Lecture-Notes-SCF
Lecture-Notes-SCF
The higher this ratio, the less likely the company will experience difficulty in
meeting its obligations as they come due.
c. Operating Cash Flow (OCF) – the cash flow a firm generates from its normal
operations; producing or selling goods or services. This definition excludes the
impact of interest on cash flow, since we want a measure that captures the cash flow
generated by the firm’s operations, not by how those operations are financed and
taxed.
𝑂𝐶𝐹 = 𝑁𝑂𝑃𝐴𝑇 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
Alternative Formula:
𝑂𝐶𝐹 = [𝐸𝐵𝐼𝑇 ∗ (1 − 𝑇𝑎𝑥 𝑅𝑎𝑡𝑒)] + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
d. Net Operating Profit After Taxes (NOPAT) – a firm’s earnings before interest and
after taxes.
NOPAT=EBIT∗( 1−Tax Rate)
e. FREE CASH FLOW (FCF)- The amount of cash flow available to investors
(creditors and owners) after the firm has met all operating needs and paid for
investments in net fixed assets and net current assets.
FCF= OFC- NFAI- NCAI
• Net Fixed Asset Investment (NFAI)- is the net investment that the firm makes
in fixed assets and refers to purchases minus sales of fixed assets.
NFAI = Change in net fixed assets + Depreciation
• Net Current Asset Investment (NCAI)- represents the net investment made by
the firm in its current (operating) assets. “Net” refers to the difference between
current assets and the sum of accounts payable and accruals.
NCAI = Net change in Current Asset – (Net change in A/P and Accrued
Liabilities)
i. Long-Term (strategic) Financial Plans - Plans that lay out a company’s planned
financial actions and the anticipated impact of those actions over periods ranging
from 2 to 10 years.
ii. Short-Term (operating-) Financial Plans- Specify short-term financial actions
and the anticipated impact of those actions.
Basic Elements of Pro Forma Statements:
How is the Percent-of-Sales Method Used to Prepare Pro Forma Income Statements?
Takeaway Points
• The percent-of-sales method uses historical percentages to predict future financial
performance.
• This method assumes that the relationship between sales and other items remains
consistent.
• It's a simple and widely used forecasting technique but may not capture changes in costs,
pricing, or operational efficiency.
ii. Considering types of Costs and Expenses
When preparing a pro forma income statement, it is essential to distinguish between fixed and
variable costs. Many businesses initially use the percent-of-sales method, which assumes that all
costs and expenses change in direct proportion to sales. However, this assumption is flawed
because some costs remain fixed regardless of sales volume.
Fixed Costs- Fixed costs are expenses that do not change with variations in sales or production
levels. These costs are incurred regardless of the business's activity. Examples include:
o Rent
o Salaries of permanent employees
o Depreciation
o Insurance premiums
o
Fixed costs provide operating leverage. As sales increase, fixed costs remain the same, which
means profits will increase disproportionately (i.e., faster than the increase in sales).
Variable Costs- Variable costs change in direct proportion to the level of sales or production.
These costs increase as sales or production increase and decrease when sales fall. Examples of
variable costs include:
o Direct materials
o Direct labor (wages for hourly workers)
o Sales commissions
o Shipping and delivery expenses
Because variable costs are tied directly to sales levels, they increase or decrease accordingly. In a
growing business, variable costs are predictable as they are linked to the level of output or sales.
How Fixed Costs Affect Profit Fluctuations:
How Fixed Costs Affect Profit Fluctuations:
Fixed costs contribute to operating leverage, meaning profits fluctuate more than revenues:
• When sales rise → Profits grow faster than sales because fixed costs remain constant.
• When sales fall → Profits decline sharply because fixed costs do not decrease.
This profit sensitivity to sales changes is a key financial risk that businesses must consider when
forecasting future earnings.
Takeaway Points
• Variable costs change in proportion to sales, while fixed costs remain unchanged
regardless of sales fluctuations.
• Accurately distinguishing between these costs is essential for realistic financial forecasting
and planning.
• Failing to account for fixed costs can lead to misleading projections, especially in periods
of rising or declining sales.
• Separating fixed and variable costs provides better insight into profit variability,
financial risks, and overall business performance.
VII. Preparing the Pro Forma Balance Sheet
When preparing a pro forma balance sheet, businesses need to estimate their future financial
position based on projected sales, expenses, and other financial data. While there are several
methods for creating a pro forma balance sheet, two approaches stand out: the percentage-of-sales
approach and the judgmental approach. Each has its strengths and weaknesses, but the judgmental
approach is widely considered to be more reliable and accurate.
Steps:
1. Estimate Projected Sales and Related Assets: Use historical relationships and future
expectations to estimate asset accounts (e.g., accounts receivable, fixed assets).
2. Adjust for Non-Sales Factors: Apply management’s judgment to adjust for non-sales
drivers, like changes in operations or investments.
3. Determine External Financing Required (EFR)
The “plug figure” is the amount of external financing needed to balance the balance sheet.
If EFR is positive, the firm needs to raise external funds (debt/equity).
If EFR is negative, the firm has excess internal funds, which can be used to pay down debt,
repurchase stock, or increase dividends.
4. Update the Balance Sheet: Adjust the balance sheet to reflect increases in debt/equity
(positive EFR) or reductions in debt/equity (negative EFR).
The "plug figure", also known as External Financing Required (EFR), is the amount of external
funds a company needs to raise in order to balance its pro forma balance sheet. This figure helps
determine whether the firm can rely on its internal financing (like retained earnings) to support
growth, or if additional external funds are required.
• Positive Plug Figure (EFR): Indicates that the firm needs to raise external funds (either
debt, equity, or other financing methods) to cover the gap.
• Negative Plug Figure (EFR): Indicates that the firm has more internal funds than needed,
meaning it can reduce debt, repurchase stock, or increase dividends.
How to get the EFR: Subtract the forecasted total liabilities and equity from the forecasted total
assets. This gives you the external financing required (EFR).