Chapter 4
Cash Flow and Financial Planning
Instructor’s Resources
Chapter Overview
This chapter introduces the financial-planning process, starting with an overview of long-term or strategic
planning and moving to a detailed exploration of short-term (operating) financial planning and its two key
components: cash and profit planning. Cash planning involves preparation of a cash budget, while profit
planning involves preparation of a pro forma income statement and balance sheet. Step-by-step examples of
cash budget and pro forma statement development are used to illustrate nuances students might find
challenging—such as depreciation expenses as a cash inflow and the distinction between operating and free
cash flow. The chapter ends by highlighting weaknesses of the simplified approaches to pro forma statements
(judgmental and percent-of-sales methods)—while still emphasizing the importance of these statements
(along with the cash budget) as tools for disciplining management thinking about the range of possible cash
flow and profitability outcomes and responses to those outcomes.
Suggested Answer to Opener-in-Review
Rapidly expanding firms—like Netflix—often must make significant investments in inventory, receivables,
and fixed assets to sustain their growth. And the related cash outlays will not always appear immediately in
calculation of profit. For example, purchase of a new capital equipment for $1 million dollars requires an
Answers to Review Questions
4-1. The financial-planning process is a two-step, highly collaborative endeavor to track the financial
implications of the firm’s specific plan for creating value for shareholders. Step one is long-term or
4-2 The three key outputs of the short-term (operating) financial planning process are the (i) cash budget,
(ii) pro forma income statement, and (iii) pro forma balance sheet.
4-3 Property classes under the Modified Accelerated Cost Recovery System (MACRS) are categorized by
Recovery Period Definition
3 years Research and experiment equipment and certain special tools
For tax purposes, firms usually depreciate assets in the first four MARCS property classes via the
double-declining-balance method, using a half-year convention (i.e., taking one-half year’s
4-4. Cash flow from operating activities captures cash inflows/outflows related to the firm’s production
cycle, beginning with the purchase of raw materials and ending with the finished product. Expenses
related to this process are considered operating flows. Cash flow from investment activities tracks
4-5. A decrease in the cash balance is a source of cash flow because funds will be used for some other
purpose, such as investment in inventory. Similarly, an increase in the cash balance is a use of cash
4-6. In compiling a cash-flow budget, it is important to recognize depreciation is a noncash expenditure
on the firm’s income statement. Put another way, depreciation expense reduces taxable income but
4-7. The statement of cash flows traces cash inflows/outflows from three different activities:
numbers and cash inflows as positive numbers.
4-8. Operating cash flow isolates cash inflows/outflows from routine operations. Interest expense and
finances or government taxes those operations.
4-9. Operating cash flow is cash flow generated from the firm’s regular production/sales of goods and
services. Free cash flow is the remainder available to providers of debt (creditors) and equity finance
4-10. The cash budget is a statement of the firm’s planned cash inflows and outflows. Management uses
and shortages. The sales forecast is key to preparing the cash budget.
4-11. The basic format of the cash budget appears below.
Jan. Feb. Nov. Dec.
Total cash receipts $XX $XX $XX $XX
Less: Total cash disbursements XX XX XX XX
The cash budget includes the following:
Cash receipts: Total cash inflows in a given period (a month in the example above). The most
Cash disbursements: Total cash outlays in a given period (again, a month above). The most
common disbursements are cash purchases, payments of accounts payable, rent/lease payments,
Net cash flow: Difference between cash receipts and disbursements in a given period (a month
above).
Ending cash: Sum of beginning cash and net cash flow for a given period (a month above).
Required total financing: Amount of funds the firm needs if ending cash for the period is less
will appear on the balance sheet as “notes payable.”
Excess cash: Amount of surplus funds if the firm’s ending cash exceeds its desired minimum
securities.
4-12. The ending cash balance, along with the required minimum cash balance, indicate whether the firm
will need additional cash or enjoy a surplus for the given period. If the ending cash balance falls short
4-13. Uncertainty is the result of forecast error. For example, the linchpin of the cash budget is the sales
forecast. No matter how complex the model used—that is, how many company-specific, market-
specific, and macroeconomic variables are employed—the sales forecast is ultimately an
4-14. Pro forma statements provide the firm with a framework for analyzing future profitability. They
depend on two key inputs: the sales forecast and financial statements from the preceding year.
4-15. In the percent-of-sales method of generating pro forma income statements, the financial manager
and interest expense) as a fixed percentage of projected sales.
4-16. The percent-of-sales method assumes all costs are variable—a weakness because most firms have
some fixed costs. For firms with significant fixed costs, the percent-of-sales method understates
4-17. The judgmental approach to the pro forma balance sheet involves estimation of some balance-sheet
items, with external finance used as a balancing or “plug” factor. This method assumes variables
4-18. The “plug” figure in the judgmental approach is the external financing necessary to bring the pro
forma balance sheet into balance. A positive value means the firm must raise funds externally to meet
4-19. The simplified approaches to pro forma statements have two weaknesses, each arising from a
problematic assumption—namely, (1) the firm’s past financial condition is an accurate predictor of
its future and (2) the values of certain variables in the statements can be forced to take desired values.
4-20. The financial manager uses pro forma statements to provide a baseline for evaluating ongoing
performance as the year begins. For example, she might perform ratio analysis and prepare
Suggested Answer to Focus on Practice Box:
“Free Cash Flow at LinkedIn”
Free cash flow is often considered a more reliable measure of firm income than reported earnings. In what
ways might corporate accountants change earnings to present a more favorable earnings statement?
There are many ways to boost reported earnings for a given year. For example, a firm could offer
exceedingly generous credit terms near the end of the fiscal year to pump up sales. The firm could also
push some expenditures planned for the last quarter of the year to the next quarter, so the expenses would
Suggested Answer to Focus on Ethics Box:
“Is Excess Cash Always a Good Thing?”
Suppose unexpected events in the market for your product leave you with significant free cash
flow. What benchmark should you use in determining the best (and most ethical) use of those
funds?
Managers should invest free cash flow in only those projects likely to earn returns above what firm
shareholders could obtain elsewhere in financial markets by investing in other firms with comparable risk
Answers to Warm-Up Exercises
E4-1 Depreciation schedule (LG 2)
Answer:
Recovery Year Recovery
by Year Depreciation
1 20% $13,000
2 32% $20,800
E4-2. Cash inflows and outflows (LG 3)
Answer:
a. Marketable securities increased Cash Outflow
b. Land and buildings decreased Cash Inflow
E4-3. Operating cash flow (LG 3)
Answer: OCF [EBIT (1 T)] depreciation, and
EBIT Sales – Cost of goods sold − Operating expenses Depreciation−. So,
E4-4. Free cash flow (LG 3)
Answer: FCF OCF Net fixed asset investment (NFAI) Net current asset investment (NCAI), and
NFAI Change in net fixed assets depreciation;
NCAI Change in current assets change in (accounts payable accruals)
E4-5. Estimating net profits before taxes (LG 5)
Answer: Rimier Corp—Pro Forma Income Statement 2020
Sales revenue $650,000
Less: Cost of goods sold
Fixed cost 250,000
Variable cost (0.35 × sales) 227,500