CASH FLOW AND

FINANCIAL PLANNING
Topic 3
Cash Flow
Cash flow, the lifeblood of the firm, is the primary
ingredient in any financial valuation model.
Whether an analyst wants to put value on an
investment that a firm is considering or the
objective is to value the firm itself, estimating cash
flow is central to the valuation process.
Statement of Cash Flows
The statement of cash flows summarizes the firm’s
cash flow over a given period. Typically, cash and
marketable securities are lump together when
assessing the firm’s liquidity because both
represent a reservoir of liquidity. The reservoir is
increased by cash inflows and decreased by cash
outflows.
Cash Flows Categories
1. Operating flows – cash inflows and outflows
directly related to the sale and production of the
firm’s products and services.
2. Investing flows – are cash flows associated with
the purchase and sale of both fixed assets and
equity investments in other firms.
3. Financing flows – result from debt and equity
financing transactions.
Inflows and Outflows
Preparation of Statement of Cash
Flows
The statement of cash flows uses data from the income
statement, along with the beginning- and end-of-period
statement of financial position.
All cash outflows, any losses, and dividends paid are
treated as negative values. The items in each category –
operating, investing, and financing – are totaled, and the
three totals are added to get the net increase (decrease)
in cash and marketable securities for the period.
Preparation of Statement of Cash
Flows
Only income and expenses with actual cash inflows
or outflows are accounted in preparing statement of
cash flows. Noncash income and expenses are
disclosed only.
Interpretation of the Statement
The statement of cash flows allows the financial
manager and other interested parties to analyze the
firm’s cash flow.

The statement can be used to evaluate progress

toward projected goals or to isolate inefficiencies.
Interpretation of the Statement
The financial manager also can prepare a statement
of cash flows developed from projected financial
statements to determine whether planned actions
are desirable in view of the resulting cash flows.
Operating Cash Flow
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.

The first step is to calculate net operating profit

after taxes (NOPAT), which represents the firm’s
earnings before interest and after taxes.
Operating Cash Flow
Operating Cash Flow
To convert NOPAT to operating cash flow (OCF)
Free Cash Flow
The firm’s free cash flow (FCF) represents the cash
available to investors – the providers of debt and
equity – after the firm has met all operating needs
and paid for net investments in fixed assets and
current assets.
Free Cash Flow
Free Cash Flow
Net Fixed Asset Investment
The 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.
Free Cash Flow
Net Current Asset Investment (NCAI)
The net current asset investment 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.
Notes payable are not included in the NCAI calculation
because they represent a negotiated creditor claim on
the firm’s free cash flows.
Free Cash Flow
Net Current Asset Investment (NCAI)
Free Cash Flow
Free Cash Flow
Free Cash Flow
The Financial Planning Process
Financial planning is 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.
The Financial Planning Process
The two key aspects of financial planning
process:
1. Cash planning – involves preparation of the
firm’s cash budget.
2. Profit planning – involves preparation of
pro forma statements.
The Financial Planning Process
The financial planning process begins with
long-term, or strategic, financial plans. The
strategic financial plans guide the formulation
of short-term, or operating, plans and budgets.
Generally, the short-term plans and budgets
implement the firm’s long-term strategic
objectives.
Long-term (Strategic) Financial Plans

Long-term financial plans lay out a company’s

planned financial actions and the anticipated
impact of those actions over periods ranging
from two to ten years.
Long-term (Strategic) Financial Plans

Those long-term plans consider proposed

outlays for fixed assets, research and
development activities, marketing and product
development actions, capital structure, and
major sources of financing.
Long-term (Strategic) Financial Plans

It also includes termination of existing

projects, product lines, or lines of business;
repayment or retirement of outstanding debts;
and any planned acquisitions.
Short-term (Operating) Financial
Plans
Short-term financial plans specify short-term
financial actions and the anticipated impact of
those actions. These plans often cover a 1- to
2- year period.
Short-term (Operating) Financial
Plans
Key inputs include the sales forecast and
various forms of operating and financial data.
Key outputs include a number of operating
budgets, the cash budget, and pro forma
financial statements.
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 by the firm to
estimate its short-term cash requirements,
with particular attention being paid to
planning for surplus cash and for cash
shortages.
Sales Forecast
The sales budget is the starting point in
preparing the master budget. The sales budget
is constructed by multiplying budgeted unit
sales by the selling price.
Sales Forecast
Production Budget
The production budget lists the number of
units that must be produced to satisfy sales
needs and to provide for the desired ending
inventory.
Production Budget
Production Budget
The production requirements are influenced
by the desired level of the ending inventory.
Inventories should be carefully planned.
Excessive inventories tie up funds and create
storage problems. Insufficient inventories can
lead to lost sales or last-minute, high-cost
production efforts.
Production Budget
Direct Materials Budget
The direct materials budget is prepared after
the production requirements have been
computed. The direct materials budget details
the raw materials that must be purchased to
fulfill the production budget and to provide for
adequate inventories.
Direct Materials Budget
Direct Labor Budget
The direct labor budget shows the direct
labor-hours required to satisfy the production
budget. By knowing in advance how much
labor time will be needed throughout the
budget year, the company can develop plans to
adjust the labor force as the situation requires.
Direct Labor Budget
Manufacturing Overhead Budget
The manufacturing budget lists all
costs of production other than direct
materials and direct labor.
Manufacturing Overhead Budget
Manufacturing Overhead Budget
The variable overhead depends on the
cost driver. It is computed by
multiplying the cost driver with the
variable overhead rate.
Ending Finished Goods Inventory
Budget
After the preparation of sales budget up to the
manufacturing overhead budget the entity can then
estimate the unit product cost. The computation of
unit product cost is necessary to: (1) determine the
cost of goods sold in the budgeted profit or loss; and
(2) the value of ending inventories. The cost of
unsold units is computed on the ending finished
goods inventory budget.
Ending Finished Goods Inventory
Budget
Selling and Administrative Expense
Budget
These includes expenses for salaries of sales
personnel and executives, utilities (not
associated with the production), advertising,
insurance, and other expenses incurred not
included as product cost.
CASH BUDGET
The cash budget is composed of four major
sections:
1. The receipts section
2. The disbursements section
3. The cash excess or deficiency section
4. The financing section
CASH BUDGET
The cash receipts include all of a firm’s inflows
of cash during a given financial period. The
most common components of cash receipts are
cash sales, collections of accounts receivable,
and other cash receipts.
CASH BUDGET
The cash disbursements include all outlays of
cash by the firm during a given financial
period. These payments include raw materials
purchases, direct labor payments,
manufacturing overhead costs, and so on, as
contained in their respective budgets.
CASH BUDGET
It is important to recognize that depreciation
and other noncash charges are not included in
the cash budget.
CASH BUDGET
The firm’s net cash flow is found by
subtracting the cash disbursements from cash
receipts in each period. The beginning balance
of cash is added to the firm’s net cash flow to
determine the ending cash for each period.
CASH BUDGET
If a cash deficiency exists during any budget
period, the company will need to borrow
funds. If there is cash excess during any budget
period, funds borrowed in previous periods
can be repaid or the excess funds can be
invested.
CASH BUDGET
The financing section details the borrowings
and repayments projected to take place during
the budget period. It also lists payments that
will be due on money borrowed.
CASH BUDGET
PROFIT PLANNING: PRO FORMA
STATEMENTS
Profit planning relies on accrual concepts to
project the firm’s profit and overall financial
position. The approaches for estimating the
pro forma statements are all based on the
belief that the financial relationships reflected
in the firm’s past financial statements will not
change in the coming period.
PROFIT PLANNING: PRO FORMA
STATEMENTS
Two inputs are required for preparing pro
forma statements:
1. Financial statements for the preceding year
2. The sales forecast for the coming year
Preparation of the Pro Forma
Statement of Profit or Loss
A simple method for developing a pro forma
statement of profit or loss is the percent-of-sales
method. It forecasts sales and then expresses the
various statement of profit or loss items as
percentages of projected sales. The percentages
used are likely to be the percentages of sales for
those items in the previous year.
Preparation of the Pro Forma
Statement of Profit or Loss

The percent-of-sales method assumes that all

the firm’s costs and expenses are variable. In
that case, it tends to understate profits when
sales are increasing and overstate profits when
sales are decreasing.
Preparation of the Pro Forma
Statement of Profit or Loss

The best way to adjust for the presence of fixed

costs when preparing a pro forma statement of
profit or loss is to break the firm’s historical
costs and expenses into fixed and variable
components.
Sales forecast
R Co. is preparing budgets for the quarter ending June
30. the budgeted sales for the next five months are:

The selling price is P10 per unit. Prepare sales budget.

Sales forecast

All sales are on account. R’s collection pattern

is: 70% collected in the month of sale, 25%
collected in the month following sale, and 5%
uncollectible. The March 31 accounts
receivable balance of P15,000 will be collected
in full. Prepare cash receipts schedule.
Production budget

The management at R Company wants ending

inventory to be equal to 20% of the following
month’s budgeted sales in units. On March 31,
2,000 units were on hand.

Prepare the production budget.

Direct materials budget
At R Company, five pounds of material are
required per unit of product. Management wants
materials on hand at the end of each month equal
to 10% of the following month’s production.
On March 31, 6,500 pounds of material are on
hand. Material cost is P0.40 per pound.
Prepare the direct materials budget.
Direct materials budget
R Company pays P0.40 per pound for its materials.
One-half of a month’s purchases is paid for in the
month of purchase and the other half is paid in the
following month.

The March 31 accounts payable balance is P6,000.

Calculate the expected cash disbursements.

Direct labor budget
At R, each unit of product requires 0.05 hours of direct
labor hours. The company has a no layoff policy so all
employees will be paid for 40 hours of work each week.

Assuming that workers are paid P10 per hour regardless

of the hours worked with no overtime pay. For the next
three months, the direct labor workforce will be paid for
a minimum of 750 hours per month.

Prepare the direct labor budget.

Manufacturing overhead budget
At R Company, manufacturing overhead is applied
to units of product on the basis of direct labor
hours. The variable manufacturing overhead rate
is P20 per direct labor hour.
Fixed manufacturing overhead is P25,000 per
month and includes depreciation of P10,000.
Prepare the manufacturing overhead budget.
Product cost

Compute the unit product cost and the amount

of ending finished goods.
Selling and administrative expense budget

At Royal, the selling and administrative expenses budget is

divided into variable and fixed components. The variable selling
and administrative expenses are P0.50 per unit sold.

Fixed selling and administrative expenses are P35,000 per month.

The fixed selling and administrative expenses include P5,000 in
costs that are not actual cash outflows of the current month.

Prepare the company’s selling and administrative expense budget.

Cash budget
R Company maintains a 16% open line of credit for
P37,500 and maintains a minimum cash balance of
P15,000. The company borrows on the first day of the
month and repays loans on the last day of the month.
During the April it pays cash dividend of P24,500. The
company also purchases P71,850 worth of equipment
on May and P24,150 on June on cash basis.
The cash balance on April 1 is P20,000.
Prepare cash budget for the quarter.
Pro-forma profit or loss

Prepare a pro forma statement of profit or loss

based on the previous budgets made.
End of Topic 3