Chapter 4
Cash Flow and Financial Planning
Instructor’s Resources
Overview
This chapter introduces the student to the financial planning process, with the emphasis on short-term (operating)
financial planning and its two key components: cash planning and profit planning. Cash planning requires
preparation of the cash budget, while profit planning involves preparation of a pro forma income statement and
balance sheet. The text illustrates through example how these budgets and statements are developed. The
weaknesses of the simplified approaches (judgmental and percent-of-sales methods) of pro forma statement
preparation are outlined. The distinction between operating cash flow and free cash flow is presented and
discussed. Current tax law regarding the depreciation of assets and the effect on cash flow are also described. The
firm’s cash flow is analyzed through classification of sources and uses of cash. The student is guided in a
step-by-step preparation of the statement of cash flows and the interpretation of this statement. This chapter ties in
every person’s need to set goals, estimate income, and budget expenditures to the firm’s need to effectively engage
in these activities.
Suggested Answer to Opener-in-Review Question
The chapter opener described a company that reported increases in revenues and profits, but even so, the
company’s free cash flow was negative. Explain why a profitable, expanding business may have negative
free cash flow.
A firm’s free cash flow (FCF) represents the cash available to investors—the providers of debt (creditors) and
equity (owners)—after the firm has met all operating needs and paid for net investments in fixed assets and current
assets.
When a firm is expanding, it may have to make additional investments in inventory, receivables, and fixed assets
such as machinery. Cash outlays for those investments don’t necessarily show up immediately in the profit
calculation, but they do reduce free cash flow. A firm may be generating high revenue and profit but may not have
enough to pay the creditors and owners. This can happen when a company needs to make significant investment,
higher than the operating cash flow, into fixed capital or working capital. When a business is in an expansion
phase, the firm has to make higher amount of investment in fixed assets and current assets to meet the growth
requirements.
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Chapter 4 Cash Flow and Financial Planning 52
Answers to Review Questions
1. The first four classes of property specified by the MACRS system categorized by the length of the
depreciation (recovery) period are called 3-, 5-, 7-, and 10-years property:
Recovery Period Definition
3 years Research and experiment equipment and certain special tools
2. The cash flow from operating activities relates to the firm’s production cyclefrom the purchase of raw materials
to the finished product. Any expenses incurred directly related to this process are considered operating flows.
3. A decrease in a cash balance is a source of cash flow because cash flow must have been released for some
4. Depreciation (and amortization and depletion) is a cash inflow to the firm because it is treated as a noncash
5. Cash flows shown in the statement of cash flows are divided into three categories and presented in the order
6. Operating cash flows take net profits after tax and add in depreciation and other noncash charges. The net
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Chapter 4 Cash Flow and Financial Planning 53
7. Operating cash flow is the cash flow generated from a firm’s normal operations of producing and selling its
8. The financial planning process is the development of long-term strategic financial plans that guide the
9. Three key statements resulting from short-term financial planning are (1) the cash budget, (2) the pro forma
10. The cash budget is a statement of the firm’s planned cash inflows and outflows. It is used to estimate its
11.The basic format of the cash budget is presented in the table below.
Cash Budget Format
Jan. Feb. Nov. Dec.
Total cash receipts $XX $XX $XX $XX
The components of the cash budget are defined as follows:
12. The ending cash balance without financing, along with any required minimum cash balance, can be used to
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Chapter 4 Cash Flow and Financial Planning 54
13. Uncertainty in the cash budget is due to the uncertainty of ending cash values, which are based on forecasted
14. Pro forma statements are used to provide a basis for analyzing future profitability and overall financial
15. In the percent-of-sales method for preparing a pro forma income statement, the financial manager begins with
16. A pro forma income statement constructed using the percentage-of-sales method generally tends to understate
17. The judgmental approach is used to develop the pro forma balance sheet by estimating some balance sheet
18. The balancing, or “plug,” figure used in the pro forma balance sheet prepared with the judgmental approach is
19. Simplified approaches to preparing pro forma statements have two basic weaknesses: (1) the assumption that the
20. The financial manager may perform ratio analysis and may possibly prepare source and use statements from
Suggested Answer to Focus on Practice Box: Free Cash Flow
at Cisco Systems
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Chapter 4 Cash Flow and Financial Planning 55
What are some of the possible ways that corporate accountants might be able to change their earnings to
portray a more favorable earnings statement?
There are many ways in which a company can increase earnings reported in a given year. They can lease instead of
Suggested Answer to Focus on Ethics Box:
How Much Is a CEO Worth?
Do you think shareholder activists would have been as upset with Nardelli’s severance package had The
Home Depot performed much better under his leadership?
It is likely that there would have been less disappointment with Mr. Nardelli’s severance package if the Home
Answers to Warm-Up Exercises
E4-1. Depreciation schedule
Answer:
Recovery Year Depreciation
1 $13,000
E4-2. Cash flows (inflows and outflows)
Answer:
a. Marketable securities increased Cash Outflow
E4-3. Operating cash flow
Answer: OCF [EBIT (1 T)] depreciation
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Chapter 4 Cash Flow and Financial Planning 56
EBIT Sales –Cost of goods sold − Operating expenses
E4-4. Free cash flow
Answer: FCF OCF Net fixed asset investment (NFAI) Net current asset investment (NCAI)
NFAI Change in net fixed assets depreciation
E4-5. Estimating net profits before taxes
Answer:
Rimier Corp
Pro Forma
Income Statement 2016
Sales revenue $650,000
Less: Cost of goods sold
Solutions to Problems
P4-1. Depreciation
LG 1; Basic
Depreciation Schedule
Year Cost (1)
Percentages
from Table 4.2 (2)
Depreciation
[(1) (2)] (3)
Asset A
1 $17,000 33% $ 5,610
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Chapter 4 Cash Flow and Financial Planning 57
P4-2. Depreciation
LG 1; Basic
Depreciation Schedule
Cork stopper machine
Year
Cost
(1)
Percentages
from Table 4.2
(2)
Depreciation
[(1) (2)]
(3)
1 $10,000 33% $ 3,300
P4-3. MACRS depreciation expense, taxes, and cash flow
LG 1, 2; Challenge
a. Depreciation expense $80,000 0.20 $16,000 (MACRS depreciation percentages found in Table
4.2 in the text.)
b. New taxable income $430,000 $16,000 $414,000
P4-4. Depreciation and accounting cash flow
LG 1, 2; Intermediate
a. Operating cash flow
Sales revenue $400,000
Less: Total costs before depreciation,
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Chapter 4 Cash Flow and Financial Planning 58
b. Depreciation and other noncash charges serve as a tax shield against income, increasing annual cash
flow.
P4-5. Classifying inflows and outflows of cash
LG 2; Basic
Item
Change
($) I/O Item
Change
($) I/O
Cash 100 O Accounts receivable 700 I
Note 1: Think of cash in terms of money in a checking account.
Note 2: As a noncash charge, depreciation is not really an I/O at all, but it will be reported as a positive
P4-6. Finding operating and free cash flows
LG 2; Intermediate
a. NOPAT EBIT (1 t)
b. OCF NOPAT depreciation
c. FCF OCF net fixed asset investment* net current asset investment**
* Net fixed asset investment change in net fixed assets depreciation
** Net current asset investment change in current assets change in
d. Keith Corporation has positive cash flows from operating activities. Depreciation is approximately the
P4-7. Cash receipts
LG 4; Basic
April May June July August
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Sales $65,000 $60,000 $70,000 $100,000 $100,000
P4-8. Cash disbursement schedule
LG 4; Basic
February March April May June July
Sales $500,000 $500,000 $560,000 $610,000 $650,000 $650,000
Purchases (0.60) $300,000 $336,000 $366,000 $390,000 $390,000
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P4-9. Cash budget—basic
LG 4; Intermediate
March April May June July
Sales $50,000 $60,000 $70,000 $80,000 $100,000
Total cash disbursements $59,000 $93,000 $97,000
Total cash receipts $62,000 $72,000 $84,000
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Chapter 4 Cash Flow and Financial Planning 61
P4-10. Personal finance: Preparation of cash budget
LG 4; Basic
Sam and Suzy Sizeman
Personal Budget
for the Period October—December 2016
October November December
Income
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