I.

Statement of Cash Flows

i. Pro-forma Statement of SCF
ii. Classification of Cash Flow Activities
a. Operating Activities – The amount of cash flows arising from
operating activities is a key indicator of the extent to which the operations
of the enterprise have generated sufficient cash flows to repay loans,
maintain the operating capability of the enterprise, pay dividends and make
new investments without recourse to external sources of financing.
Operating activities include cash inflows and outflows directly related to
the sale and production of the firm's products and services.
Examples are:
Inflows
o Sales of goods
o Revenue from services
o Returns on interest earnings assets (interest)
o Returns on equity securities (dividends)
o Receipts from contracts held for dealing and trading purposes
o Tax refunds unless identified with financing and investing
activities
Outflows
o Payments for purchases of inventories
o Payments for operating expenses (salaries, rent, insurance, etc.)
o Payments for purchases from suppliers other than inventory
o Payments for lenders (interest)
o Payments for taxes unless identified with financial and investing
activities
b. Investing Activities - The separate disclosure of cash flows arising from
investing activities is important because the cash flows represent the extent to
which expenditures have been made for resources, intended to generate future
income and cash flows. These are cash flows associated with the purchase and sale
of both fixed assets and equity investments in other firms. Clearly, purchase
transactions would result in cash outflows, whereas sales transactions would
generate cash inflows. Examples are:
Inflows
o Sales of long-lived assets such as property, plant and equipment,
intangibles and other long-term assets.
o Sales of debt or equity securities of other entities
o Collection of loans (principal) to others (other than advances and
loans made by a financial institution)
Outflows
o Acquisitions of long-lived assets such as property, plant and
equipment, intangibles and other long-term assets
o Purchases of debt or equity securities of other entities
o Loans (principal) to others (other than advances and loans made by
a financial institution)
c. Financing Activities - The financing flows result from debt and equity
financing transactions. Financing activities include borrowing from
creditors and repaying the principal; and obtaining resources from owners
and providing them with a return on the investment. Examples are:
Inflows
o Proceeds from borrowing (short-term and long-term)
 o Proceeds from issuing the firm's own equity securities
Outflows
o Repayment of debt principal
o Repurchase of a firm's own shares
o Payment of dividends
o Acquisition of the enterprise's own shares

iii. Presentation of Operating Activities

a. Direct Method - Direct method presents cash flows as they were generated and
spent. In reporting the cash flows from operating activities enterprises are
encouraged to report major classes of gross cash receipts and gross cash payments
and the net cash flow from operating activities. It uses a Cash Basis Income
Statement. Non-cash expenses will not be recognized in Direct Method such as
Depreciation. Amortization, Losses, as well as gains from sale since it doesn't have
an actual inflow of cash.
b. Indirect Method - Uses Net Income as a base. Reverses the effect of non-cash
transactions. It uses Accrual Basis Income Statement.

II. Developing the Statement of Cash Flows

a. Classifying Inflows and Outflows of Cash
▪ Inflow - A decrease in an asset, such as the firm’s cash balance, is an inflow
of cash. It is because cash that has been tied up in the asset is released and
can be used for some other purpose, such as repaying a loan.
▪ Outflow - An increase in the firm’s cash balance is an outflow of cash
because additional cash is being tied up in the firm’s cash balance.
▪ Basic Inflows and Outflows of Cash

• Depreciation (like amortization and depletion) is a noncash charge, an

expense that is deducted on the income statement but does not involve an
actual outlay of cash. Therefore, when measuring the amount of cash flow
generated by a firm, we have to add depreciation back to net income or we
will understate the cash that the firm has truly generated.
• Because depreciation is treated as a separate cash inflow, only gross rather
than net changes in fixed assets appear on the statement of cash flows. The
change in net fixed assets is equal to the change in gross fixed assets minus
the depreciation charge. Therefore, if we treated depreciation as a cash
inflow as well as the reduction in net (rather than gross) fixed assets, we
would be double counting depreciation.

i. Application of Direct and Indirect Method in presenting CF Activities

III. Interpreting the SCF

i. Usefulness of the Statement of Cash Flows
 Although net income provides a long-term measure of a company’s success or failure,
cash is its lifeblood.
Without cash, a company will not survive.
For small and newly developing companies, cash flow is the single most important
element for survival. Even medium and large companies must control cash flow.

Usefulness to Creditors or Lender?

• Creditors examine the cash flow statement carefully because they are concerned
about being paid.
• They begin their examination by finding net cash provided by operating
activities.
• High amount of net cash provided by operating activities indicates that a company
is able to generate sufficient cash from operations to pay its bills without further
borrowing.
• Conversely, a low and negative amount of net cash from operating activities
indicates that a company may have to borrow or issue equity securities to acquire
sufficient cash to pay its bills.
• Creditors asks the following questions in the company’s cash flow statements:
1. Is the company generating sufficient positive cash flows from its ongoing
operations to remain variable?
2. Will the company be able to meet its financial obligations to creditors?
3. What expansion activities took place and how were those financed?
4. Will the company be able to pay its customary dividend?
5. Why did cash decrease even though a net income was reported?
6. To what extent will the company have to borrow money in order to make
needed investments?
7. What happened to the proceeds received from the issuance of capital stock?
• Note: One should recognize that companies can fail even though they report net
income.
The difference between net income and net cash provided by operating activities
can be substantial.
ii. Use of SCF in measuring the Firm’s:
a. Financial Liquidity – refers to the “measures to cash” of assets and liabilities.
Readers of financial statements often assess liquidity by using the Current Cash
Debt Coverage Ratio, which indicates whether the company can pay off its current
liabilities from its operations in a given year.

𝑁𝑒𝑡 𝐶𝑎𝑠ℎ 𝑃𝑟𝑜𝑣𝑖𝑑𝑒𝑑 𝑏𝑦 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐴𝑐𝑡𝑖𝑣𝑖𝑡𝑖𝑒𝑠

𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑪𝒂𝒔𝒉 𝑫𝒆𝒃𝒕 𝑪𝒐𝒗𝒆𝒓𝒂𝒈𝒆 𝑹𝒂𝒕𝒊𝒐 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
The higher current cash debt coverage ratio, the less likely a company will have
liquidity problems.
b. Financial Flexibility – refers to a company’s ability to respond and adapt to
financial adversity and unexpected needs and opportunities.
The Cash Debt Coverage Ratio provides information on financial flexibility. It
indicates a company’s ability to repay its liabilities from net cash provided by
 operating activities, without having to liquidate the assets employed in its
operations.

𝑁𝑒𝑡 𝐶𝑎𝑠ℎ 𝑃𝑟𝑜𝑣𝑖𝑑𝑒 𝑏𝑦 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐴𝑐𝑡𝑖𝑣𝑖𝑡𝑖𝑒𝑠

𝑪𝒂𝒔𝒉 𝑫𝒆𝒃𝒕 𝑪𝒐𝒗𝒆𝒓𝒂𝒈𝒆 𝑹𝒂𝒕𝒊𝒐 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

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)

IV. The Financial Planning Process (Theory)

Financial Planning Process- an important aspect of the firm’s operations because it

provides road maps for guiding, coordinating, and controlling the firm’s actions to
achieve its objectives.
Two key aspects of the financial planning process are cash planning and profit planning.
Cash planning involves preparation of the firm’s cash budget. Profit planning involves
preparation of pro forma statements.

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:

1. Based on Historical Financial Relationships

The assumption behind pro forma statements is that the financial patterns observed in past
statements will largely continue in the upcoming period. This means that key ratios, such
as profit margins, cost structures, and expense relationships, are expected to remain
relatively stable unless major changes occur.
2. Two Primary Inputs Required for Preparation
• Financial Statements from the Previous Year
o Past income statements and balance sheets serve as the foundation for projecting
future financial performance.
• Sales Forecast for the Coming Year
o Since revenue drives many financial variables (e.g., costs, expenses, and net
income), a reliable sales forecast is crucial for an accurate pro forma statement.

i. Use of percent-of-sales method

A simple and commonly used approach for developing a pro forma income statement is the
percent-of-sales method. This method assumes that most income statement items (such
as cost of goods sold, operating expenses, and net income) vary proportionally with sales.

How is the Percent-of-Sales Method Used to Prepare Pro Forma Income Statements?

1. Forecast Future Sales

Estimate the expected sales for the upcoming period based on historical data and market
trends.
2. Express Income Statement Items as Percentages of Sales
Use past financial data to determine historical expense-to-sales ratios and apply them to
the projected sales figure.
3. Calculate Projected Values
Multiply the projected sales by the corresponding percentage for each income statement
item.

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.

i. Use of Judgmental Approach

The judgmental approach offers a more refined and practical method for preparing the
pro forma balance sheet. Unlike the percentage-of-sales approach, which applies a rigid
sales ratio, the judgmental approach relies on management’s judgment and insights to
estimate the values of certain balance sheet accounts, adjusting for expected changes in
operations, investments, or financing needs.

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).

External Financing Required (EFR) / "Plug Figure"

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).

Formula: EFR=Forecasted Assets−(Forecasted Liabilities+Forecasted Equity)

• If the result is positive, it means the firm needs additional external financing.
• If the result is negative, the firm has excess internal funds.

Understanding the Significance of the Plug Figure

• Financial Planning: It helps businesses understand how much external financing they will
need to support growth or expansion plans.
• Balance Sheet Management: Ensures that the pro forma balance sheet is balanced, with
assets equaling liabilities plus equity.
• Decision-Making: Guides management decisions on whether to issue more debt or equity,
adjust dividends, or use internal funds more efficiently.