditures have been made for resources, intended to generate future
income and cash flows. These are cash flows associated with the purchase and
sale of both fixed assets and equity investments in other firms. Clearly, purchase
transactions would result in cash outflows, whereas sales transactions would
generate cash inflows. Examples are:
Inflows
o Sales of long-lived assets such as property, plant and equipment,
intangibles and other long-term assets.
o Sales of debt or equity securities of other entities
o Collection of loans (principal) to others (other than advances and
loans made by a financial institution)
Outflows
o Acquisitions of long-lived assets such as property, plant and
equipment, intangibles and other long-term assets
o Purchases of debt or equity securities of other entities
o Loans (principal) to others (other than advances and loans made by
a financial institution)
c. Financing Activities - The financing flows result from debt and equity
financing transactions. Financing activities include borrowing from
creditors and repaying the principal; and obtaining resources from owners
and providing them with a return on the investment. Examples are:
Inflows
o Proceeds from borrowing (short-term and long-term)
 o Proceeds from issuing the firm's own equity securities
Outflows
o Repayment of debt principal
o Repurchase of a firm's own shares
o Payment of dividends
o Acquisition of the enterprise's own shares

ii. Presentation of Operating Activities

a. Direct Method - Direct method presents cash flows as they were generated and
spent. In reporting the cash flows from operating activities enterprises are
encouraged to report major classes of gross cash receipts and gross cash
payments and the net cash flow from operating activities. It uses a Cash Basis
Income Statement. Non-cash expenses will not be recognized in Direct Method
such as Depreciation. Amortization, Losses, as well as gains from sale since it
doesn't have an actual inflow of cash.
b. Indirect Method - Uses Net Income as a base. Reverses the effect of non-cash
transactions. It uses Accrual Basis Income Statement. Starts with accrual net
income and converts to cash basis.

II. Developing the Statement of Cash Flows

a. Classifying Inflows and Outflows of Cash
 Inflow - A decrease in an asset, such as the firm’s cash balance, is an
inflow of cash. It is 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.
 Outflow - 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.
 Basic Inflows and Outflows of Cash

 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.
 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.

i. Application of Direct and Indirect Method in presenting CF Activities

Indirect method:
III. Interpreting the SCF
i. Usefulness of the Statement of Cash Flows
Although net income provides a long-term measure of a company’s success or failure,
cash is its lifeblood.
Without cash, a company will not survive.
For small and newly developing companies, cash flow is the single most important
element for survival. Even medium and large companies must control cash flow.

Usefulness to Creditors or Lender?

 Creditors examine the cash flow statement carefully because they are concerned
about being paid.
 They begin their examination by finding net cash provided by operating
activities.
 High amount of net cash provided by operating activities indicates that a
company is able to generate sufficient cash from operations to pay its bills
without further borrowing.
 Conversely, a low and negative amount of net cash from operating activities
indicates that a company may have to borrow or issue equity securities to
acquire sufficient cash to pay its bills.
 Creditors asks the following questions in the company’s cash flow statements:
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 creditors?
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?
 Note: One should recognize that companies can fail even though they report net
income.
The difference between net income and net cash provided by operating activities
can be substantial.
ii. Use of SCF in measuring the Firm’s:
a. Financial Liquidity – refers to the “measures to cash” of assets and liabilities.
Readers of financial statements often assess liquidity by using the Current Cash
Debt Coverage Ratio, which indicates whether the company can pay off its
current liabilities from its operations in a given year.
 Net Cash Provided by Operating Activities
C CDCR=
Average Current Liabilities

The higher current cash debt coverage ratio, the less likely a company will have
liquidity problems.

b. Financial Flexibility – refers to a company’s ability to respond and adapt to

financial adversity and unexpected needs and opportunities.
The Cash Debt Coverage Ratio provides information on financial flexibility. It
indicates a company’s ability to repay its liabilities from net cash provided by
operating activities, without having to liquidate the assets employed in its
operations.
Net Cash Provide by Operating Activities
C DCR=
Average Total Liabilities

The higher this ratio, the less likely the company will experience difficulty in
meeting its obligations as they come due.

c. Operating Cash Flow (OCF) – the cash flow a firm generates from its normal
operations; producing or selling goods or services. This definition excludes the
impact of interest on cash flow, since we want a measure that captures the cash
flow generated by the firm’s operations, not by how those operations are financed
and taxed.

OCF=NOPAT + Depreciation

Alternative Formula:
OCF=[ EBIT∗( 1−Tax Rate ) ] + Depreciation

d. Net Operating Profit After Taxes (NOPAT) – a firm’s earnings before interest
and after taxes.

NOPAT=EBIT∗( 1−Tax Rate)

e. FREE CASH FLOW (FCF)- 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 and net current assets.

FCF=OCF −NFAI−NCAI

 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.
NFAI = Change in net fixed assets + Depreciation
 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.
NCAI = Net change in Current Asset – (Net change in A/P and Accrued
Liabilities)

IV. The Financial Planning Process

 Financial Planning Process- 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.
Two key aspects of the financial planning process are cash planning and profit
planning. Cash planning involves preparation of the firm’s cash budget. Profit
planning involves preparation of pro forma statements.
i. Long-Term (strategic) Financial Plans - Plans that lay out a company’s planned
financial actions and the anticipated impact of those actions over periods ranging
from 2 to 10 years.
ii. Short-Term (operating-) Financial Plans- Specify short-term financial actions
and the anticipated impact of those actions.

V. Cash Budget
It is an essential financial tool for businesses that helps to estimate
cash inflows and outflows over a specific period. It ensures that a
company has enough cash to meet its obligations while also
planning for future investments or savings. A well-prepared cash
budget allows businesses to avoid cash shortages and make
informed decisions about financing or investing excess cash.

i. The Sales Forecast

The foundation of a cash budget starts with the sales forecast. This is a prediction
of future sales based on historical data, market trends, and strategic goals. The
sales forecast is crucial because it directly influences cash inflows, as it predicts
how much revenue the business expects to generate during a given period.

ii. Preparing the Cash Budget

When preparing a cash budget, it’s essential to forecast both the
cash receipts and disbursements. Here’s a breakdown of these components:
a. Cash Receipts refer to the money that a business expects to receive,
primarily from sales. It includes:

 Cash sales: Money paid immediately for products or services.

 Credit sales collections: Payments for sales made on credit, expected
to be received in the future.
 Other receipts: Any other sources of cash, such as loans, interest
income, or asset sales.

b. Cash Disbursements are the payments that a business plans to make

during the period, such as:
 Operating expenses: Payroll, utilities, rent, and other regular costs.
  Capital expenditures: Payments for assets like equipment or
machinery.
 Debt payments: Loan repayments and interest expenses.

c. Net Cash Flow, Ending Cash, Financing, and Excess Cash

Once the cash receipts and cash disbursements are forecasted, the
business calculates the net cash flow. This is the difference between total
cash inflows and outflows. Here’s what follows
 Net Cash Flow:
o Positive net cash flow means that inflows exceed outflows,
indicating a cash surplus.
o Negative net cash flow means that outflows exceed inflows,
indicating a cash deficit.
 Ending Cash:
o This is the cash balance at the end of the period, calculated by
adding or subtracting the net cash flow from the starting cash
balance.
 Financing:
o If there’s a negative net cash flow (a cash deficit), the business
may need to secure financing, such as loans or credit lines, to
cover the shortfall.
 Excess Cash:
o If there’s a positive net cash flow (cash surplus), the business
might consider investing the excess cash or saving it for future
needs.

VI. Profit Planning: Pro Forma Income Statement

Basic Elements of Pro Forma Statements:
 Based on Historical Financial Relationships
o The assumption behind pro forma statements is that the financial patterns
observed in past statements will largely continue in the upcoming period. This
means that key ratios, such as profit margins, cost structures, and expense
relationships, are expected to remain relatively stable unless major changes
occur.
 Two Primary Inputs Required for Preparation
o Financial Statements from the Previous Year. Past income statements and
balance sheets serve as the foundation for projecting future financial
performance.
o Sales Forecast for the Coming Year. Since revenue drives many financial
variables (e.g., costs, expenses, and net income), a reliable sales forecast is
crucial for an accurate pro forma statement.

i. Use of percent-of-sales method

A simple and commonly used approach for developing a pro forma income statement
is the percent-of-sales method. This method assumes that most income statement
items (such as cost of goods sold, operating expenses, and net income) vary
proportionally with sales.

How is the Percent-of-Sales Method Used to Prepare Pro Forma Income

Statements?
1. Forecast Future Sales
o Estimate the expected sales for the upcoming period based on historical data
and market trends.
2. Express Income Statement Items as Percentages of Sales
o Use past financial data to determine historical expense-to-sales ratios and
apply them to the projected sales figure.
 3. Calculate Projected Values
o Multiply the projected sales by the corresponding percentage for each income
statement item.

Takeaway Points
o The percent-of-sales method uses historical percentages to predict future
financial performance.
o This method assumes that the relationship between sales and other items
remains consistent.
o It's a simple and widely used forecasting technique but may not capture
changes in costs, pricing, or operational efficiency.

ii. Considering types of Costs and Expenses

When preparing a pro forma income statement, it is essential to distinguish between
fixed and variable costs. Many businesses initially use the percent-of-sales method,
which assumes that all costs and expenses change in direct proportion to sales.
However, this assumption is flawed because some costs remain fixed regardless of
sales volume.
 Fixed Costs- Fixed costs are expenses that do not change with variations in sales or
production levels. These costs are incurred regardless of the business's activity.
Examples include:
o Rent
o Salaries of permanent employees
o Depreciation
o Insurance premiums
Fixed costs provide operating leverage. As sales increase, fixed costs remain the
same, which means profits will increase disproportionately (i.e., faster than the
increase in sales).

 Variable Costs- Variable costs change in direct proportion to the level of sales or
production. These costs increase as sales or production increase and decrease when
sales fall. Examples of variable costs include:
o Direct materials
o Direct labor (wages for hourly workers)
o Sales commissions
o Shipping and delivery expenses
Because variable costs are tied directly to sales levels, they increase or decrease
accordingly. In a growing business, variable costs are predictable as they are linked to
the level of output or sales.

How Fixed Costs Affect Profit Fluctuations:

Fixed costs contribute to operating leverage, meaning profits fluctuate more than
revenues:
 When sales rise → Profits grow faster than sales because fixed costs remain
constant.
 When sales fall → Profits decline sharply because fixed costs do not decrease.
This profit sensitivity to sales changes is a key financial risk that businesses must
consider when forecasting future earnings.

Takeaway Points
 Variable costs change in proportion to sales, while fixed costs remain unchanged
regardless of sales fluctuations.
 Accurately distinguishing between these costs is essential for realistic financial
forecasting and planning.
  Failing to account for fixed costs can lead to misleading projections, especially in
periods of rising or declining sales.
 Separating fixed and variable costs provides better insight into profit variability,
financial risks, and overall business performance.

VII. Preparing the Pro Forma Balance Sheet

When preparing a pro forma balance sheet, businesses need to estimate their future
financial position based on projected sales, expenses, and other financial data. While
there are several methods for creating a pro forma balance sheet, two approaches
stand out: the percentage-of-sales approach and the judgmental approach. Each has its
strengths and weaknesses, but the judgmental approach is widely considered to be
more reliable and accurate.
i. Use of Judgmental Approach
The judgmental approach offers a more refined and practical method for
preparing the pro forma balance sheet. Unlike the percentage-of-sales approach,
which applies a rigid sales ratio, the judgmental approach relies on
management’s judgment and insights to estimate the values of certain balance
sheet accounts, adjusting for expected changes in operations, investments, or
financing needs.

Steps:
1. Estimate Projected Sales and Related Assets: Use historical relationships and
future expectations to estimate asset accounts (e.g., accounts receivable, fixed
assets).
2. Adjust for Non-Sales Factors: Apply management’s judgment to adjust for
non-sales drivers, like changes in operations or investments.
3. Determine External Financing Required (EFR)
a. The “plug figure” is the amount of external financing needed to
balance the balance sheet.
b. If EFR is positive, the firm needs to raise external funds (debt/equity).
c. If EFR is negative, the firm has excess internal funds, which can be
used to pay down debt, repurchase stock, or increase dividends.
4. Update the Balance Sheet: Adjust the balance sheet to reflect increases in
debt/equity (positive EFR) or reductions in debt/equity (negative EFR).

External Financing Required (EFR) / "Plug Figure"

The "plug figure", also known as External Financing Required (EFR), is the
amount of external funds a company needs to raise in order to balance its pro
forma balance sheet. This figure helps determine whether the firm can rely on its
internal financing (like retained earnings) to support growth, or if additional
external funds are required.
o Positive Plug Figure (EFR): Indicates that the firm needs to raise external
funds (either debt, equity, or other financing methods) to cover the gap.
o Negative Plug Figure (EFR): Indicates that the firm has more internal funds
than needed, meaning it can reduce debt, repurchase stock, or increase
dividends.

How to get the EFR: Subtract the forecasted total liabilities and equity from the
forecasted total assets. This gives you the external financing required (EFR).

Formula: EFR=Forecasted Assets−(Forecasted Liabilities+Forecasted Equity)

 If the result is positive, it means the firm needs additional external
financing.
 If the result is negative, the firm has excess internal funds.
Understanding the Significance of the Plug Figure
 Financial Planning: It helps businesses understand how much external
financing they will need to support growth or expansion plans.
 Balance Sheet Management: Ensures that the pro forma balance sheet is
balanced, with assets equaling liabilities plus equity.
 Decision-Making: Guides management decisions on whether to issue
more debt or equity, adjust dividends, or use internal funds more
efficiently.