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Contents

Financial Planning and Forecasting, Definition of Financial planning, Short Term Financial Plan & Long-Term Financial Plan, Sales Forecasts, Pro Forma Financial Statements, Analyzing the firms cashflow, Depreciation and MACRS, Types of firm’s cash flows, Determination of different cash flows: Operating Cash Flows, NCAI, NFAI and FCF

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Financial Planning

Financial Planning is the process of estimating the capital required and determining it’s competition. It is the process of framing financial policies in relation to procurement, investment and administration of funds of an enterprise.

The projection of sales, income, and assets based on alternative production and marketing strategies, as well as the determination of the resources needed to achieve these projection is called financial planning.

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Objectives of Financial Planning• Determining capital requirements- This will depend

upon factors like cost of current and fixed assets, promotional expenses and long- range planning. Capital requirements have to be looked with both aspects: short- term and long- term requirements.

• Determining capital structure- The capital structure is the composition of capital, i.e., the relative kind and proportion of capital required in the business. This includes decisions of debt- equity ratio- both short-term and long- term.

• Framing financial policies with regards to cash control, lending, borrowings, etc.

• Maximum Utilization of Scares Resources: A finance manager ensures that the scarce financial resources are maximally utilized in the best possible manner at least cost in order to get maximum returns on investment.

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Importance of Financial Planning1. Ensuring Adequate Funds: Financial planning is important

because it ensures the adequate funds available to meet the needs of future, and present.

2. Preparing Good Budget: It helps to prepare a good budget

3. Assessing Financial Situation: Financial planning assess business' financial situation

4. Formulating Financial Strategies: It determines its objectives and formulating financial strategies of how to achieve them.

5. Performance Evaluation: Financial planning should become a continuous activity where the plan is reviewed regularly and performance measured against specific devised targets

6. Balance Between Outflow and Inflow of Funds: Financial Planning helps in ensuring a reasonable balance between outflow and inflow of funds so that stability is maintained.

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Importance of Financial Planning

7. Easy Investment Environment for Fund Suppliers: Financial Planning ensures that the suppliers of funds are easily investing in companies which exercise financial planning.

8. Making Growth and Expansion Programs: Financial Planning helps in making growth and expansion programs which helps in long-run survival of the company.

9. Facing Market Challenges Easily: Financial Planning reduces uncertainties with regards to changing market trends which can be faced easily through enough funds.

10.Reducing The Uncertainties: Financial Planning helps in reducing the uncertainties which can be a hindrance to growth of the company. This helps in ensuring stability an d profitability in concern.

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Financial Planner An investment professional who helps individuals set and achieve their long-term financial goals, through investments, tax planning, asset allocation, risk management, retirement planning, and estate planning. The role of a financial planner is to find ways to increase the client's net worth and help the client accomplish all of his/her financial objectives.

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Financial Planning Types1. Long-Term (Strategic) Financial Plans: An investment plan or

strategy with a term of usually longer than one year. A long-term financial plan involves more uncertainty than anything short-term because, typically, market trends are more easily predictable in the short term. On the other hand, planning for the long-term is necessary in order to enjoy financial security in retirement. Thus, while planning for the long term is necessary, one's plan must be flexible to account for the uncertainty inherent to it.

2. Operating (Short-Term) Financial Planning: A financial plan outlining investment and other financial goals for the coming fiscal year. Short-term financial plans involve less uncertainty than long-term financial plans because, generally speaking, market trends are more easily predictable in the short term. Likewise, short-term financial plans are more easily amendable as a result of the short time frame. Short-term financial plans usually invest in short-lived securities, such as T-bills. A short-term financial plan aims to achieve goals that would be beneficial for one's long-term financial plan.

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Long-term (Strategic) Financial PlansLong-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 exposed to a high degree of operating uncertainty tend to use shorter plans.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.–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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Short-Term (Operating) Financial PlansShort-term (operating) financial plans specify short-term financial actions and the anticipated impact of those actions and typically cover a 1- to 2-year operating period.• 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.• 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.

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Cash Planning: Cash Budgets

The cash budget 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 shortfalls 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.

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• 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.

Cash Planning: Cash Budgets….

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The General Format of Cash Budgets

Cash Budget Format

Jan. Feb. Nov. Dec.

Cash receipts $xx $xx $xx $xx

Less: Cash disbursements xx xx xx xx

Net cash flow xx xx xx xx

Add: Beginning cash xx xx xx xx

Ending cash xx xx xx xx

Less: Minimum cash balance

xx xx xx xx

Required total financing (Notes payable)

$xx

Excess cash balance (Marketable securities)

$xx

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Pro Forma Financial Statements

• Pro forma financial statements– Sales forecasts– Percent of sales method

• Three important uses:– Forecast the amount of external financing that will be

required– Evaluate the impact that changes in the operating plan

have on the value of the firm– Set appropriate targets for compensation plans

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Steps in Financial Forecasting

1.Forecast sales

2.Project the assets needed to support sales

3.Project internally generated funds

4.Project outside funds needed

5.Decide how to raise funds

6.See effects of plan on ratios and stock price

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Depreciation

Depreciation: The systematic charging of a portion of the costs of fixed assets against annual revenues over time is called Depreciation. This is a historical cost of fixed assets over time.Depreciable life of an Asset :The time period over which an asset is depreciated is called depreciable life of that asset.

The depreciable value of an asset (the amount to be depreciated) is its full cost, including outlays for installation. No adjustment is required for expected salvage value.Example: Orin Corporation acquired a new machine at a price of $38000 and installation costs of $2000. What is the depreciable value of the machine?Now, the Depreciable Value is: $40000

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MACRS: What is it?One of the depreciation methods is MACRS which stands for Modified Accelerated Cost Recovery System. It is used to determine the depreciation of assets for tax purpose.•Some other depreciation methods are: Straight-line; Double-Declining balance and sum-of-the-year-digits.

3 years: Research equipment and certain special tools.5 years: Computers, typewriters, copiers, duplicating equipment, cars, light duty trucks, qualified technological equipment, and similar assets.7 years: Office furniture, fixtures, most manufacturing equipment, railroad track, and single-purpose agricultural and horticultural structures.10 years Equipment used in petroleum refining or in the manufacture of tobacco products and certain food products.

First Four Property Classes Under MACRS

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Rounded Depreciation %age by recovery year using MACRS

Recovery Year 3 years 5 years 7 years 10 years

1 33% 20% 14% 10%

2 45% 32% 25% 18%

3 15% 19% 18% 14%

4 7% 12% 12% 12%

5 12% 9% 9%

6 5% 9% 8%

7 9% 7%

8 4% 6%

9 6%

10 6%

11 4%

Total 100% 100% 100% 100%

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Example 01: Calculating Depreciation using MACRS

Boca Corporation purchased a machine having a cost of $40000 including installation cost and recovery period of 5 years. Find out the depreciation in each year.

Year Cost %age Depreciation

1 $40000 20% $8000

2 $40000 32 12800

3 $40000 19 7600

4 $40000 12 4800

5 $40000 12 4800

6 $40000 5 2000

Total 100% $40000

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Practice 01: Calculating Depreciation

On March 20, 2009, Norton Systems acquired two new assets. Asset A was research equipment costing $17000 and having a 3-year recovery period. Asset B was duplicating equipment having an installed cost of $45000 and a 5-year recovery period. Using MACRS depreciation percentages, prepare a depreciation schedule for each of these assets.

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Firm’s Cash Flows1. Operating Cash Flow

Cashflow directly related to sale and production of the firm’s products and services.

2. Investment Cash FlowCashflow associated with purchase and sale of both fixed assets and business interests.

3. Financing Cash FlowsCashflows that result from debt and equity financing transactions; includes incurrence and repayment of debt, cash inflow from the sale of stock, and cash outflows to pay cash dividends or repurchase stock.

4. Free cash flowsThe amount of cashflow available to investors after the firm has met all operating needs and paid for investments in net fixed assets and not current assets.

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Baker Corporation Income Statement, 2013

Sales revenue $ 1700Less: Cost of Goods Sold (1000)Gross Profit $ 700Less: Operating Expenses:

Selling Expenses ($ 110)Lease exp ($120)Depreciation exp ($100)

Total Operating Exp ($ 330)Earnings Before Interest and Taxes (EBIT) $ 370Less Interest Exp ($ 70)Earnings Before Taxes (EBT) $ 300Less: Taxes @ 40% ($ 120)Net Profit After Taxes $180Less: Preferred stock dividend ($ 10)Earnings Available to Common stockholders $170

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Example 01: Calculating Operating Cashflow

Calculate Baker Corporation’s Operating cashflow for 2013 from the given income statement.

Solution:

OCF = EBIT – Taxes + Depreciation

OCF = $370 – $120 + $100

OCF = $350

A firm’s operating cash flow (OCF) is the cash flow it generates from its normal operations—producing and selling its output of goods or services

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Free cash Flows

FCF = OCF – NFAI – NCAIHere, NFAI = Net Fixed Asset InvestmentNCAI = Net Current Asset InvestmentNFAI = Change in net fixed Assets + Depreciation NCAI = Change in Current Assets – Change in

Accounts payable - Change in Accruals

The firm’s free cash flow (FCF) represents the amount of cash flow available to investors—the providers of debt (creditors) and equity (owners)—after the firm has met all operating needs and paid for investments in net fixed assets and net current assets. It represents the summation of the net amount of cash flow available to creditors and owners during the period.

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Example 02: Calculating NFAIThe Baker Corporations 2012 fixed asset was $1000 and 2013 fixed asset was $1200 and the depreciation for 2013 was $100. Find out the Baker’s NFAI.

Solution:Fixed Assets in 2013 = $ 1200Fixed Assets in 2012 = $ 1000 Change in Net Fixed Asset = $200So,NFAI = Change in net fixed Asset + Depreciation

= $ 200 + $ 100= $ 300

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Example 03: Calculating NCAIThe following information is available for Baker Company’s 2013 and 2012 Balance Sheet statement.

2013 2012 Change

Current Asset $2000 $1900 ?

Accounts Payable $700 $500 ?

Accruals $100 $200 ?

NCAI = Δ in Current Assets – Δ in A/P - Δ in Accruals)NCAI = $ 100 - $ 200-(-$100) = $ 0

Example 04: Calculating FCFFrom the previous example 01, 02 and 03, calculate the Free Cash Flow for Baker Company.Solution: FCF = OCF – NFAI – NCAIFCF = $350 - $ 300 - $ 0 = $ 50

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A Sample Cash Flow StatementCash Flow from Operating ActivitiesNet profits after taxes (Net Income) $180Depreciation 100Decrease in accounts receivable 100Decrease in inventories 300Increase in accounts payable 200Decrease in accruals (100)Cash provided by operating activities $780Cash Flow from Investment ActivitiesIncrease in gross fixed assets ($300)Changes in business interests 0Cash provided by investment activities ( 300)Cash Flow from Financing ActivitiesDecrease in notes payable ($100)Increase in long-term debts 200Changes in stockholders’ equity 0Dividends paid (80)Cash provided by financing activities 20Net increase in cash and marketable securities $500

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Practice: 01

2013 2012Sales $1500 $1435

Cost of goods sold (1230) (1176.7)Depreciation (50) (40)

Earnings before interests and Taxes (EBIT) 130 133.3EBT 90 98.3

Taxes (40%) (36.0) (39.3)Net income 54.0 59.0Total Current Assets $465.0 400.0Total Fixed Assets 380.0 350.0

Total Assets $845.0 $750.0===== =====

Accounts payable $70.0 $60.0Accruals 60.0 55.0Long term bonds 300.0 255.0

Calculate FCF for 2013 from the following information:

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Practice: 02The Bangla-Longla Company has purchased an asset which cost Taka 50000 and an installation charge of Taka 10,000 in the year of 2010 with five years of working life. The following information are given for Bangla-Longla Company. Calculate the FCF from the given information for 2013.

2013 2012

EBIT Tk 27500 ------------

Depreciation Tk ?????? ------------

Current Assets Tk 8200 Tk 6800

Fixed Assets Tk 14800 Tk 15000

Accounts Payable Tk 1600 Tk 1500

Accruals Tk 200 Tk 300

Taxes Tk 933 ------------

Net Profit Tk 1400 ------------

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Practice: 03The Bangla-Longla Company has purchased an asset which cost Taka 60000 and an installation charge of Taka 10,000 in the year of 2008 with five years of working life. The following information are given for Bangla-Longla Company. Calculate the FCF from the given information for 2010.

2010 2009

EBIT Tk 27500 ------------

Depreciation Tk ?????? ------------

Current Assets Tk 8200 Tk 6800

Fixed Assets Tk 14800 Tk 15000

Accounts Payable Tk 1600 Tk 1500

Accruals Tk 200 Tk 300

Taxes Tk 933 ------------

Net Profit Tk 1400 ------------

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Practice 04: FCF Calculation

During the year, Xero, Ltd. Experienced an increase in net fixed assets of Tk 300000 and had depreciation of Tk 200000. It also experienced an increase in current assets of Tk 150000 and an increase in accounts payable of Tk 75000. If operating cash flow (OCF) for the year was Tk 700000, Calculate the firm’s free cash flow (FCF) for the year.

NFAI = Change in net Fixed Assets + Depreciation = Tk 300000 + Tk 200000 = Tk 500000NCAI = Change in Current Assets – Change in Accounts payable -

Change in Accruals)= Tk 150 000 – Tk 75000 – Tk 0 = Tk 75000FCF = OCF – NFAI – NCAISo, FCF = Tk 700000 – Tk 500000 – Tk 75000FCF = Tk 125000

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Example 06: Accounting Cash FlowA firm had earnings after taxes of $50,000 in 2009. Depreciation charges were $28,000, and a $2,000 charge for amortization of a bond discount was incurred. What was the firm’s accounting cash flow from operations during 2009?

Solutions:Earnings after taxes $50,000Plus: Depreciation 28,000Plus: Amortization 2,000Cash flow from operations $80,000

Cash flow from operations = Net profits after taxes + Depreciation + other noncash charges

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Practice 05: Depreciation and accounting cash flow

A firm in the third year of depreciating its only asset, which originally cost $180,000 and has a 5-year MACRS recovery period, has gathered the following data relative to the current year’s operations.

Accruals $ 15,000Current assets 120,000Interest expense 15,000Sales revenue 400,000Inventory 70,000Total costs before depreciation, interest, and taxes 290,000Tax rate on ordinary income 40%

a. Use the relevant data to determine the accounting cash flow from operations for the current year.

b. Explain the impact that depreciation, as well as any other noncash charges, has on a firm’s cash flows.

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Solution: Depreciation and accounting cash flow

a. Cash flow from operations:Sales revenue $400,000Less: Total costs before depreciation,interest, and taxes -290,000Depreciation expense -34,200Interest expense -15,000Net profits before taxes $ 60,800Less: Taxes at 40% -24,320Net profits after taxes $ 36,480Plus: Depreciation +34,200Cash flow from operations $ 70,680b. Depreciation and other noncash charges serve as a tax

shield against income, increasing annual cash flow.

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Home Practice 01

a. Calculate the firm’s accounting cash flow from operations for the year ended December 31, 2003,

b. Calculate the firm’s operating cash flow (OCF) for the year ended December 31, 2003,

c. Calculate the firm’s free cash flow (FCF) for the year ended December 31, 2003,

d. Interpret, compare, and contrast your cash flow estimates in parts a, b, and c.

Consider the balance sheets and selected data from the income statement of Keith Corporation that follow.