Chapter 1 Making Economic Decisions

Chapter 1 Making Economic Decisions

Chapter 7 Funds Analysis, Cash-Flow Analysis, and Financial Planning Learning Objectives After studying Chapter 7, you should be able to: Explain the difference between the flow of funds (sources and uses of funds) statement and the statement of cash flows -- and understand the benefits of using each. Define "funds" and identify sources and uses of funds. Create a sources and uses of funds statement, make adjustments, and analyze the final results. Describe the purpose and content of the statement of cash flows as well as implications that can be drawn from it. Prepare a cash budget from forecasts of sales, receipts, and disbursements -- and know why such a budget should be flexible. Develop forecasted balance sheets and income statements. Understand the importance of using probabilistic information in forecasting financial statements and evaluating a firm's condition. Topics Topics

Flow of Funds (Sources and Uses) Statement Accounting Statement of Cash Flows Cash-Flow Forecasting Range of Cash-Flow Estimates Forecasting Financial Statements Flow Flow of of Funds Funds Statement Statement A summary of a firms changes in financial position from one period to another; it is also called a sources and uses of funds statement or a statement of changes in financial position. Has been replaced by the cash flow statement (1989) in U.S. audited annual reports. Why Why Examine Examine the the Flow Flow of of Funds Funds Statement

Statement QUESTION? Why should we bother to understand a Flow of Funds Statement that is no longer required to appear in U.S. audited annual reports? Why Why Examine Examine the the Flow Flow of of Funds Funds Statement Statement The Flow of Funds Statement: Includes important noncash transactions while the cash flow statement does not. Is easy to prepare and often preferred

by managers for analysis purposes over the more complex cash flow statement. Helps you to better understand the cash flow statement, especially if it is Flow Flow of of Funds Funds Statement Statement What are funds? All of the firms investments and claims against those investments. Extends beyond just transactions involving cash. Sources Sources and and Uses Uses Statement Statement The letters labeling the boxes stand for Uses, Sources, Assets, and Liabilities (broadly

defined). The pluses (minuses) indicate increases (decreases) in assets or liabilities. A S + U L + - BWs BWs Determination Determination of of Sources Sources and and Uses Uses Assets Cash and C.E. Acct. Rec. Inventories Prepaid Exp

Accum Tax Prepay 2007 Current Assets $ Fixed Assets (@Cost) Less: Acc. Depr. Net Fix. Assets $ Investment, LT Other Assets, LT $ 2006 90 394 696 5 10 1,195 1030 (329) 701 50 223

$ $ $ $ +/- 100 410 616 5 9 1,140 930 (299) 631 50 223 2,044 S/U + + +

S S U -U N/A N/A N/A U --- BWs BWs Determination Determination of of Sources Sources and and Uses Uses Assets Cash and C.E. Acct. Rec. Inventories Prepaid Exp Accum Tax Prepay 2007

$ 90 394 696 5 10 Current Assets $ 1,195 Fixed Assets (@Cost) 1030 Less: Acc. Depr. (329) Net Fix. Assets $ 701 Investment, LT 50 Other Assets, LT 223 Total Assets $ 2,169 2006 $

$ $ $ +/- 100 $10 410 16 616 80 5 9 1 1,140 930 (299) 631 70 50 223 2,044 S/U S S

U -U N/A N/A N/A U --- BWs BWs Determination Determination of of Sources Sources and and Uses Uses Liabilities and Equity Notes Payable Acct. Payable Accrued Taxes Other Accrued Liab. $ 2007 290

94 16 100 $ $ Current Liab. $ 500 Long-Term Debt 530 Shareholders Equity Com. Stock ($1 par) 200 Add Pd in Capital 729 Retained Earnings 210 Total Equity $ 1,139 Total Liab/Equity $ 2,169 $ $ 2006

295 94 16 100 505 453 200 729 157 1086 2,044 +/- - + + S/U U ---N/A S --S

N/A BWs BWs Determination Determination of of Sources Sources and and Uses Uses Liabilities and Equity Notes Payable Acct. Payable Accrued Taxes Other Accrued Liab. $ 2007 290 94 16 100 $

$ Current Liab. $ 500 Long-Term Debt 530 Shareholders Equity Com. Stock ($1 par) 200 Add Pd in Capital 729 Retained Earnings 210 Total Equity $ 1,139 Total Liab/Equity $ 2,169 $ $ 2006 295 94 16 100 505 453

200 729 157 1086 2,044 +/- $ 5 S/U U ---N/A 77 S 53 --S N/A Basic Basic Sources Sources and and Uses Uses

Statement Statement SOURCES Increase, Retained Earnings $ 53 Decrease, Accounts Receivable 16 Increase, Long-Term Debt 77 Decrease, Cash + Cash Equivalents 10 USES $156 Increase, Inventories $80 Increase, Accum Tax Prepay 1 Decrease, Notes Payable 5 Increase, Net Fixed Assets 70 $156 Adjusting Adjusting the the Basic Basic Sources Sources

and and Uses Uses Statement Statement The following three slides are Basket Wonders Balance Sheet and Income Statement that was discussed in Chapter 6. This information will be needed to adjust the basic Sources and Uses Statement. Basket Basket Wonders Wonders Balance Balance Sheet Sheet (Asset (Asset Side) Side) Basket Wonders Balance Sheet (thousands) Dec. 31, 2007a Cash and C.E. Acct. Rec.c Inventories Prepaid Exp d Tax Prepay

$ 90 394 696 5 Accum 10 a. How the firm stands on a specific date. b. What BW owned. c. Amounts owed by customers. d. Future expense items Current Assetse $1,195 Fixed already paid. Assets (@Cost)f 1030 Less: e. Cash/likely convertible to Acc. Depr. g (329) Net cash within 1 year. Fix. Assets $ 701 f. Original amount paid. Investment, LT 50 Other g. Acc. deductions for wear Assets, LT 223 Total and tear. b

Assets $2,169 Basket Basket Wonders Wonders Balance Balance Sheet Sheet (Liability (Liability Side) Side) Basket Wonders Balance Sheet (thousands) Dec. 31, 2007 Notes Payable $ 290 Acct. Payablec 94 Accrued Taxes d 16 Other Accrued Liab. d 100 Current Liab. e $ 500 Long-Term Debt f 530 Shareholders Equity Com. Stock ($1 par) g 200 Add Pd in Capital g

729 Retained Earnings h 210 Total Equity $1,139 Total Liab/Equitya,b $2,169 a. Note, Assets = Liabilities + Equity. b. What BW owed and ownership position. c. Owed to suppliers for goods and services. d. Unpaid wages, salaries, etc. e. Debts payable < 1 year. f. Debts payable > 1 year. g. Original investment. h. Earnings reinvested. Basket Basket Wonders Wonders Income Income Statement Statement Basket Wonders Statement of Earnings (in thousands) for Year Ending 12/31/2007a

Net Sales $ 2,211 Cost of Goods Sold b 1,599 Gross Profit $ 612 SG&A Expenses c 402 EBITd $ 210 Interest Expensee 59 EBT f $ 151 Income Taxes 60 EATg $ 91 Cash Dividends 38 Increase in RE $ 53 a. Measures profitability over a time period. b. Received, or receivable, from customers.

c. Sales comm., adv., officers salaries, etc. d. Operating income. e. Cost of borrowed funds. f. Taxable income. g. Amount earned for shareholders. Adjusting Adjusting the the Basic Basic Sources Sources and and Uses Uses Statement Statement Recognize Profits and Dividends Change in retained earnings is composed of profits and dividends. Source: Net Profit $91 Less Use: Cash Dividends 38 (Net) Source: Incr., R.E. $53 Adjusting

Adjusting the the Basic Basic Sources Sources and and Uses Uses Statement Statement Recognize Depreciation and Gross Changes in Fixed Assets Change in net fixed assets is composed of depreciation and fixed assets. Source: Depreciation $ 30 Less Use: Add. to F.A. 100 (Net) Use: Incr., Net F.A. $ 70 Sources Sources and and Uses Uses Statement Statement (Sources

(Sources Side) Side) SOURCES Funds provided by operations Net Profit $ 91 Depreciation 30 Decrease, Accounts Receivable Increase, Long-Term Debt Decrease, Cash + Cash Equivalents $224 16 77 10 Sources Sources and and Uses Uses Statement Statement (Uses (Uses Side) Side) USES Dividends $ 38

Additions to fixed assets Increase, Inventories Increase, Accum. Tax Prepay Decrease, Notes Payable 224 100 80 1 5 Analyzing Analyzing the the Sources Sources and and Uses Uses Statement Statement Sources Uses Primarily through net profit from operations and long-term debt

increases. Primarily through an increase in inventories and expenditures on capital assets. Statement Statement of of Cash Cash Flows Flows A summary of a firms payments during a period of time. This statement reports cash inflows and outflows based on the firms operating activities, investing activities, and financing activities. Statement of Cash Flows Cash Flow from Operating Activities Shows impact of transactions not defined as investing or financing activities. These cash flows are generally the cash effects of transactions that enter into the determination

of net income. Cash Flow From Operating Activities Cash Inflows From sales of goods or services From interest and dividend income Cash Outflows To pay suppliers for inventory To pay employees for services To pay lenders (interest) To pay government for taxes To pay other suppliers for other operating expenses Cash Flow From Operating Activities It would seem more logical to classify interest and dividend income as an investing inflow, while interest paid certainly looks like a financing outflow. But, the U.S. Financial Accounting Standards Board -- by a slim 4 to 3 vote -- classified these items as operating flows. Statement Statement of of Cash

Cash Flows Flows Cash Flow from Investing Activities Shows impact of buying and selling fixed assets and debt or equity securities of other entities. Cash Flow from Financing Activities Shows impact of all cash transactions with shareholders and the borrowing and repaying transactions with lenders. Cash Flow From Investing Activities Cash Inflows From sale of fixed assets (property, plant, equipment) From sale of debt or equity securities (other than common equity) of other entities Cash Outflows To acquire fixed assets (property, plant, equipment) To purchase debt or equity securities (other than common equity) of other entities Cash Flow From Financing

Activities Cash Inflows From borrowing From the sale of the firms own equity securities Cash Outflows To repay amounts borrowed To repurchase the firms own equity securities To pay shareholders dividends Indirect Method Statement of Cash Flows Cash Flow from Operating Activities Net Income $ 91 Depreciation 30 Decrease, accounts receivable Increase, inventories Increase, accum. tax prepay Net cash provided (used) by activities $ 56 16 ( 80)

( 1) operating Indirect Method Statement of Cash Flows Cash Flow from Investing Activities Additions to Fixed Assets Net cash provided (used) by activities $(100) $(100) investing Indirect Method Statement of Cash Flows Cash Flow from Financing Activities Increase, notes payable Increase, long-term debt Dividends paid $ ( 5) 77 ( 38) Net cash provided (used) by financing activities

$ 34 Indirect Method Statement of Cash Flows Increase (decrease) in cash and cash equivalents $ ( 10) Cash and cash equivalents, 2006 100 Cash and cash equivalents, 2007 $ 90 Supplemental cash flow disclosures Interest paid $ 59 Taxes paid 60 Direct Method Statement of Cash Flows Cash Flow from Operating Activities Cash received from customersa $2,227 Cash paid to suppliers and employeesb (2,051) Interest paid ( 59) Taxes paidc

( 61) Net cash provided (used) by activities $ 56 a, b, c operating See Worksheet on next slide for calculation Worksheet for Preparing Operating Activities Section (a) +(-) (b) +(-) Sales $2,211 Decrease (increase) in AR Cash received from customers 16 $2,227 COGS - Depreciation + SGA

Increase (decrease) in inventory $1,971 80 Cash paid to suppliers and employees $2,051 (c) +(-) Income taxes (federal / state) Incr (Decr) in accum. tax prepay Taxes paid $ $ 1 61 60 Direct Method Statement of Cash Flows

Cash Flow from Investing Activities Additions to Fixed Assets Net cash provided (used) by activities $(100) $(100) investing Direct Method Statement of Cash Flows Cash Flow from Financing Activities Decrease, notes payable $ ( 5) Increase, long-term debt 77 Dividends paid ( 38) Net cash provided (used) by financing activities $ 34 Direct Method Statement of Cash Flows Increase (decrease) in cash and C.E. Cash and cash equivalents, 2006 100 Cash and cash equivalents, 2007

90 $ ( 10) $ Supplemental cash flow disclosures Net Income $ 91 Depreciation 30 Decrease, accounts receivable 16 Increase, inventories ( 80) Increase, accum. tax prepay ( 1) Net cash provided (used) by operating Cash Cash Flow Flow Forecasting Forecasting A Cash Budget is a forecast of a firms future cash flows arising from collections and disbursements, usually on a monthly basis. The financial manager is better able to:

Determine the future cash needs of the firm Plan for the financing of these needs Exercise control over cash and liquidity of the firm The The Sales Sales Forecast Forecast Internal Sales Forecast Sales representatives project sales for the period in question (sales under their control or management). Sales projections are screened and consolidated for product lines. Product line sales projections are consolidated into a single forecast. The The Sales Sales Forecast Forecast External Sales Forecast Economists project overall economic and business trends that will affect the firm. Expected market share is projected for current and new product lines. Product line sales projections are

consolidated into a single forecast. BWs BWs Cash Cash Flow Flow Forecast Forecast Lisa Miller has finalized a cash flow forecast for the first six months of 2008. Lisa is expecting 90% of monthly sales will be credit sales with 80% of credit sales collected in 30 days, 20% in 60 days, and no bad debts. Hint: The cash flow forecast will be used in forecasting the financial statements later in this chapter. Collections Collections and and Other Other Cash Cash Receipts Receipts (Thousands) (Thousands) SALES NOV DEC JAN

Credit Sales, 90% $193 $212 Cash Sales, 10% 21 24 Total Sales, 100% $214 $236 CASH COLLECTIONS Cash sales, current 80% of last months credit sales 20% of 2-month-old credit sales Total sales receipts FEB $154 17 $171 $ 17 169 $ 15 123

39 42 $225 $180 $135 15 $150 Collections Collections and and Other Other Cash Cash Receipts Receipts (Thousands) (Thousands) SALES MAR APR Credit Sales, 90% $256 Cash Sales, 10% 28 Total Sales, 100%

$284 CASH COLLECTIONS Cash sales, current $ 28 80% of last months 108 credit sales 20% of 2-month-old 31 credit sales Total sales receipts $167 MAY JUN $205 $160 $190 23 18 21 $228 $178 $211 $ 23 205

$ 18 164 $ 21 128 27 51 41 $255 $233 $190 Schedule Schedule of of Projected Projected Cash Cash Disbursements Disbursements (Thousands) (Thousands) DEC Purchases

JAN FEB $ 39 $ 35 $ 64 CASH DISBURSEMENTS FOR PURCHASES AND OPERATING EXPENSES 100% of last months $ 39 $ 35 purchases Wages paid 90 94 Other expenses paid 34 34 Total disbursements (purchases and operating expenses) $163 $163 Schedule Schedule of of Projected

Projected Cash Cash Disbursements Disbursements (Thousands) (Thousands) MAR Purchases APR MAY JUN $ 53 $ 40 $ 48 $ 50 CASH DISBURSEMENTS FOR PURCHASES AND OPERATING EXPENSES 100% of last months purchases Wages paid Other expenses paid Total disbursements (purchases and operating expenses)

$ 64 111 107 34 $209 $ 53 $ 40 92 $ 48 92 34 34 34 $194 $166 $174 Schedule Schedule of of Net Net Cash Cash Disbursements

Disbursements (Thousands) (Thousands) JAN Total disbursements for purchases and operating Capital expenditures Dividend payments Income taxes Total cash disbursements FEB $163 70 0 25 $258 MAR $163 $209 expenses 40 0 0 9 0 0 $203 $218

Schedule Schedule of of Net Net Cash Cash Disbursements Disbursements (Thousands) (Thousands) APR Total disbursements for purchases and operating Capital expenditures Dividend payments Income taxes Total cash disbursements MAY $194 0 0 25 $219 JUN $166 $174 expenses 0 0

0 10 0 0 $166 $184 Projected Projected Net Net Cash Cash Flows Flows and and Cash Cash Balances Balances JAN Beginning cash balance FEB MAR $ 90 $ 57 $ 34 Total cash receipts 225 180 167

Total cash disbursements 258 203 218 Net cash flow $( 33) $( 23) $( 51) Ending cash balance without additional financing ( 17) $ 57 $ 34 $ Projected Projected Net Net Cash Cash Flows Flows and and Cash Cash Balances Balances APR Beginning cash balance

MAY JUN $( 17) $ 19 $ 86 Total cash receipts 255 233 190 Total cash disbursements 219 166 184 Net cash flow $ 36 $ 67 $ 6 Ending cash balance without additional financing $ 19 $ 86 $ 92 Range Range of of Cash-Flow Cash-Flow Estimates

Estimates Examine factors that may influence cash receipts such as changes in the state of the economy that influence consumer buying decisions and pricing strategies. Examine factors that may influence cash disbursements such as changes in the state of the economy that impact operations, capital expenditures, and dividend payments. Management Management Uncertainty Uncertainty in in Ending Ending Cash Cash Balances Balances PROBABILITY OF OCCURRENCE January Distribution $42 $51 $60

$69 $78 ENDING CASH BALANCE (thousands) Management Management Uncertainty Uncertainty in in Ending Ending Cash Cash Balances Balances PROBABILITY OF OCCURRENCE February Distribution $4 $15 $26 $37

$48 ENDING CASH BALANCE (thousands) Summary Summary of of the the Range Range of of Cash-Flow Cash-Flow Estimates Estimates Allows examination of the relevant factors which may generate uncertainty regarding future cash flows. Enables management to better plan for contingencies that will arise than using a single-point estimate of monthly cash flows. Forecasting

Forecasting Financial Financial Statements Statements Expected future financial statements based on conditions that management expects to exist and actions it expects to take. Considerations (1) Forecasted Income Statement (2) Forecasted Balance Sheet Forecasting Forecasting BWs BWs Income Income Statement Statement Lisa Miller is forecasting the income statement for 2008. She estimates that sales for the 6 months ended June 30 will be $1,222,000. COGS are estimated from the average of years 2005 through 2007. Selling, general, and administrative costs are forecasted at $34,000 per month, while the income tax rate is assumed equal to 40%. Cash dividends and interest expenses are expected to remain constant.

Basket Basket Wonders Wonders Forecasted Forecasted Income Income Statement Statement Basket Wonders Forecasted Statement of Earnings (in thousands) for Six Months Ending June 30, 2008 Net Salesa $ 1,222 Cost of Goods Sold b 865 Gross Profit $ 357 SG&A Expenses c 204 EBIT $ 153 Interest Expensed 29 EBT $ 124 Income Taxes

50 EAT $ 74 Cash Dividendse 19 Increase in RE $ 55 a. From sales budget. b. Average of 68.7, 71.3, and 72.3% multiplied by net sales. c. $34,000 x 6 months. d. Assumed to be $29,000. e. Did not change. Six (6) months of dividends = (.5) ($38,000) = $19,000. Basket Basket Wonders Wonders Balance Balance Sheet Sheet (Asset (Asset Side) Side) Forecasted Balance Sheet (thousands) June 30, 2008 Cash and C.E.a Acct. Rec.b

Inventoriesc Prepaid Exp Tax Prepay a. From Cash Flow $ 92 Forecast. 222 b. 100% June, 20% May. 692 5 Accum c. Inv Turnover = 2.5/yr. 10 Current Assets $1,021 Fixed Assets (@Cost) 1,140 Less: Acc. Depr. (386) Net Fix. Assetsd $ 742 Investment, LT 50 Other Assets, LT 223 Total Assets $2,036 d. Capital expenditure of $110,000 and depreciation of $69,000. ASSUMPTIONS

Basket Basket Wonders Wonders Balance Balance Sheet Sheet (Liability (Liability Side) Side) Forecasted Balance Sheet (thousands) June 30, 2008 Notes Payablea $ 226 Acct. Payableb 50 Accrued Taxes c 16 Other Accrued Liab. d 20 Current Liab. $ 312 Long-Term Debt 530 Shareholders Equity Com. Stock ($1 par) 200 Add Pd in Capital 729 Retained Earnings e

265 Total Equity $1,194 Total Liab/Equity $2,036 a. Previous balance less amount paid down. b. 100% of June purchases. c. No net change in accruals. d. Decrease in unpaid wages, salaries, etc. e. Increase in retained earnings (See 7-57). ASSUMPTIONS Sustainable Sustainable Growth Growth Modeling Modeling Steady-State Steady-State Model Model A/S = Total-Assets-to-Sales Ratio NP/S = Net Profits / Sales (Net Profit Margin) b = Retention rate of earnings

D/Eq = Debt-to-Equity Ratio S0 = Most recent Annual Sales S = Sales Changes from S0 Assets = Retained Earnings + Debt NP D A NP S b (S0 S ) b (S0 S ) S S S Eq [7A.1] Sustainable Sustainable Growth Growth Modeling Modeling Steady-State Steady-State Model Model Sustainable Growth Rate (SGR) NP

D NP b( )(1 ) b( ) S S Eq Eq SGR S A NP D 1 b( NP ) ( ) b( )(1 ) Eq S S Eq [7A.2] Sustainable Sustainable Growth Growth Modeling

Modeling Under Under Changing Changing Assumptions Assumptions Sustainable Growth Rate (SGR) D S (Eq0 Eq Div )(1 )( ) Eq A 1 1 SGR S0 NP D S 1 ( )(1 )( ) Eq A S [7A.3]

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