After analyzing the pro forma statements the

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Unformatted text preview: operations to achieve shortterm financial goals. For example, if projected profits on the pro forma income statement are too low, a variety of pricing and/or cost-cutting actions might be initiated. If the projected level of accounts receivable on the pro forma balance sheet is too high, changes in credit or collection policy may be called for. Pro forma statements are therefore of great importance in solidifying the firm’s financial plans for the coming year. Review Questions 3–18 3–19 What are the two key weaknesses of the simplified approaches to preparing pro forma statements? What is the financial manager’s objective in evaluating pro forma statements? S U M M A RY FOCUS ON VALUE Cash flow, the lifeblood of the firm, is a key determinant of the value of the firm. The financial manager must plan and manage—create, allocate, conserve, and monitor—the firm’s cash flow. The goal is to ensure the firm’s solvency by meeting financial obligations in a CHAPTER 3 Cash Flow and Financial Planning 127 timely manner and to generate positive cash flow for the firm’s owners. Both the magnitude and the risk of the cash flows generated on behalf of the owners determine the firm’s value. In order to carry out the responsibility to create value for owners, the financial manager uses tools such as cash budgets and pro forma financial statements as part of the process of generating positive cash flow. Good financial plans should result in large free cash flows that fully satisfy creditor claims and produce positive cash flows on behalf of owners. Clearly, the financial manager must use deliberate and careful planning and management of the firm’s cash flows in order to achieve the firm’s goal of maximizing share price. REVIEW OF LEARNING GOALS Understand the effect of depreciation on the firm’s cash flows, the depreciable value of an asset, its depreciable life, and tax depreciation methods. Depreciation is an important factor affecting a firm’s cash flow. The depreciable value of an asset and its depreciable life are determined by using the modified accelerated cost recovery system (MACRS) standards in the federal tax code. MACRS groups assets (excluding real estate) into six property classes based on length of recovery period—3, 5, 7, 10, 15, and 20 years—and can be applied over the appropriate period by using a schedule of yearly depreciation percentages for each period. LG1 Discuss the firm’s statement of cash flows, operating cash flow, and free cash flow. The statement of cash flows is divided into operating, investment, and financing flows. It reconciles changes in the firm’s cash flows with changes in cash and marketable securities for the period. Interpreting the statement of cash flows requires an understanding of basic financial principles and involves both the major categories of cash flow and the individual items of cash inflow and outflow. From a strict financial point of view, a firm’s operating cash flows, the cash flow it generates from normal operations, is defined to exclude interest and taxes; the simpler accounting view does not make these exclusions. Of greater importance is a firm’s free cash flow, which is the amount of cash flow available to investors—the providers of debt (creditors) and equity (owners). LG2 Understand the financial planning process, including long-term (strategic) financial plans and short-term (operating) financial plans. The two LG3 key aspects of the financial planning process are cash planning and profit planning. Cash planning involves the cash budget or cash forecast. Profit planning relies on the pro forma income statement and balance sheet. Long-term (strategic) financial plans act as a guide for preparing short-term (operating) financial plans. Long-term plans tend to cover periods ranging from 2 to 10 years and are updated periodically. Short-term plans most often cover a 1- to 2-year period. Discuss the cash-planning process and the preparation, evaluation, and use of the cash budget. The cash planning process uses the cash budget, based on a sales forecast, to estimate shortterm cash surpluses and shortages. The cash budget is typically prepared for a 1-year period divided into months. It nets cash receipts and disbursements for each period to calculate net cash flow. Ending cash is estimated by adding beginning cash to the net cash flow. By subtracting the desired minimum cash balance from the ending cash, the financial manager can determine required total financing (typically borrowing with notes payable) or the excess cash balance (typically investing in marketable securities). To cope with uncertainty in the cash budget, sensitivity analysis or simulation can be used. A firm must also consider its pattern of daily cash receipts and cash disbursements. LG4 Explain the simplified procedures used to prepare and evaluate the pro forma income statement and the pro forma balance sheet. A pro forma income statement can be developed...
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