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Financial Planning and Forecasting:

Cash Flows and Financial Statement Analysis

Corporate Finance

Dr. A. DeMaskey

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Learning Objectives

• Questions to be answered:– What are the basic financial statements and how are

they used? – What kinds of financial information do users need?– What is the difference between accounting income and

cash flow?– How are different sources of income taxed based on the

U.S. tax code?– How are financial statements used by managers to

improve performance?

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Financial Statements

• Balance Sheet

• Income Statement

• Statement of Retained Earnings

• Statement of Cash Flows

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Cash Flows

• Net Cash Flows

• Free Cash Flows

• Operating Cash Flows

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MVA and EVA

• Market Value Added (MVA)

• Economic Value Added (EVA)

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Individual Income Taxes

• Taxable Income

• Marginal versus Average Tax Rate

• Taxes on Dividend and Interest Income

• Capital Gains versus Ordinary Income

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Corporate Income Taxes

• Interest and Dividend Income Received by a Corporation

• Interest and Dividend Income Paid by a Corporation

• Ordinary Gains and Losses• Capital Gains and Losses• Corporate Loss Carry-Back and Carry-

Forward

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Financial Statement Analysis• Ratio Analysis

– Liquidity ratios– Asset management ratios– Debt management ratios– Profitability ratios– Market value ratios

• Du Pont System– ROA– ROE

Expense control (PM)

Asset utilization (TATO)

Debt utilization (EM)

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Limitations of Ratio Analysis

• Large firms

• Industry averages

• Inflation

• Window dressing

• Accounting practices

• Operating policies

• Interpretation of ratios

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Qualitative Factors

• Key customer

• Key product

• Single supplier

• Foreign sales

• Competition

• Future prospects

• Legal and regulatory environment

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Financial Planning and Forecasting Financial Statements

• Plans: strategic, operating, and financial

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

• Additional Funds Needed (AFN) formula

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Pro Forma Financial Statements

• 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

• Forecast sales

• Project the assets needed to support sales

• Project internally generated funds

• Project outside funds needed

• Decide how to raise funds

• See effects of plan on ratios and stock price

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Sales Forecast

• Division sales forecasts based on historical growth• Level of economic activity and overall demand for

the product• Market share for each product line in each market• If foreign sales, include currency fluctuations,

trade agreements, governmental policies, etc.• Inflation• Advertising campaigns, promotional discounts,

credit terms, etc.

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Projecting Pro Forma Statements with the Percent of Sales Method

• Project sales based on forecasted growth rate in sales

• Forecast some items as a percent of the forecasted sales– Costs– Cash– Accounts receivable

• Items as percent of sales– Inventories

– Net fixed assets

– Accounts payable and accruals

• Choose other items– Debt (which determines

interest)

– Dividends (which determines retained earnings)

– Common stock

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What are the additional funds needed (AFN)?

AFN =Required

assetincrease

-Spontaneous

liabilityincrease

-Increase

in retainedearnings

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Summary: How different factors affect the AFN forecast

• Excess capacity:– Existence lowers AFN.

• Base stocks of assets: – Leads to less-than-proportional asset increases.

• Economies of scale:– Also leads to less-than-proportional asset

increases.• Lumpy assets:

– Leads to large periodic AFN requirements

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Other Techniques for Forecasting Financial Statements

• Regression Analysis for Asset Forecasting– Relationship between type

of asset and sales is linear.

– Get historical data on a good company, then fit a regression line to see how much a given sales increase will require in way of asset increase.

• Excess Capacity Adjustments– Full capacity sales

– Target fixed assets-to-sales ratio

– Required level of fixed assets