Can you think of three examples of fixed expenses that a business may incur?
They may include:
■ salaries
■ rent payable
■ insurance
■ depreciation of equipment.
You may have thought of others.
Activity 2.11
Where sales are increasing, the per-cent-of-sales method will increase fixed expenses in line with the increase in sales. The effect will be to overstate expenses and to understate profits for the period. Where sales are decreasing, the opposite will be true. The higher the level of fixed expenses incurred by the business, the greater will be the resulting overstatement or understatement when the level of sales changes.
The above suggests that the per-cent-of-sales method is best suited to a business with at least one of two possible characteristics. Try to identify at least one of these.
It is probably best suited to a business where:
■ sales remain stable over time, and/or
■ expenses are not fixed but vary directly with sales.
The second characteristic mentioned, however, would be a very rare occurrence. For most businesses, fixed expenses account for the greater part of total expenses incurred.
Activity 2.12
LONG-TERM CASH FLOW PROJECTIONS
The projected cash flow statement prepared in Activity 2.4 required a detailed analysis of each element of the cash flows of the business. This approach may be fine when dealing with a short forecast horizon. However, as the forecasting horizon increases, forecasting difficul- ties start to mount. A point will be reached where it is simply not possible to undertake such detailed analysis.
To prepare projected cash flow statements for the longer term, a method that uses simplify- ing assumptions rather than detailed analysis may be used. The starting point is normally to identify the sales revenue for each year of the planning horizon. The operating profit (that is, profit before interest and taxation) for each year is then calculated as a percentage of the sales revenue figure. (The particular percentage is often determined by reference to past experience.) A few simple adjustments can then be made to the annual operating profits in order to derive annual operating cash flows.
These adjustments rely on the fact that, broadly, sales revenue gives rise to cash inflows and expenses give rise to outflows. As a result, operating profit will be closely linked to the operat- ing cash flows. This does not mean that operating profit for the year will be equal to operating
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52 CHAPTER 2 FINANCIAL PLANNING
cash flows. An important reason for this is timing differences. When sales are made on credit, the cash receipt occurs some time after the sale. Thus, sales revenue made towards the end of a particular year will be included in that year’s income statement. Most of the cash from those sales, however, will flow into the business and should be included in the cash flows for the following year. Fortunately, it is easy to deduce the cash received, as we see in Example 2.3.
Example 2.3
The sales revenue figure for a business for the year was £34 million. The trade receivables totalled £4 million at the beginning of the year, but had increased to £5 million by the end of the year.
Basically, the trade receivables figure is dictated by sales revenue and cash receipts.
It is increased when a sale is made and decreased when cash is received from a credit customer. If, over the year, the sales revenue and the cash receipts had been equal, the beginning-of-year and end-of-year trade receivables figures would have been equal. Since the trade receivables figure increased, it must mean that less cash was received than sales revenues were made. This means that the cash receipts from sales must be £33 million (that is, 34 -(5 -4)).
Put slightly differently, we can say that as a result of sales, assets of £34 million flowed into the business during the year. If £1 million of this went to increasing the asset of trade receivables, this leaves only £33 million that went to increase cash.
Other important adjustments for timing differences relate to cash payments for purchases (by adjusting for opening and closing trade payables) and cost of goods sold (by adjusting for opening and closing inventories). The same general point, however, is true in respect of most other items that are taken into account in deducing the operating profit figure. An important exception is depreciation, which is not normally associated with any movement in cash. It is simply an accounting entry.
All of this means that we can take the operating profit (profit before interest and taxation) for the year, add back the depreciation charged in arriving at that profit, and adjust this total amount for movements in trade (and other) receivables and payables and for inventories. This will provide us with a measure of the operating cash flows. If we then go on to deduct pay- ments made during the year for taxation, interest on borrowings and dividends, we have the net cash flows from operations.
When preparing long-term cash flow projections, however, detailed adjustments to each element of working capital (that is, inventories, trade receivables and trade payables) can be avoided. A simplifying assumption can be adopted that takes working capital investment as a fixed percentage of sales revenue. Changes in the working capital investment are then calculated according to changes in sales revenue.
Why might calculating working capital as a fixed percentage of sales provide a reasonable simplifying assumption?
Key elements of working capital, such as trade receivables, inventories and trade payables, tend to increase, or decrease, in line with increases, or decreases, in sales revenue.
Activity 2.13
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LONG-TERM CASH FLOW PROJECTIONS 53
Let us now look at a worked example to see how a projected cash flow statement, using the approach outlined, is prepared.
Example 2.4
Santos Engineering Ltd started operations on 1 January Year 1 and has produced the following forecasts for annual sales revenue:
Year to 31 December Year 1 Year 2 Year 3 Year 4 Forecast sales
revenue (£) 500,000 560,000 640,000 700,000
The following additional information has been provided:
1 The operating profit of the business is expected to be 20 per cent of the sales revenue throughout the four-year period.
2 The business has issued £400,000 5 per cent loan notes, which are redeemable at the end of Year 4.
3 The tax rate is expected to be 25 per cent throughout the four-year period. Tax is paid in the year following the year in which the relevant profits were made.
4 An initial investment in working capital of £50,000 is required. Thereafter, investment in working capital is expected to represent 10 per cent of sales revenue for the relevant year.
5 Depreciation of £40,000 per year must be charged for the non-current assets currently held.
6 Land costing £490,000 will be acquired during Year 2. This will not be depreciated as it has an infinite life.
7 Dividends of £30,000 per year will be announced for Year 1. Thereafter, dividends will rise by £6,000 each year. Dividends are paid in the year following the period to which they relate.
8 The business has a current cash balance of £85,000.
We shall now prepare projected cash flow statements showing the financing require- ments of the business for each of the next four years. The starting point is to calculate the projected operating profit for the period and then to make the depreciation and the work- ing capital adjustments as described earlier. This will provide us with a figure of operating cash flows. We then simply adjust for the interest, tax and dividends to deduce the net cash flows from operations each year.
The financing requirements for Santos Engineering Ltd are calculated as follows:
Projected cash flow statements Year 1
£
Year 2
£
Year 3
£
Year 4
£
Sales revenue 500,000 560,000 640,000 700,000
Operating profit (20%) 100,000 112,000 128,000 140,000
Depreciation 40,000 40,000 40,000 40,000
Working capital* (50,000) (6,000) (8,000) (6,000)
Operating cash flows 90,000 146,000 160,000 174,000
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54 CHAPTER 2 FINANCIAL PLANNING
Year 1
£
Year 2
£
Year 3
£
Year 4
£
Interest (20,000) (20,000) (20,000) (20,000)
Tax** (20,000) (23,000) (27,000)
Dividends (30,000) (36,000) (42,000)
Non-current assets (490,000)
Loan repayment _______ ________ ________ (400,000)
Net cash flows from
operations 70,000 (414,000) 81,000 (315,000)
Opening balance 85,000 155,000 (259,000) (178,000)
Closing balance 155,000 (259,000) (178,000) (493,000)
* The initial investment in working capital will be charged in the first year. Thereafter only increases (or decreases) in the level of working capital will be shown as an adjustment.
** The tax charge for each year is shown below.
Year 1
£
Year 2
£
Year 3
£
Year 4
£ Operating profit (as
above)
100,000 112,000 128,000 140,000
Interest (20,000) (20,000) (20,000) (20,000)
Profit before tax 80,000 92,000 108,000 120,000
Tax (25%) (20,000) (23,000) (27,000) (30,000)
Note: Tax will be paid in the year after the relevant profit is made. (Note 3)