Chapter 7 Funds Analysis, Cash Flow Analysis, and Financial Planning

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Chapter 7 Funds Analysis, Cash Flow Analysis,
and Financial Planning
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Cash flow and financial distress

• In China, most ST firms get into financial
  distress. If they could not get financial help
  soon they will not stand of feet
• But why does they get themselves in such a hell ?
  They have got much money with IPO.

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Study Objectives

• Flow of funds statement
• Accounting statement of cash flows
• Cash-flow forecasting
• Range of cash-flow estimates
• Forecasting financial statements

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Flow of funds statements

• Flow of funds statement is a summary of a firms
  changes in financial position from one period to
  another
• WHY do we need a flow of funds statement?
• By arranging a companys flow of funds in a
  systematic fashion, the analyst can better
  determine whether the decisions made for the firm
  resulted in a reasonable flows of funds or in
  questionable flows, which warrant future
  inspection

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What is funds?

• Funds all of the firms investments and claims
• We define funds as the claims and investments
  because many important transactions are not
  reported in cash

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What does flow of funds tell us?

• The sources and uses of funds during a period of
  time
• The firms flow of funds is therefore comprised
  of the individual changes in balance sheet items
  between two points in time
• The flow of funds statement portrays net rather
  than gross changes, although an analysis of the
  gross funds flow of a firm over time would be
  much more revealing than analysis of net funds
  flow, we are usually constrained by the financial
  information available

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What are source? Uses?

• Sources of funds any decrease in an asset item
  or any increase in an claim item
• Uses of funds any increase in an asset item or
  any decrease in a claim item
• See Table 7-1 the determination of sources and
  uses

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Adjustments

• In the former computation, the change in fixed
  assets and retained earnings is a mixed result of
  changes, and what we want is detailed information
  of changes in these items
• See computation page 175

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Implications of funds of statement analysis

• Imbalances in the use of funds can be detected
  and appropriate actions undertaken
• An analysis of the major sources of funds in the
  past reveals what portions of the firms growth
  were financed internally and externally
• We can judge whether the firm has expanded at too
  fast a rate and whether the firms financing
  capability is strained

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Accounting statement of cash flow

• Statement of cash flow is a summary of a firms
  cash receipts and cash payments during a period
  of time
• The purpose of the statement of cash flow is to
  report a firms cash inflows and outflows, during
  a period of time, segregated into three
  categories operating, investing, and financing
  activities

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The usefulness of statement of cash flow

• It helps the financial manager to assess and
  identify
• A companys ability to generate future net cash
  inflows from operations to pay debts, interest,
  and dividends
• A companys need for external financing
• The reasons for differences between net income
  and net cash flow from operating activities
• The effects of cash and noncash investing and
  financing transactions

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Contents of the statement

• The statement of cash flows explains changes in
  cash (and cash equivalents) by listing the
  activities that increased cash and those
  decreased cash
• Each activitys cash inflow or outflow is
  segregated according to one of three broad
  category types operating, investing, or
  financing activity
• Table 7-4 (page 178) lists the activities found
  most often in a typical statement of cash flows

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Alternative forms of the statement

• The cash flow statement may be presented using
  either a direct method or an indirect method.
  The only difference between the direct and
  indirect methods of presentation concerns the
  reporting of operating activities the investing
  and financing activity sections would be
  identical under either method

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Analyzing the statement of cash flow

• Operating cash inflow, dividend and investment
  outflow
• Sales revenue inflow, inventory and employee
  wages outflow
• Analyzing of Aldine page 180

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Cash-flow forecasting

• Cash budget a forecast of a firms future cash
  flows arising from collections and disbursements,
  usually on a monthly basis
• Cash flow reveals the timing and amount of
  expected cash inflows and outflows over the
  period studied.
• With this information, the financial manager is
  better able to determine the future cash needs of
  the firm, plan for the financing of these needs,
  and exercise control over the cash and liquidity
  of the firm.
• Without cash budget, the firm may run into
  financial difficulty

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The preparation of cash budget

• Sales forecast
• Collections and other cash receipts
• Cash disbursements
• Net cash flow and cash balance
• Means of meeting the cash deficits

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The sales forecast

• Often this is done by marketing department
• This forecast can be based on an internal
  analysis, an external one, or both.
• With an internal approach, sale representatives
  are asked to project sales for the forthcoming
  period. The product sales managers screen these
  estimates and consolidate them into sales
  estimates for product lines. The estimates for
  the various product lines are then combined into
  an overall sales estimate for the firm.

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The sales forecast

• The basic problem with an internal approach is
  that it can be too myopic. Often, significant
  trends in the economy and in the industry are
  overlooked
• With an external approach, economic analysts make
  forecasts of the economy and of industry sales
  for several years to come. They may use
  regression analysis to estimate the association
  between industry sales and economy in general.
  The next step is to estimate market share by
  individual products, prices that are likely to
  prevail, and the expected reception of new
  product
• From this information, an external sales forecast
  can be prepared

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The sales forecast

• The defect of external approach is that the data
  used in the computation are not always very
  accurate, most of them are estimated by scholars
  or experts who are not familiar with product
  markets
• Past experience will show which of the two
  forecasts is likely to be more accurate
• In general, the external forecast should serve as
  a foundation for the final sales forecast, often
  modified by internal forecast

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Collections and other cash receipts

• Collections here means to determine the cash
  receipts from the sales
• For cash sales, cash is received at the time of
  the sale for credit sales, the receipts comes
  later. How much later depends on the billing
  terms, the type of customer, and the credit and
  collection policies of the firm
• Example Table 7-7, page 183

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Cash receipts

• Cash receipts may arise from the sale of assets,
  as well as from external financing and investment
  income. These cash receipts need estimations or
  advanced planning

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Cash disbursements

• Operation disbursements and other disbursements
• Operation disbursements are expenses occurred to
  maintain operation, such as material, wages,
  power, interest, tax, etc.
• How does the firm estimate Operation
  disbursements ?
• Sales---production schedules---material
  purchasing, labor cost, and other expenses
• Example Table 7-8 page 184

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Other disbursements

• Capital expenditures the expenditures involves
  long-term investment. They are planned in
  advance, so they are predictable for the
  short-term cash budget
• Dividend payments for most companies are stable
  and are paid on specific date
• Federal taxes can be estimated according to the
  firms sales and income

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Net cash flow and cash balance

• After having taken all foreseeable cash inflows
  and outflows into account, we combine the cash
  receipts and disbursements, and compute the
  projected cash position by month
• If, in a month there is a cash deficit, the
  financial manager should take measures to meet
  this deficit. The feasible measures may including
  borrowing from bank or delaying capital
  expenditures or payments for purchases

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Example

• The cash manager of Monet Paint are preparing a
  cash budget for the 6 months from April through
  September. Their cash management model is based
  on the following assumptions
• Recent and forecasted sales are

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Example
Month 2(actual) 3(actual) 4(forecast) 5 6 7 8 9 10
Sales forecast 400000 500000 600000 700000 800000 800000 700000 600000 500000
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Example

• Twenty percent of sales are collected in the
  month of sale, 50 are collected in the month
  following the sale, and 30 are collected in the
  second month following the sale
• Purchases are 60 of sales, and purchases are
  paid for 1 month prior to sale
• Wages and salaries are 12 of sales and are paid
  in the same month as the sale
• Rent of 10000 is paid each month. Additional
  cash operating expense of 30000 per month will
  be incurred for April through July. These will
  decrease to 25000 for August and September

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Example

• Tax payments of 20000 and 30000 are expected
  in April and July, respectively. A capital
  expenditure of 150000 will occur in June, and
  the firm has a mortgage payment of 60000 due in
  May
• The cash balance at the end of March is 150000.
  Managers want to maintains a minimum balance of
  100000 at all times. The firm will borrow what
  it needs to achieve the minimum balance. Any cash
  above the minimum will be used to pay off any
  loan balance until it is eliminated.

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Cash receipts budget
month 4 5 6 7 8 9
sales 600000 700000 800000 800000 700000 600000
Collection(current) 20 120000 140000 160000 160000 140000 120000
Previous month 50 250000 300000 350000 400000 400000 350000
2nd month previous 30 120000 150000 180000 210000 240000 240000
Total cash receipts 490000 590000 690000 770000 780000 710000
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Cash disbursement budget
month 4 5 6 7 8 9
purchase 420000 480000 480000 420000 360000 300000
Wages and salaries 72000 84000 96000 96000 84000 72000
Rent 10000 10000 10000 10000 10000 10000
Cash operating expense 30000 30000 30000 30000 25000 25000
Tax installments 20000 30000
Capital expenditures 150000
Mortgage payment 60000
Total cash disbursement 552000 664000 766000 586000 479000 407000
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Cash balance and deficits meetings
month 4 5 6 7 8 9
Net cash flow -62000 -74000 -76000 184000 301000 303000
Beginning cash balance 150000 100000 100000 100000 122000 423000
Available balance 88000 26000 24000 284000 423000 726000
Monthly borrowing 12000 74000 76000
Monthly repayment 162000
Ending balance 100000 100000 100000 122000 423000 726000
Cumulative loan balance 12000 86000 162000 0 0 0
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Range of cash flow estimates

• Depending on the care devoted to preparing the
  budget and the volatility of cash flows resulting
  from the nature of the business, actual cash
  flows will deviate more or less widely from those
  that are expected.
• In the face of uncertainty, we must provide
  information about the range of possible outcomes

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Deviations from expected cash flows

• To take into account deviations from expected
  cash flows, it is desirable to work out
  additional cash budget
• We can change assumptions of cash flow and
  display new cash budget. For example, different
  sales volume, price, etc.
• See figure 7-1, distributions of ending cash
  balances

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Use of probabilistic information

• The expected cash position plus the distribution
  of possible outcomes give us a considerable
  amount of information
• additional funds required or the funds released
  under various possible outcomes
• the firms ability to adjust to deviations from
  the expected outcomes
• From the standpoint of internal planning, it is
  far better to allow for a range of possible
  outcomes than to rely solely on the expected
  outcome

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Forecasting financial statements

• Forecast financial statements are expected
  financial statements based on conditions that
  management expects to exist and actions it
  expects to take
• A cash budget gives us information about only the
  prospective future cash positions of the firm,
  whereas forecast statements embody expected
  estimates of all assets and liabilities as well
  as of income statement items
• Much of the information that goes into the
  preparation of the cash budget can be used to
  derive a forecast income statement

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Forecast income statement

• Sales revenue sales forecast
• Assume cost can be divided into fixed cost and
  variable cost
• Cost of goods sold assume variable cost
• Selling, general and administrative expense
  assume fixed cost
• Income tax according to tax law
• Dividend according to dividend policy

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Forecast balance sheet

• Forecast asset assume fixed turnover ratios for
  receivables and inventories
• Future net fixed assets are estimated by adding
  planned expenditures to existing net fixed assets
  and substracting from this sum the book value of
  any fixed assets sold along with depreciations
  during the period
• Forecasting liabilities accounts payable
  according to purchase and payments amounts wages
  according to production schedule shareholders
  equity according to net profit less dividend
• Example page 189-191