WK - 3 - Cash Flows and Financial Forecast PDF

Free Cash Flow
Concept of free cash flow

Future cash flows generated from an investment that are free to
distribute to the investors (including stockholders and creditors)
that determine the value of the investment.
Financial cash flow presents free cash flow (FCF); by free, we
mean it is after necessary expenses (reinvestments) needed for
continuing operations.
Financial cash flow differs from accounting cash flow
The accounting cash flow statement determines accounting cash flows,
which explains the change in cash and equivalents.
The cash flow statement mixes cash flows from operating and
financing activities, so it does not directly give the information on
financial cash flow.
Cash Flows and Financial Forecast 1
Free Cash Flow

FCF=(R-E)*(1-t)+t*Dep-cap exp- change in WC
The FCF formula

Cap. Exp
Free cash flow (FCF) = OCF NCS NWC

Operating cash flow (OCF): from a companys normal
business activities; typically calculated based on EBIT or

net income.
Top down!
OCF = EBIT + Depreciation Taxes

= EBIT( 1 Tax rate) + Depreciation
where, Taxes = EBIT Tax rate
Bottom up
OCF = Net income + Depreciation + (1 Tax rate) Interest expense

where, Net income = ( EBIT Interest expense)(1 Tax rate)
Unleavened CF , irrelevant to capital structure!!
Free Cash Flow

Investment on fixed assets
Net capital spending (NCS), or capital expenditure, represents
the amounts paid by the firm for investments in fixed assets,
which is the net money spent on fixed assets less money
received from sales of fixed assets.
NCS is a function of how fast a firm is growing or expecting to

grow. High growth firms will have much higher capital spending
than low growth firms.
Given changes in net fixed assets, NFA, and depreciation, net
capital spending is calculated as:
NCS = NFA + Depreciation
Note: Ending NFA = Beginning NFA Depreciation+ NCS
Free Cash Flow

Investment on working capital
Increase in net working capital, NWC, represents the firms
investment on its working capital.
NWC = Ending NWC Beginning NWC
In accounting terms, NWC is the difference between current

assets (cash, inventory and accounts receivable) and current
liabilities (accounts payable and debt due within the next year).
For valuation purposes, the calculation of NWC needs to exclude
the effects of non-operating current assets and liabilities (next slide).
NWC= cash+inventory+receivable-payable
Free Cash Flow

Non-operating CA and CL
Some components of the accounting measures of current assets and
current liabilities (such as excess cash and debt interests) are not
operation or production related, and hence their changes do not
adequately reflect requirement for working capital investment.
Cash: When a company increased its cash by increasing
retained earnings (reducing dividend payment), does increased
cash mean reduced free cash flow?
Short-term debt: When a company changed its capital structure
by borrowing less while raising more equity capital, does the
reduction in short-term debt mean reduced free cash flow?
Free Cash Flow

Therefore, a cleaner definition of working capital from the cash
flow perspective is:
NWC = Non-cash CA Non-debt CL
As any investment in this measure of working capital ties up cash,
an increases (decreases) in working capital will reduce (increase)
FCF in that period.
Working capital calculated using above formula tends to be

volatile from year to year. So, alternatively, we often determine
NWC as a proportion of revenues.
This alternative method is the percentage-of-sales approach to
financial forecast, which is to be discussed below.
Free Cash Flow

Example: The Gap, as a retailer, has substantial working capital
needs. The following table reports its current assets and current
liabilities at the end of the 2013 and 2014 financial years,
respectively.
Current assets
Cash
Inventory
Other non-cash CA
Current liabilities
2013
2014
$466
$350
$1,462
$1,704
$285
$335
2013
2014
Accounts payable
$806
$1,067
Short-term debt
$392
$395
Other non-debt CL
$778
$702
Free Cash Flow

The following table summarizes the calculations of NWC in years 2013
and 2014 as a percent of revenues.
Suppose that revenues will grow at 13% in 2015, 9% in 2016, and 7% in
2017. If NWC will change proportionally with sales at the average percent
of sales during 2013-2014, predict changes in NWC for 2015-2017.
History
Non-cash CA
Non-debt CL
NWC
NWC as % of revenues
NWC
Revenues
2013
$1,747
$1,584
$163
2014
$2,039
$1,769
$270
1.4%
2.0%
$107
$13,673
$11,635
Forecast
2015E
2016E
2017E
$263
1.7%
-$7
$15,450
$286
1.7%
$23
$16,841
$306
1.7%
$20
$18,020
Free Cash Flow

Example: Calculating FCF (using next two slides)
OCF = EBIT + Depreciation Taxes = 694 + 65 208 = $551
NCS = Ending NFA Beginning NFA + Depreciation
= 1,709 1,644 + 65 = $130
Based on operating CA and CL:
NWC = Ending NWC Beginning NWC
= (1,243 291) (1,008 271) = $215

FCF = 551 130 215 = $206
Free Cash Flow

Global Corporation
2012 Income Statement ($million)
Net sales (Revenues)
Cost of goods sold (COGS)
Depreciation
Earnings before interest and taxes (EBIT)
Interest paid
Taxable income (EBT)
Taxes (at 30%)
Net income (NI)
Dividends
Addition to retained earnings
$1,509
750
65
$ 694
70
$ 624
187
$ 437
$109
328
Free Cash Flow

Global Corporation
2012 and 2013 Balance Sheet ($millions)
Assets
Current assets:
Cash and equivalents
Accounts receivable
Inventory
Total current assets
2011
$104
455
553
$1,112
Fixed assets:
Property, plant and equip.
$1,233
Intangible assets and others
411
Total fixed assets
$1,644
Total assets
$2,756
2012
$160
688
555
$1,403
$1,280
429
$1,709
$3,112
Liabilities and Equity
2011
2012
Current liabilities:
Accounts payable
Notes payable
Accrued expenses
Total current liabilities
$232
157
39
$428
$266
98
25
$389
Long-term debt
$408
$454
Owners equity
Common stock and
paid-in surplus
Retained earnings
Total equity
Total liabilities and equity
600
640
1,320
1,629
$1,920 $2,269
$2,756 $3,112
Adjusting Earnings
Obtaining most recent financial information
Constructing trailing 12-month data
7/1-6/30
1.1-31/12 China
From most recent half-year or quarterly reports

Most recent annualized earnings
Most recent balance sheet items

May have to use some items from latest annual report
Example on the next slide

Make sure earning is updated
Obtaining the updated earnings information is particularly
important for smaller and more volatile firms.
Updated Financial Status
Sept 2009
Mar 2010
Sept 2010
Mar 2011
Sept 2011
April 11
Bs: direct use half yearly
INCOME ITEM:
Adjusting Earnings
Adjustments for R&D expenses
R&D expenses are to generate future growth, so are long-term
investment in nature.
Accounting standards however require that all R&D spending be
expensed in the period in which they occur. Hence,

R&D expenses are included in operating expenses.
R&D expenses do not show up on the balance sheet as part of
the total assets of the firm.
To capitalize R&D expenses
Correct earnings & shareholder equity for R&D expenses

R&D assets need to be amortized.
Adjusting Earnings
The effect of R&D expenses on equity
Adjusted equity = Equity + Value of R&D assets
As capital investment, R&D expenses increase long-term assets
and hence equity, and are amortized over time.
The assets from R&D expenses equals the sum of all unamortized
portions of all previous years R&D expenses.
The effect of R&D expenses on earnings

Adjusted operating earnings = Operating earnings
EBIT
+ Current-years R&D expenses Amortization of R&D assets
where amortization is the total amortization of all assets from R&D

expenses of previous years.
Updated Financial Status
Year 1:
Adjusted
Equity :
Adjusting Earnings
Adjustments for lease expenses
Operating lease vs Finance lease

OL shorter than item life
Else for 10 year VS 30 year
Operating lease expenses are financial expenses, but are
treated as operating expenses (often revealed in footnotes).

Converting operating leases into debt
Adjusted debt = Debt + Value of lease commitments
where value of lease commitments equals the present value of lease
commitments discounted at kd.
The effect on operating earnings

Adjusted operating earnings = Operating earnings
+ (Operating lease expenses Depreciation on leased assets)
Operating earnings + Value of lease RD

Adjusting Earnings
Extraordinary and unusual items
Earnings that can be used as a basis for projections should
reflect continuing operations, and not one-time items.
One-time expense or income items (e.g., a large restructuring
charge): should be excluded in the calculation of earnings.

Some items may appear less frequently than annually, but still
recur at some regular intervals (e.g., every 3 years). In this case,

one option is to spread the expense out by calculating its effect
on earnings annually.
Forecast and Cash Flows

Forecast using the percentage-of-sales approach
When most balance sheet and income statement accounts
vary with sales, we can obtain the financial statement forecast

based on a sales forecast.
With the percentage-of-sales approach
We start with sales forecast.
Then based upon it, we determine pro-forma (forecasted)
financial statements.
Then the needs for external financing can be identified.

Determine the growth of company
Sales forecast
Sales forecast is the starting point of financial forecast, and is
key to long-term planning.

Perfect knowledge is impossible since sales depend on the
uncertain future state of the economy

Try to identify all valuable investment opportunities within the
company, and make reasonable assumptions about the future
overall market for the companys products.
Get help in estimating sales from businesses that specialize in
macroeconomic and industry projections

Using historical growth information to predict future growth
Historical average growth
Technical analysis
Liner or log-linear regression models

More sophisticated time series models
Using information from analyst forecasts of earnings growth

Analyst forecasts of growth can be better because they can use
information other than historical, including other public information

and even private information.
More useful for more analyst coverage (e.g., for larger firms).
Less reliable for greater variation in analyst forecasts.
Understanding fundamental factors
Know about the company.
Managerial efficiency, payout policy, financing policy

The companys long-term plan

Income statement forecast
For many income statement items that vary directly with sales
(e.g. costs), use historical data to determine their relations

with (as a percent of) sales.
For items that do not necessarily change directly with sales,
understand the specific mechanism. For example:

Interest expense depends on debt.
Dividends depend on the firms payout policy.

To obtain free cash flows, we only need to forecast income
items down to EBIT.
Interest / dividend.
Mature companies in developed countries hv stable dividend policy.
But China and HK don't usually pay dividend.
Not relate to SALES

Effective vs. marginal tax rate
The effective tax rate is computed from the reported income
statement as: Effective tax rate = Taxes due / Taxable income
The marginal tax rate depends on the tax code and reflects what
firms have to pay as taxes on their marginal income.
Use the highest.
If the same tax rate has to be applied to earnings every period,

the safer choice is the marginal tax rate.
Most of the taxable income of publicly traded firms is at the highest
marginal tax bracket.

Most tax-reduction benefits cannot sustained in perpetuity.
Suffer loss. - MTR not useful in near future.

The effect of net operating losses
There are tax savings for firms having large net operating losses
carried forward or continuing operating losses. There are two
ways of capturing this effect:
Approach 1: Changing tax rates over time (from zero to positive
and then to the marginal tax rate).
Change gradually from 0 to MTR
Approach 2: Valuing the expected tax savings generated by net

operating losses and the firm without considering the tax savings
separately, and then adding them up.
The second approach is often used when the firm already has
positive earnings but has a large net operating loss carried forward.

Balance sheet forecast
For assets items that vary directly with sales, use historical data
to determine their relations with (as a percentage of) sales.

Fixed asset :%/sales
Notes payable, long-term debt, and equity generally do not vary
with sales; they depend on management decisions on capital

structure.
Change in the retained earnings portion of equity will come from
the dividend decision.

Ending retained earnings
= Beginning retained earnings + (Net income Dividends)
BS: State variable

IS: flow variables.

External funding needed (EFN)
LTD/ SH equity : No relationship with SALES.

Imbalance: LHS&RHS.
External funding needed: the difference between the forecast
increase in assets and the forecast increase in liabilities and equity.

EFN = Total assets (Liabilities + Shareholders equity)
Understanding EFN
To support yr forecast , u need more fund to support

your asset. So need EFN.
Negative or positive EFN

Dealing with EFN: the firms financing strategy
Evaluating the financial forecast and plan
-EFN: asset requirement is less than what u load.
You may hv too much cash.
+EFT: need more Equity or debt.
+: need to decide how to get additional capital

; OR increase RE
-: make future investment or just pay dividend.
( special dividend )

Get additional finance:
Growth and (internal & external) financing

At low levels of growth, internal financing (retained earnings) may
exceed the required investment in assets.
At high levels of growth, internal financing will not be enough, and
the company can do the following:
To increase profit margin (higher operating efficiency)
More realistic. !!!!!
To increase asset turnover (higher asset-use efficiency)

To reduce dividend payout (more internal financing)
To raise equity capital (cost of equity; stock market conditions)
To borrow money (cost of debt; credit risk)
Is the sales growth forecast realistic?
FF need revise and revise again and then

achieve balance.
This is called FINANCIAL PLANNING --company's LT plan.
Make sure it is realistic !
Financial Forecast: Example

R&E Supply is a modest-size wholesaler of plumbing and
electrical supplies (in the heating, ventilation, air
conditioning and refrigeration industry), located in Little
Rock, Arkansas. Carl Miller Sr. started refrigeration and
electric supply with a single refrigeration and electric supply
store on East Markham Street in Little Rock, Arkansas in
1935.
The company currently has an annual revenue of $10 to 20
million and employs a staff of 20 to 50.
Financial Statements for R&E Supplies, Inc.

December 31 ($thousand)
2002
2003
2004
2005*
2002
2003
2004
2005*
Didn't issue additional and repurchase

Selected historical financial ratios
History
Annual growth rate in sales
2002
--
2003
23%
2004
17%
Forecast
2005
28%
Ratios tied to sales (%)

85
86
86
9
10
11
27
29
27
11
15
16
Cost of goods sold (% sales)

General, selling & admin. expenses (% sales)
Total current assets (% sales)
Current liabilities excluding debt (% sales)
84
9
28
9
Tax/earnings before tax

Dividends/earnings after tax
Other ratios in percent (%)

45
45
45
45
50
50
50
50
2006
25% Average.
86
12
28
14
45
50

Pro forma income statement, 2006
Income Statement (December 31, 2006; $thousand)
Net sales
Cost of goods sold
Gross profit
Expenses:
General, selling and admin expenses
Net interest expense (760 @ 10%)
15:LTD.
Earnings before tax
- assuming LTD doesn't change !
Tax
Earnings after tax
$ 25,766
22,159
3,607
3,092
76
439
198
$ 241
Comments
25% increase
86% of sales
12% sales
45% tax rate

Pro forma balance sheet, 2006
Balance Sheet (December 31, 2006; $thousand)
Assets
Current assets
Net fixed assets
Total assets
$ 7,214
412
7,626
Liabilities and Owners Equity

Current portion of long-term debt
Other current liabilities
Total current liabilities
Long-term debt
Common stock
Retained earnings
Total liabilities and owners equity
100
3,607
3,707
660
150
1,700
$ 6,217
External funding required
$ 1,409
Comments
28% sales
1.6% sales
As in 2005
14% sales
Existing debt
As in 2005
As explained

Balance-sheet items
Retained earnings: $1,700 = $1,580 + $241 - $121
External funding needed: $1,409 = $7,626 - $6,217
Interest expense
The interest expense is calculated for existing debt at the beginning
of the financial year, $760 thousands, without taking into account
any new debt needed in the year.
If interest expense needs to be calculated for both existing and new

debt, then there would be a circularity problem: On the one hand,
interest expenses depend on total debt, which in turn depends on
the external funding required; on the other hand, the required
$1409: need
at
external
funding depends on interest expenses.
- end of the year: NP. WONT affect current year interest expense.
-start of the year : CP! Change interest expense and then change the ETN again.
Complicated.
WE assume interest expense at the beginning of year based on existing level of debt !!
Forecasting with a Computer Spreadsheet:

Pro-Forma Financial Forecast for R&E Supplies
ASSUMPTIONS BOX
A
1
2 Year
3
4
5
6
7
8
9
10
11
12
13
14
15
Net sales
Growth rate in net sales
Cost of good sold/net sales
Gen., sell. & admin. expenses/net sales
Long-term debt
Current portion long-term debt
Interest rate
Tax rate
Dividend/earnings after tax
Current assets/net sales
Net fixed assets
Current liabilities/net sales
Owners' equity
B
2005 Actual
2006
$20,613
$760
$100
25.0%
86.0%
12.0%
$660
$100
10.0%
45.0%
50.0%
28.0%
1.6%
14.0%
$1,730
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
B
Equations
C
Forecast
Income Statement Forecast (2006)

Net sales
Cost of goods sold
Gross profit
Gen. sell. & admin. exp.
Interest expense
Earnings before tax
Tax
Earnings after tax
Dividends paid
Additions to retained earnings
=B3+B3*C4
=C5*C19
=C19-C20
=C6*C19
=C9*(C7+C8)
=C21-C22-C23
=C10*C24
=C24-C25
=C11*C26
=C26-C27
Balance Sheet (2006)

Current assets
Net fixed assets
Total assets
=C12*C19
=C13*C19
=C31+C32
7,215
412
7,627
Current liabilities without debt

Long-term debt
Equity
Total liabilities & shareholders' equity
=C14*C19
=B7
=B15+C28
=C35+C36+C37
3,607
760
1,851
6,218
External Capital Required
=C33-C38
$25,766
22,159
3,607
3,092
76
439
198
242
121
121
$1,409
Sensitivity and scenario analyses

Forecasting risk: the possibility that errors in projected cash flows
will lead to incorrect decisions, which is unavoidable because
uncertainty is involved in financial planning
Sensitivity analysis: identifying the sensitivity of a key decision

variable (e.g., external funding required) to a single factor (e.g.,
sales growth or the cost of goods sold), holding other factors
constant
Scenario analysis: determining the effect on our forecast by

changing a set of factors at a time
Scenario and sensitivity analyses generate various possibilities some are good and some are bad, which deepen our understanding
of the project and help us make a better decision (though we dont
get any guidance as to what to do).

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Free Cash Flow

Concept of free cash flow

Free Cash Flow

The FCF formula

Free cash flow (FCF) = OCF NCS NWC

business activities; typically calculated based on EBIT or

OCF = EBIT + Depreciation Taxes

OCF = Net income + Depreciation + (1 Tax rate) Interest expense

Free Cash Flow

NCS is a function of how fast a firm is growing or expecting to

Free Cash Flow

In accounting terms, NWC is the difference between current

Cash Flows and Financial Forecast 4

Free Cash Flow

reduction in short-term debt mean reduced free cash flow?

Cash Flows and Financial Forecast 5

Free Cash Flow

Working capital calculated using above formula tends to be

Cash Flows and Financial Forecast 6

Free Cash Flow

Cash Flows and Financial Forecast 7

Free Cash Flow

Cash Flows and Financial Forecast 8

Free Cash Flow

= (1,243 291) (1,008 271) = $215

Cash Flows and Financial Forecast 9

Free Cash Flow

Cash Flows and Financial Forecast 10

Free Cash Flow

Liabilities and Equity

Cash Flows and Financial Forecast 11

From most recent half-year or quarterly reports

Most recent balance sheet items

Example on the next slide

Obtaining the updated earnings information is particularly

important for smaller and more volatile firms.

Cash Flows and Financial Forecast 12

Updated Financial Status

expensed in the period in which they occur. Hence,

Correct earnings & shareholder equity for R&D expenses

The effect of R&D expenses on earnings

+ Current-years R&D expenses Amortization of R&D assets

where amortization is the total amortization of all assets from R&D

Updated Financial Status

Cash Flows and Financial Forecast 16

Operating lease vs Finance lease

Operating lease expenses are financial expenses, but are

treated as operating expenses (often revealed in footnotes).

The effect on operating earnings

Operating earnings + Value of lease RD

charge): should be excluded in the calculation of earnings.

recur at some regular intervals (e.g., every 3 years). In this case,

Cash Flows and Financial Forecast 18

Forecast and Cash Flows

vary with sales, we can obtain the financial statement forecast

Cash Flows and Financial Forecast 19

Forecast and Cash Flows

key to long-term planning.

uncertain future state of the economy

Cash Flows and Financial Forecast 20

Forecast and Cash Flows

Liner or log-linear regression models

Using information from analyst forecasts of earnings growth