Measuring Cash Flows Financial Planning Dr C Bulent

Measuring Cash Flows & Financial Planning Dr. C. Bulent Aybar Professor of International Finance

Net Operating Cash Flows • The procedure for estimating net operating cash flows consists of reconciling the dollar amount of an income statement account with the change in the corresponding balance sheet account. • Balance sheet accounts used for the adjustments are those related to the firm’s operating cycle (i. e. , comprising the firm’s net operating working capital) • NOPAT=EBIT x (1 -T) • NOCF=EBIT(1 -T)+Depreciation-NCAI © Dr. C. Bulent Aybar

• FCF=NOPAT + Depreciation -Net Current Asset Investments(NCAI)- Net Fixed Asset Investments (NFAI) – NCAI=Change in Current Assets –Change in (A/P+Accruals) – NCAI=Change Working Capital Requirement (WCR)=(Cash(? )+Inventories+A/R)-(A/P+Accruals) – NCAI=Change in WCR – NFAI=Change in Net Fixed Assets +Depreciation © Dr. C. Bulent Aybar

Net Fixed Asset Investments=(Acquisitions-Disposals) +Gross Fixed Assets Beg +Acquisitions -Disposals -Cum. Depreciation + Current Period Depreciation =Net Fixed Assets End (Acquisitions-Disposals)=Net Fixed Assets End –Gross Fixed Assets Beg – (Cumulative Depreciation + Current Period Depreciation) (Acquisitions-Disposals)=Net Fixed Assets (End) –[Net Fixed Assets (Beg) +Cum Depr. ]+[Cum Depr. + Current Period Depr] (Acquisitions-Disposals)=Net Fixed Assets (End) –Net Fixed Assets (Beg) + Current Period Depreciation © Dr. C. Bulent Aybar

Free Cash Flows • FCF = EBIT × (1 – T) + Depreciation – NCAI– NFAI © Dr. C. Bulent Aybar

Terminology • Other terms used for NCAI: DWCR=Net Operating Working Capital DWCR=Change in Working Capital Requirement • Operating Capital Investment= NFAI+ DWCR • Operating Capital Investment= NFAI+NCAI © Dr. C. Bulent Aybar

Example: Free Cash Flow Calculation • Wells Water Systems recently reported $8, 250 of sales, $4, 500 of operating costs other than depreciation, and $950 of depreciation. • The company had no amortization charges, it had $3, 250 of outstanding bonds that carry a 6. 75% interest rate, and its federal-plus-state income tax rate was 35%. • In order to sustain its operations and thus generate sales and cash flows in the future, the firm was required to spend $750 to buy new fixed assets and to invest $250 in net operating working capital. • How much free cash flow did Wells generate? © Dr. C. Bulent Aybar

Solution – Sales Revenues=$8, 250 – Operating Expenses=$4, 500 – Depreciation: $950 – Outstanding Debt : $3, 250 Interest Rate=6. 75% – Federal-plus-state income tax rate: 35%. – NFAI=750 – NCAI=250 – FCF=(Sales-Operating Expenses-Depreciation)x (1 -0. 35)+Depreciation. NCAI-NFAI – FCF=(8, 250 -4, 500 -950)(1 -0. 35)+950 -250 -750 – FCF=1, 770 © Dr. C. Bulent Aybar

Example • Bartling Energy Systems recently reported $9, 250 of sales, $5, 750 of operating costs other than depreciation, and $700 of depreciation. • The company had no amortization charges, it had $3, 200 of outstanding bonds that carry a 5% interest rate, and its federal-plus-state income tax rate was 35%. • In order to sustain its operations and generate sales and cash flows in the future, the firm was required to make $1, 250 of capital expenditures on new fixed assets and to invest $300 in net operating working capital (DWCR). By how much did the firm's net income exceed its free cash flow? © Dr. C. Bulent Aybar

Summary • Sales Revenues 9, 250 • Operating Costs 5, 750 • Depreciation 700 • Interest Expense 3, 250 x 0. 05= 160 • Taxe Rate 35% © Dr. C. Bulent Aybar

Net Income and Free Cash Flow Compared Net Income Sales Revenues Operating Costs Depreciation EBIT Interest Expense EBT Taxes NI 9, 250 5, 750 700 2, 800 160 2, 640 924 1, 716 Free Cash Flow EBIT x (1 -T) Depreciation NCAI NFAI FCF 2, 800 1, 820 700 300 1, 250 970 NI > FCF by $746 © Dr. C. Bulent Aybar

Financial Planning and Pro Forma Statements • A pro forma statement is simply a prediction of what the company's financial statements will look like at the end of the forecast period. • These predictions may vary in terms of detail and precision, but they should be logical and consistent. • A major purpose of pro forma forecasts is to estimate a company's future need for external funding! © Dr. C. Bulent Aybar

External Funding Requirement • External Funding Required=Projected Total Assets(Projected Liabilities + Projected Owner’s Equity) IF DTA>D(Shareholders Equity + Liabilities) External Funds Needed IF DTA<D(Shareholders Equity + Liabilities) Excess Funds to be Deployed © Dr. C. Bulent Aybar

Percent of the Sales Method • Links Income Statement and Balance Sheet figures to future sales! • The rationale for the percent-of-sales approach is the linkage between income statement and balance sheet items and the sales. • Obviously, this will not be true for all of the entries in a company's financial statements. © Dr. C. Bulent Aybar

Steps in Percent of Sales Method • The first step in a percent-of-sales forecast should be an examination of historical data to determine which financial statement items have varied in proportion to sales in the past. • This will enable us to decide which items can safely be estimated as a percentage of sales and which must be forecast using other information. • The second step is to forecast sales. © Dr. C. Bulent Aybar

Example: ABC Supplies Inc • ABC Supplies, Inc. , a modest-size wholesaler of plumbing and electrical supplies, has been a customer of the XYZ bank for a number of years. • The company has maintained average deposits of approximately $30, 000 and has had a $50, 000 short-term, renewable loan for five years. • The company has prospered, and the loan has been renewed annually with only cursory analysis. © Dr. C. Bulent Aybar

ABC Needs a Loan To Support its Growth • In late 2008, the president of ABC Supplies visited the bank and requested an increase in the short-term loan for 2009 to $500, 000. • The president explained that despite the company's growth, accounts payable had increased steadily and cash balances had declined. • A number of suppliers had recently threatened to put the company on COD for future purchases unless they received payments more promptly. • When asked why he was requesting $500, 000, the president replied that this amount seemed "about right" and would enable him to pay off his most insistent creditors and rebuild his cash balances. © Dr. C. Bulent Aybar

Banks Require Pro Forma Financial Statements! • Knowing that the bank's credit committee would never approve a loan request of this magnitude without careful financial projections, the lending officer suggested that he and the president prepare pro forma financial statements for 2009. • He explained that these statements would provide a more accurate indication of ABC's credit needs. © Dr. C. Bulent Aybar

ABC Supplies Income Statements (in thousands) Income Statements 2005 2006 2007 2008 $11, 190 9, 400 1, 790 $13, 764 11, 699 2, 065 $16, 104 13, 688 2, 416 $20, 613 17, 727 2, 886 1, 019 1, 239 1, 610 2, 267 100 103 110 90 Earnings before tax 671 723 696 529 Tax 302 325 313 238 Net sales Cost of goods sold Gross profit Expenses: General, selling, and administrative expenses Net interest Expense Earnings after tax $ 369 $ 398 $ 383 $ 291

ABC Balance Sheets (in thousands) Balance Sheets 2005 2006 2007 2008 Assets Current assets: Cash and securities $ 671 $ 551 $ 644 $ 412 Accounts receivable 1. 343 1. 789 2. 094 2. 886 Inventories 1. 119 1. 376 1. 932 2. 267 14 12 15 18 3. 147 3. 728 4. 685 5. 583 128 124 295 287 $ 3, 275 $ 3, 852 $ 4, 980 $ 5, 870 $ $ Prepaid expenses Total current assets Net fixed assets Total assets Liabilities and Owners' Equity Current liabilities: Bank loan Accounts payable 50 2426 3212 60 50 5 50 7 10 100 18 1, 122 1, 550 2, 536 3, 380 960 150 910 150 860 150 760 150 1043 1242 1434 1580 $ 3, 275 $ 3, 852 $ 4, 980 $ 5, 870 Total current liabilities Long-term debt Total liabilities and owners' equity 50 1443 Accrued wages , Retained earnings 50 1, 007 Current portion long-term debt Common stock 50 . . .

Trends • The first step in preparing pro forma projections is to examine the company's financial statements, in this case for the years 2005 through 2008, in search of stable patterns. 2005 Annual Growth Rate in Sales Ratios Tied to Sales 2006 2007 2008 (E) 2009 (F) 23% 17% 28% 25% Cost of goods sold (% of sales) General, selling, and administrative expenses Cash and securities (days sales in cash) Accounts receivable (collection period) Inventories (inventory turnover) Accounts payable (payables period) 84 85 85 86 86 9 9 10 11 12 22 15 15 7 18 44 47 47 51 51 8 9 7 8 9 39 45 65 66 59 Tax/Earnings Before Tax Dividends/Earnings After Tax 45 45 45 50 50 50 © Dr. C. Bulent Aybar

Observations • The president's concern about declining liquidity and increasing trade payables is well founded; – cash and securities have fallen from 22 days of sales to 7 days of sales, – accounts payable have risen from a payables period of 39 days to 66 days. • Another concern is the increase in cost of goods sold and general, selling, and administrative expenses in proportion to sales. • Earnings clearly are not keeping pace with sales. © Dr. C. Bulent Aybar

• The last column in the table contains the projections agreed to by ABC's president and the lending officer. • In line with recent experience, sales are predicted to increase 25 percent over 2008. • General, selling, and administrative expenses will continue to rise as a result of an unfavorable labor settlement. • After comparing ABC’s cash balances to historical levels and to those of competitors, the president believes cash and securities should rise to at least 18 days' sales. • Because cash and securities are generally low return assets, this figure represents the minimum amount the president believes is necessary to operate the business efficiently. © Dr. C. Bulent Aybar

• This reasoning is reinforced by the fact that any cash or securities balances above this minimum will just add to the loan amount and thus cost the company more money. • Since much of ABC's cash balances will sit in his bank, the lending officer readily agrees to the projected increase in cash. • The president also thinks accounts payable should decline to no more than a payables period of 59 days. The tax rate and the dividends-to-earnings, or payout, ratio are expected to stay constant. © Dr. C. Bulent Aybar

Summary of key Assumptions Used In Forecasting ABC Supplies Assumptions for 2009 ($ thousands) Growth rate in net sales Cost of good sold/net sales 25. 00% 86. 00% Gen. , sell. & admin. Expenses/Net Sales Long-term debt Current portion long-term debt 12. 00% Interest rate Cash and securities (days sales in cash) Accounts receivable (collection period) 10. 00% Inventories (inventory turnover) Accounts payable (payables period) 666 100 18 51 9 59 Tax rate Dividend/earnings aftertax Current assets/net sales 45. 00% 50. 00% Net fixed assets Current liabilities/net sales 280 14. 00% 29. 00%

2009 Pro Forma Income Statements Net sales Cost of goods sold Gross profit General, S&A Expenses Net interest expense Earnings before tax Tax Earnings after tax 2008 20, 613. 00 17, 727 2, 886 2, 267 90. 00 529. 00 238. 00 291. 00 2009 25, 766. 25 22, 158. 98 3, 607. 28 3, 091. 95 90. 00 425. 33 191. 40 233. 93 Comments 25% Increase in Sales 86% of Sales 12% of Sales Initially Constant 45% Tax Rate

2009 Pro Forma Balance Sheet 2008 2009 Comments Cash and securities 412. 00 1, 270. 66 18 Days Sales Accounts receivable 2, 886. 00 3, 600. 22 51 day collection period Inventories 2, 267. 00 2, 462. 11 9 times turnover 18. 00 20. 00 Rough Estimate 5, 583. 00 7, 352. 99 287. 00 280. 00 5, 870. 00 7, 632. 99 50. 00 - 3, 212. 00 3, 581. 86 100. 00 18. 00 22. 00 3, 380. 00 3, 703. 86 Long-term debt 760. 00 660. 00 Common stock 150. 00 Retained earnings 1, 580. 00 1, 696. 96 Total liabilities and owners' equity 5, 870. 00 6, 210. 83 Assets Current assets: Prepaid expenses Total current assets Net fixed assets Total assets Liabilities and Owners' Equity Current liabilities: Bank loan Accounts payable Current portion long-term debt Accrued wages , Total current liabilities Financing Requirement 1422. 16 59 Day payment period Rough Estimate

• The management should decide how to finance the gap. • If the company decides to finance the funding requirement of 1, 422. 16 with equity, the balance sheet can be adjusted quickly with a plug in equal to this amount in shareholder’s equity. • If the funding requirement is plugged into the liabilities as short term bank loan, it will change the net income because of change in interest income. • Through an iterative process we can determine the exact amount of the financing needed © Dr. C. Bulent Aybar

Weaknesses of Simplified Approaches • The major weaknesses of the approaches to pro forma statement development outlined above lie in two assumptions: – That the firm’s past financial performance will be replicated in the future – That certain accounts can be forced to take on desired values • For these reasons, it is imperative to first develop a forecast of the overall economy and make adjustments to accommodate other facts or events. © Dr. C. Bulent Aybar

Another Example: Garmin Inc. 2005 Income Statement We are given Income Statement and Balance Sheet of Garmin Inc. for 2005 Income Statement Revenues Cost of Goods Sold Gross Profit Selling and General Administrative Expenses Operating Income Interest Expense EBT Taxes Net Income 2005 % of Sales 10, 000 100% 5, 500 55% 4, 500 45% 800 8% 3, 700 37% 500 5% 3, 200 960 2, 240

Garmin Inc. 2005 Balance Sheet End of Year Current Assets Net Plant and Equipment Total Assets Current Liabilities Long Term Debt Connon Stock & Paid in Capital Retained Earnings Total Liabilities and Equity Financing Deficiency (Surplus) 2005 2, 000 18, 000 20, 000 1, 000 500 13, 500 20, 000 % of Sales 20% 180% 200% 10% 200%

Proforma Income Statement and Balance Sheet • Assumptions: – Sales grow at 10% in 2006 – The following do not change with sales: – Taxes – Long Term Debt – Common Stock and Paid in Capital • Prepare the pro-forma income statement and Balance sheet assuming: – A) No dividends paid – B) 50% payout © Dr. C. Bulent Aybar

Projected Income Statement -2006 Income Statement Revenues Cost of Goods Sold Gross Profit Selling and General Administrative Expenses Operating Income Interest Expense EBT Taxes Net Income 2005 10, 000 5, 500 4, 500 800 3, 700 500 3, 200 960 2, 240 % 100% 55% 45% 8% 37% 5% 2006 11, 000 6, 050 4, 950 880 4, 070 500 3, 570 1071 2, 499 Note that Interest Expense and Taxes were not pro rated to sales! Since We assumed no change in LT debt, interest expense remained constant!

Balance Sheet Under Two Assumptions Balance Sheet End of Year 2005 Current Assets 2, 000 20% 2, 200 Net Plant and Equipment 18, 000 180% 19, 800 Total Assets 20, 000 200% 22, 000 Current Liabilities 1, 000 10% 1, 100 Long Term Debt 5, 000 500 500 Retained Earnings 13, 500 15, 999 14, 750 Total Liabilities and Equity 20, 000 22, 599 21, 350 (599) 650. 5 Common Stock & Paid in Capital External Funds Required (Surplus) % 2006 (A) 2006 (B)

Evaluation of Pro-forma Statements • Under the assumption that no dividends are paid, there is a financing surplus. We could reconcile this assuming capital expenditures, dividend payments or Stock repurchases. • If we assume capital expenditures, we will need another iteration to balance assets and liabilities. • Under the assumption of 50% dividend payment, we have a financing deficiency of $650. 5. Depending on how we finance this, we may or may not need further iterations. For instance, if we assume short or long term debt, the interest payments will change and will have an impact on retained earnings. Balancing may require several iterations. © Dr. C. Bulent Aybar

Cash Planning: Cash Budgets • The cash budget or cash forecast is a statement of the firm’s planned inflows and outflows of cash. • It is used to estimate short-term cash requirements with particular attention to anticipated cash surpluses and shortfalls. • Surpluses must be invested and deficits must be funded. • The cash budget is a useful tool for determining the timing of cash inflows and outflows during a given period. • Typically, monthly budgets are developed covering a 1 -year time period.

Cash Planning: Cash Budgets • The cash budget begins with a sales forecast, which is simply a prediction of the sales activity during a given period. • A prerequisite to the sales forecast is a forecast for the economy, the industry, the company and other external and internal factors that might influence company sales. • The sales forecast is then used as a basis for estimating the monthly cash inflows that will result from projected sales— and outflows related to production, overhead and other expenses.

The General Format of the Cash Budget

Coulson Industries • Coulson Industries, a defense contractor, is developing a cash budget for October, November, and December. • 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.

Projected Cash Receipts 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. In December, Coulson will receive a $30, 000 dividend from stock in a subsidiary. Column 1 Forecast sales Cash sales (20%) Collections of A/R: Lagged 1 month (50%) Lagged 2 months (30%) Other cash receipts Total cash receipts Aug. $100 $20 Sept. S 200 $40 Oct. $400 $ 80 Nov. $300 $ 60 Dec. S 200 $ 40 50 100 30 200 60 $210 $320 150 120 30 $340

Coulson Cash Disbursements • Coulson Company has also gathered the relevant information for the development of a cash disbursement schedule. – Purchases will represent 70% of sales— – 10% will be paid immediately in cash, – 70% is paid the month following the purchase, – and the remaining 20% is paid two months following the purchase. • The firm will also expend cash on rent, wages and salaries, taxes, capital assets, interest, dividends, and a portion of the principal on its loans. . © Dr. C. Bulent Aybar

Disbursement Schedule Column 1 Purchases (0. 70 x sales) Cash purchases (10%) Payments of A/P: Lagged 1 month (70%) Lagged 2 months (20%) Rent payments Wages and salaries Tax payments Fixed-asset outlays Interest payments Cash dividend payments Principal payments Total cash disbursements Aug. $70 $7 Sept. $140 $14 Oct. $280 $ 28 Nov. $210 $ 21 Dec. S 140 $ 14 49 98 14 5 48 196 28 5 38 147 56 5 28 25 130 10 20 $213 $418 20 $305

Cash Balance and Minimum Cash • 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. © Dr. C. Bulent Aybar

A Cash Budget for Coulson Industries ($000) October November December $210 $320 $340 213 418 305 Net cash flow -3 -98 35 Add: Beginning cash 50 47 -51 $ 47 -51 -16 Less: Minimum cash balance 25 25 25 Required total financing (notes payable) — $ 76 $ 41 $ 22 — — Total cash receipts" Less: Total cash disbursements'' Ending cash Excess cash balance (marketable securities)

Evaluating the Cash Budget • Cash budgets indicate the cash shortages or surpluses in the months covered by the forecast. • The excess cash of $22, 000 in October should be invested in marketable securities. The deficits in November and December need to be financed.

Coping with Uncertainty in the Cash Budget • One way to cope with cash budgeting uncertainty is to prepare several cash budgets based on several forecasted scenarios (e. g. , pessimistic, most 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 the alternatives. © Dr. C. Bulent Aybar

A Scenario Analysis October November December Pessimistic Most Likely Optimistic Total cash receipts Less: Total cash disbursements Net cash flow Add: Beginning cash Ending cash Less: Minimum cash balance Required total financing Excess cash balance $160 $210 $285 $210 $320 $410 $275 $340 $422 200 213 248 380 418 467 280 305 320 ($40) ($3) $ 37 ($170) ($98) ($57) ($5) $ 35 $102 50 50 50 10 47 87 ($160) ($51) 30 $ 10 $ 47 $ 87 ($160) ($51) $ 30 ($165) ($16) $132 15 25 25 $185 $ 76 $190 $ 41 — — $ 15 — $ 22 $ 62 $ 5 $107