Financial Planning and
Forecasting:
Cash Flows and Financial
Statement Analysis
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Corporate Finance
Dr. A. DeMaskey
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Learning Objectives
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• Questions to be answered:
– What are the basic financial statements and how are
they used?
– What kinds of financial information do users need?
– What is the difference between accounting income and
cash flow?
– How are different sources of income taxed based on the
U.S. tax code?
– How are financial statements used by managers to
improve performance?
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Financial Statements
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Balance Sheet
Income Statement
Statement of Retained Earnings
Statement of Cash Flows
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Cash Flows
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• Net Cash Flows
• Free Cash Flows
• Operating Cash Flows
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MVA and EVA
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• Market Value Added (MVA)
• Economic Value Added (EVA)
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Individual Income Taxes
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Taxable Income
Marginal versus Average Tax Rate
Taxes on Dividend and Interest Income
Capital Gains versus Ordinary Income
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Corporate Income Taxes
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• Interest and Dividend Income Received by
a Corporation
• Interest and Dividend Income Paid by a
Corporation
• Ordinary Gains and Losses
• Capital Gains and Losses
• Corporate Loss Carry-Back and CarryForward
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Financial Statement Analysis
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• Ratio Analysis
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Liquidity ratios
Asset management ratios
Debt management ratios
Profitability ratios
Market value ratios
• Du Pont System
– ROA
– ROE
Expense control (PM)
Asset utilization (TATO)
Debt utilization (EM)
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Limitations of Ratio Analysis
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Large firms
Industry averages
Inflation
Window dressing
Accounting practices
Operating policies
Interpretation of ratios
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Qualitative Factors
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Key customer
Key product
Single supplier
Foreign sales
Competition
Future prospects
Legal and regulatory environment
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Financial Planning and Forecasting
Financial Statements
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• Plans: strategic, operating, and financial
• Pro forma financial statements
– Sales forecasts
– Percent of sales method
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• Additional Funds Needed (AFN) formula
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Pro Forma Financial Statements
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• Three important uses:
– Forecast the amount of external financing that
will be required
– Evaluate the impact that changes in the
operating plan have on the value of the firm
– Set appropriate targets for compensation plans
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Steps in Financial Forecasting
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Forecast sales
Project the assets needed to support sales
Project internally generated funds
Project outside funds needed
Decide how to raise funds
See effects of plan on ratios and stock price
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Sales Forecast
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• Division sales forecasts based on historical growth
• Level of economic activity and overall demand for
the product
• Market share for each product line in each market
• If foreign sales, include currency fluctuations,
trade agreements, governmental policies, etc.
• Inflation
• Advertising campaigns, promotional discounts,
credit terms, etc.
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Projecting Pro Forma Statements
with the Percent of Sales Method
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• Project sales based on
forecasted growth rate in
sales
• Forecast some items as a
percent of the forecasted
sales
– Costs
– Cash
– Accounts receivable
• Items as percent of sales
– Inventories
– Net fixed assets
– Accounts payable and
accruals
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• Choose other items
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– Debt (which determines
interest)
– Dividends (which
determines retained
earnings)
– Common stock
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What are the additional funds
needed (AFN)?
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AFN =
Required
asset
increase
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Spontaneous
liability
increase
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Increase
in retained
earnings
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Summary: How different factors
affect the AFN forecast
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• Excess capacity:
– Existence lowers AFN.
• Base stocks of assets:
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– Leads to less-than-proportional asset increases.
• Economies of scale:
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– Also leads to less-than-proportional asset
increases.
• Lumpy assets:
– Leads to large periodic AFN requirements
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Other Techniques for Forecasting
Financial Statements
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• Regression Analysis for
Asset Forecasting
– Relationship between type
of asset and sales is linear.
– Get historical data on a
good company, then fit a
regression line to see how
much a given sales increase
will require in way of asset
increase.
• Excess Capacity
Adjustments
– Full capacity sales
– Target fixed assets-to-sales
ratio
– Required level of fixed
assets
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