Cash Flow and Financial Planning

Chapter 4
Cash Flow
and Financial
Planning
Learning Goals
LG2 Discuss the firm’s statement of cash flows,

operating cash flow, and free cash flow.
© Pearson Education Limited, 2015. 4-2

Analyzing the Firm’s Cash Flow
• Importance of Cash flow:
(a)it is the primary driver of a firm’s value, and
(b) firms must have cash, not earnings, to pay their bills.
• Cash flow (as opposed to accounting “profits”) is the
primary ingredient in any financial valuation model.
• From an accounting perspective, cash flow is
summarized in a firm’s statement of cash flows.
• From a financial perspective, firms often focus on:
– operating cash flow, which is used in managerial decision-
making, and
– free cash flow, which is closely monitored by participants in
the capital markets.

Developing the Statement of Cash Flows
p.166-173 Section 4.1
• The statement of cash flows summarizes the firm’s

cash flow (inflow and outflow) over a given period of time.
• Firm’s cash flows fall into three categories:
1. Operating flows: cash flows directly related to sale and
production of the firm’s products and services. e.g. Honda
selling a car.
2. Investment flows: cash flows associated with purchase
and sale of both fixed assets and equity investments in other
firms. e.g. buying new machines to start a new line of
business.
3. Financing flows: cash flows that result from debt and
equity financing transactions; include incurrence and
repayment of debt, cash inflow from the sale of stock, and
cash outflows to repurchase stock or pay cash dividends.
Incurring either short-term or long-term debt will result in
cash inflow while repaying debt would result in cash outflow.

Classifying Inflows and Outflows of Cash
Table 4.3
Inflows and Outflows of Cash

Table 4.4 Baker Corporation 2015 Income
Statement ($000)

Table 4.5 Baker Corporation Balance
Sheets ($000)

Table 4.5 Baker Corporation Balance
Sheets ($000) (Cont.)

Table 4.6 Baker Corporation Statement of Cash
Flows ($000) for the Year Ended December 31,
2015

Interpreting Statement of
Cash Flows
• The statement of cash flows ties the balance sheet
at the beginning of the period with the balance
sheet at the end of the period after considering the
performance of the firm during the period through
the income statement.
• The net increase (or decrease) in cash and
marketable securities should be equivalent to the
difference between the cash and marketable
securities on the balance sheet at the beginning of
the year and the end of the year.

Operating Cash Flow
• A firm’s operating Cash Flow (OCF) is the cash flow a
firm generates from normal operations—from the production
and sale of its goods and services. We exclude the impact of
interest on cash flows, because we want a measure that captures the
cash flow from operations, not by how the operations are financed.
• OCF may be calculated as follows:
Where,
NOPAT= Net Operating Profits After Taxes and T=Corporate Tax Rate

Operating Cash Flow (cont.)
• Substituting for Baker Corporation, we get:

OCF = [$370 ×(1.00 – 0.40] + $100 = $222 + $100 = $322
• Thus, we can conclude that Baker’s operations are

generating positive operating cash flows.

Free Cash Flow
• Free cash flow (FCF) is 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 (NFAI) and net current assets (NCAI).
Where:
NFAI represent net investment that a firm makes in fixed assets:

purchase minus sales of fixed assets
NCAI represent the net investment made by the firm in current

assets
Free Cash Flow (cont.)
• Using Baker Corporation we get:

NFAI = [($1,200 - $1,000) + $100] = $300
NCAI = [($2,000 - $1,900) - ($800 - $700)] = $0
FCF = $322 - $300 - $0 = $22
• Thus, the firm generated adequate cash flow to

cover all of its operating costs and investments and
had free cash flow available to pay investors.

Review of Learning Goals
LG2 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. From a strict financial point of
view, a firm’s operating cash flow is defined to exclude
interest. Of greater importance is a firm’s free cash flow,
which is the amount of cash flow available to creditors and
owners.

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Chapter 4

LG2 Discuss the firm’s statement of cash flows,

© Pearson Education Limited, 2015. 4-2

© Pearson Education Limited, 2015. 4-3

• The statement of cash flows summarizes the firm’s

© Pearson Education Limited, 2015. 4-4

© Pearson Education Limited, 2015. 4-5

© Pearson Education Limited, 2015. 4-6

© Pearson Education Limited, 2015. 4-7

© Pearson Education Limited, 2015. 4-8

© Pearson Education Limited, 2015. 4-9

© Pearson Education Limited, 2015. 4-10

© Pearson Education Limited, 2015. 4-11

• Substituting for Baker Corporation, we get:

• Thus, we can conclude that Baker’s operations are

© Pearson Education Limited, 2015. 4-12

NFAI represent net investment that a firm makes in fixed assets:

NCAI represent the net investment made by the firm in current

• Using Baker Corporation we get:

• Thus, the firm generated adequate cash flow to

© Pearson Education Limited, 2015. 4-14

LG2 Discuss the firm’s statement of cash flows,

© Pearson Education Limited, 2015. 4-15

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