Firm Cash Flows & Depreciation

Analyzing a Firm's Cash Flows

• Cash flow, as opposed to accounting profits, is the financial manager's main focus.
• Depreciation is a key factor that affects cash flow.
• From an accounting perspective, cash flow is summarized in a firm's Statement of Cash Flows.
• Firms focus on operating cash flow for managerial decisions and free cash flow for capital market monitoring.

Depreciation

• Depreciation is the systematic allocation of fixed asset costs against annual revenue over time.
• Depreciation for tax purposes is determined by the Modified Accelerated Cost Recovery System (MACRS).
• Various depreciation methods are used for reporting purposes.

Depreciation and Cash Flow

• Financial managers prioritize cash flows over profits themselves.
• Non-cash charges should be added back to the net profit after taxes to show actual cash flows from operations.
• Depreciation and non-cash expenses lower taxable income, creating a tax shield and enhancing cash flow.

Depreciable Value and Life under MACRS

• The depreciable base of an asset under MACRS includes its full cost and the outlays for its installation.
• Expected salvage value does not require adjustment.
• The depreciable life of an asset for tax purposes is determined by its MACRS recovery period.
• MACRS property classes and rates are detailed in tables.

Depreciation Example: Baker Corporation

• Baker Corporation acquired a machine costing $40,000 with a 5-year recovery period.
• Year 1 depreciation expense is $8,000 (20% of $40,000).
• Year 2 depreciation expense is $12,800 (32% of $40,000).
• Year 3 depreciation expense is $7,600 (19% of $40,000).
• Year 4 depreciation expense is $4,800 (12% of $40,000).
• Year 5 depreciation expense is $4,800 (12% of $40,000).
• Year 6 depreciation expense is $2,000 (5% of $40,000).
• Total depreciation over the asset's depreciable life is $40,000.

Depreciation Preference

• Business owners prefer a depreciation schedule that provides 100% depreciation because a dollar saved today is worth more than a dollar saved tomorrow when positive taxable income is present.

Developing The Statement of Cash Flows

• Firms cash flow over a given period of time is summarized in firms statement of cash flows
• The statement of cash flows is divided into three sections:
  • Operating flows
  • Investment flows
  • Financing flows
• These flows are captured in figure 3.1.

Classifying Inflows and Outflows of Cash

• The statement of cash flows summarizes the inflows and outflows of cash during a given period.
• Inflows (Sources):
  • Lower any asset.
  • any increase in the liability.
  • Profits after taxes.
  • Depreciation and other noncash.
  • Sale of stock.
• Outflows (Uses):
  • Raising any asset.
  • lowering any liability.
  • Net loss.
  • Paid dividends.
  • Stock repurchase.

Interpreting the Statement of Cash Flows

• Ties the balance sheet at the period beginning with the balance sheet at the end after considering the firms performance (Income Statement).
• Net cash (increase or decrease) should be = cash difference and security on the balance sheet at the year`s beginning and end.

Operating Cash Flow

• (OCF) is a cash flow generated from normal operations like production, and goods and services sales.
  • Calculated as follows:
    • NOPAT = EBIT x (1 – T)
    • OCF = NOPAT + Depreciation
    • OCF = [EBIT x (1 - T)] + Depreciation
• Using Baker Corporation as an example:
  • OCF = [$370 x (1 - .40) + $100 = $322 Conclusion: Baker's operations produce positive operating cash flows.

Free Cash Flow

• (FCF) is available cash flow to debt and equity holders after meeting operating needs and paying assets investments.
  • FCF = OCF – NFAI - NCAI
    • NFAI = Change in net fixed assets + Depreciation
    • NCAI = Change in CA – Change in A/P and Accruals
    • Using Baker Corporation as an example:
      • NFAI = [($1,200 - $1,000) + $100] = $300
      • NCAI = [($2,000 - $1,900) + ($800 - $700)] = $0
      • FCF = $322 – $300 - $0 = $22
  • This FCF is used to pay creditors and equity holders.

Financial Planning Process

• Financial planning manages, coordinates, and controls actions that achieve objectives.
• Two key aspects are cash planning and profit planning.
• Cash planning involves creating a cash budget.
• Profit planning involves creating both cash budgets and pro forma financial statements.

Long-Term Strategic Financial Plans

• Lay out a company's planned financial actions and its potential impact for 2 to 10 years.
• Firms exposed to high operating uncertainty use shorter plans.
• They are part of an integrated strategic plan alongside production and marketing plans to guide achievement of goals.
• Consider activities including:
  • Fixed asset investments
  • R&D
  • Marketing and product development
  • Capital structure
  • Funding sources.
• Supported by a budget series, annual plan and profit plans.

Short-Term (Operating) Financial Plans

• Specify short-term financial actions and impact, covering 1-2 year operating periods.
• Key inputs include sales forecasts and operating and financial data.
• Key outputs include operating budgets, the cash budget, and pro forma financial statements.

Short-Term Financial Plans: Process

• Short-term financial planning starts with a sales forecast.
• Production plans factor in lead times and raw material needs on sales forecast.
• Direct labor, factory overhead, and operating expense estimates come from production plans.
• Pro forma income statement and cash budget are then prepared which ultimately leads to a pro forma balance sheet.

Cash Planning

• A cash budget (or forecast) is a statement of planned cash inflows and outflows.
• Used to estimate short-term cash requirements, noting anticipated surpluses and shortfalls.
• Cash surpluses must be invested and deficits must be funded.
• Useful for determining timing of cash inflows/outflows throughout a given period.
• Typically monthly budgets are developed covering 1 year.
• Prerequisite includes forecast for the economy, industry, company and other factors that influence the company sales.
• Sales forecast estimates monthly inflows (from sales) and outflows (production, overhead, etc).

Cash Budget: Coulson Industries Example (Receipts)

• Coulson Industries is developing a cash budget for October, November, and December:
  • August sales were $100,000 and September sales were $200,000
  • Forecasted sales for October, November, and December are $400,000, $300,000 and $200,000 respectively.
• Collection pattern :
  • 20% cash sales.
  • 50% collected after 1 month.
  • 30% is collected after 2 months.
• The company also expects to dividend stock in a subsidiary of $30,000.

Cash Budget: Coulson Industries Disbursements

• Purchases represent 70% of sales-10% paid immediately in cash; 70% the following month; and 20% two months later.
• The company also has outflows for rents, salaries, wages, taxes, capital assets, interest/dividends, and loan principal.

Cash Budget: Coulson (Combining Receipts and Disbursements)

• Coulson's data combine the receipt with disbursement budgets to derive the cash budget. At the end of September:
  • $50,000 cash balance.
  • $0 notes payable.
  • $0 marketable securities balance. Coulson wishes to maintain a minimum $25,000 cash balance; thus the company will have excess cash in October and a deficit in November-December.

Evaluating the Cash Budget

• Cash budgets highlight the extent of expected cash shortages or surpluses within the forecasted periods.
• An excess $22,000 cash in October should be invested in marketable securities.
• Deficits in November and December will need to be financed.

Coping with Uncertainty in the Cash Budget

• Prepare budgets on several forecasted scenarios (pessimistic, most likely, optimistic scenario).
• Management can then work out amount of financing it takes to cover the most adverse position from range of cash flows.
• This provides a sense of alternatives riskiness.

Pro Forma Statements

• Projected financial statements including income statements and balance sheets
• The inputs requirements most common include:
  • Financial statements from the preceding year.
  • Sales forecast for the year ahead.
  • Key assumptions on several factors
• Developed by using the forgoing inputs.

Pro Forma Statements Step 1

• Creating a sales forecast like Vectra Manufacturing using 2007.
• Sales Forecast = Dollar sales (Total) increasing unit price.
• Cover increases by increasing varied costs with labor.

Pro Forma Statements Step 2

• By using a simple percentage-of-sales method by developing a pro forma income statement.
• Start with a sales forecast and show expenses with sold goods as a percentage of the sales.
• Applying Vectra`s is easiest by recasting sales percentage historically.
• By using percentage and forecast, entire income statement can be projected.
• Assumptions:
  • All costs and all aspects of variables.
  • Under state sale profits when they are increasing and overstate them when sale is decreasing, which should be accounted for.
    • Also, expenses should be segmented into fixed and variable components.

Pro Forma Statements Step 3

• This is best done using a judgmental approach.
• The judgmental approach uses some estimated values to make sure the numbers are balanced.
• To apply, must use simplifying assumptions in Vectra Manufacturing.

Pro Forma Statements: Balance Sheet Assumptions

• Aim for $6,000 minimum cash balance, and holding marketable securities at an average level of $4,000.
• Accounts receivable average is to be nearly $16,875, around 45 sales days .[(45/365) x $135,000].
• Inventory is to stay roughly the same at $16,000. ($4,000) 25% of Raw materials and 75 % ($12,000) of goods are shipped.
• After buying a new $20,000 system and $8,000 for depreciation : Fixed assets = $63,000.
• Purchase nearly $40,500 for 30% in annual sales (Sales x $135,000): Pay accounts in 73 days = around $8,100.

Pro Forma Statements: Remaining

• Tax will amount to $455, about 25% of liability on tax.
• There will be no changes to long term debt and stock.
• Remaining will change to pro forma.

Evaluating Pro Forma Statements

• In Simplified Approach:
  • The weakness is the assumption for future replications.
  • Is necessary to develop overall economy on forecast, adjust events and factor into account.