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Funds Analysis

The second portion of our examination of the tools of financial analysis and planning deals with the analysis of funds flows and cash flows and with financial forecasting. A flow of funds statement (also known as a sources and uses of funds statement or a statement of changes in financial position) is a valuable aid to a financial manager or a creditor in evaluating the uses of funds by a firm and in determining how the firm finances those uses. In addition to studying past flows, the financial manager can evaluate future flows by means of a funds statement based on forecasts. Until 1989, all US corporate annual reports were required to present flow of funds statement in addition to a balance sheet and income statement. The cash flow statement now officially replaces the flow of funds statement in annual reports. The purpose of the cash flow statement is to report a firm's cash inflows and outflows - not its flow of funds - segregated into three categories: operating, investing, and financing activities. Although this statement certainly serves as an aid for analyzing cash receipts and disbursements, important current period investing and financing noncash transactions are omitted. Therefore the analyst will still want to prepare a flow of funds statement in order to more fully understand the firm's funds flows.

Another major tool, the cash budget, is indispensable to the financial manager in determining the short-term cash needs of the firm and, accordingly, in planning its short-tern financing. When cash budgeting is extended to include a range of possible outcomes, the financial manager can evaluate the business risk and liquidity of the firm and plan for a real istic margin of safety. The financial manager can adjust the firm's liquidity cushion, rearrang the maturity structure of its debt, arrange a line of credit with a bank, or do some combination of the three.

The preparation of forecast balance sheets and income statements enables the financii manager to analyze the effects of various policy decisions on the future financial condition and performance of the firm. Such statements may derive from the cash budget or be based on past or projected financial ratios and/or other assumptions. We examine each of these tools in turn.

The final method of analysis, contained in an Appendix to this chapter, involves sustainable growth modeling. Here we determine whether the sales growth objectives of the compan are consistent with its operating efficiency and with its financial ratios. This powerful tool of analysis allows us to simulate the likely effects of changes in target ratios when we move from a steady-state environment.

Cash budgeting, the preparation of forecast statements, and even sustainable growth modeling are made easier through use of a computer spreadsheet program. Such programs arc readily available for financial analysis and planning.

Alternative "Funds" Definitions

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The financial manager makes decisions to ensure that the firm has sufficient funds to meet financial obligations when they are due and to take advantage of investment opportunities. To help the analyst appraise these decisions (made over a period of time), we need to study the firm's flow of funds. By arranging a company's flow of funds in a systematic fashion, the analyst can better determine whether the decisions made for the firm resulted in a reasonable flow of funds or in questionable flows, which warrant further inspection.

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What Are Sources? Uses?

We prepare a basic, bare-bones funds statement by ( 1 ) determining the amount and direction of net balance sheet changes that occur between two balance sheet dates, (2) classifying net balance sheet changes as either sources or uses of funds, and (3) consolidating this information in a sources and uses of funds statement format. In the first of these steps, we simply place one balance sheet beside the other, compute the changes in the various accounts, and note the direction of change - an increase (+) or decrease (-) in amount. In step 2, each balance sheet item change is classified as either a source or use of funds, as follows:

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Adjustments

Although we could begin to analyze our "basic" sources and uses statement right now, a few minor adjustments will provide us with an even more useful statement with which to work. We will want to better explain the change in retained earnings and that in net fixed assets. We purposely separated these two items from all the rest. Once we give a more detailed explanation of these two net changes, the rest will remain virtually untouched.

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Analyzing the Sources and Uses of Funds Statement

In Table 7.3 we see that the principal uses of funds for the 20X2 fiscal year were dividends, additions to fixed assets, increases in inventories and long-term investment, and a sizable decrease in taxes payable. These were financed primarily by funds provided by operations, a decrease in accounts receivable, and an increase in bank loans. Also of note is the fact that the firm has increased its cash balance by $3,000. In a sources and uses of funds analysis, it is useful to place cash dividends opposite net profits and additions to fixed assets opposite depreciation. Doing this allows the analyst to easily evaluate both the amount of the dividend payout and the net increase (decrease) in fixed assets.

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Content and Alternative Forms of the Statement

The purpose of the statement of cash flows is to report a firm's cash inflows and outflows, during a period of time, segregated into three categories: operating, investing, and financing activities. This statement is required under Statement of Financial Accounting Standard (SFAS). When used with the information contained in the other two basic financial statements and their related disclosures, it should help the financial manager to assess and identify

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Analyzing the Statement of Cash Flows

We see that while Aldine's reported net income for 20X2 was $201,000, its cash flow from operating activities was $219,000. Interestingly, the company spent $169,000 - slightly more than 75 percent of its entire operating cash flow - on new fixed assets and long term investments. (Only the additions to fixed assets, however, would seem to be a recurring annual expenditure.) This left only $50,000 of operating cash flow to cover dividend payments of $143,000. Increased borrowings, mostly short term, provided the additional financing to cover dividend payments and provide for a small increase in cash and cash equivalents. When we consider that about half of Aldine's operating cash flow goes to replace depreciating assets, the firm's ability to maintain its current dividend seems to depend on its ability to continue to borrow funds. We may, therefore, be witnessing a signal that the firm will be encountering difficulty in maintaining its current dividend into the future.

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The Sales Forecast

The key to the accuracy of most cash budgets is the sales forecast. This forecast can be based on an internal analysis, an external one, or both. With an internal approach, sales representatives are asked to project sales for the forthcoming period. The product sales managers screen these estimates and consolidate them into sales estimates for product lines. The estimates for the various product lines are then combined into an overall sales estimate for the firm. The basic problem with an internal approach is that it can be too myopic. Often, significant trends in the economy and in the industry are overlooked.

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Collections and Other Cash Receipts

The sales forecast out of the way, the next job is to determine the cash receipts from these sales. For cash sales, cash is received at the time of the sale; for credit sales, the receipts come later. How much later depends on the billing terms, the type of customer, and the credit and collection policies of the firm. Pacific Jams Company offers terms of "net 30," meaning that payment is due within 30 days after the invoice date. Also assume that, in the company's experience, an average of 90 percent of receivables are collected one month from the date of sale and the remaining 10 percent are collected two months from sale date if no bad-debt losses occur. Moreover, on the average, 10 percent of total sales are cash sales.

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Cash Disbursements

Next comes a forecast of cash disbursements. Given the sales forecast, management may choose to gear production closely to seasonal sales, to produce at a relatively constant rate over time, or to have mixed production strategy.

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