Corporate Finance Week 3 — Financial Planning & Cash Management
Focus: financial planning + cash management (CFO’s job: don’t run out of cash; finance operations; choose investments).
1) Cash-management objective and the Week 3 “toolkit”
Week 3 is about anticipating future funding needs early enough so the firm does not run out of cash.
Exam-style workflow (diagnose → forecast → conclude funding needed):
- Ratio analysis (operational + financial)
- Working capital management
- Sources & uses of funds (balance-sheet changes → where cash came from / went)
- Pro forma Income Statement & Balance Sheet
- Cash budgeting
2) Ratio analysis: what matters and what the lecturer cares about
A) “Ratios are like blood tests” (interpretation)
Key message: a single ratio is not informative by itself. The real skill is interpreting multiple ratios together.
- Compare within the statements (other ratios).
- Compare over time (trend).
- Compare to an industry benchmark.
B) “Don’t memorize” — but you must know how to apply
- Ratios are on the formula sheet, so memorisation is not the focus.
- You must be able to compute/setup and interpret directionally (high vs low; improving vs worsening).
- Then tie to a story: operations, pricing power, efficiency, credit terms, inventory policy, financing risk.
C) What inputs you use (CFA framing)
- Financial analysis = selecting/evaluating/interpreting financial data plus other information to assess current and future condition.
- Data sources to consider:
- Financial disclosures (10-Q / 10-K)
- Economic data
- Market data
D) Common-size analysis (vertical vs horizontal)
Common-size is the “before ratios” step: identify structural changes, not just levels.
Vertical common-size:
- Balance sheet: each item as % of total assets
- Income statement: each item as % of sales/revenues
Horizontal common-size:
- Compare changes over time relative to a base year
E) Ratio families you should recognise
- Profitability
- Liquidity
- Interest coverage
- Leverage
- Operating returns
- Valuation
- Working-capital ratios
F) Limitations (easy marks)
- Ratios reflect current/past trends, not the future
- Different accounting policies reduce comparability
- Balance sheet is a date snapshot
- Creative accounting can distort conclusions
3) Warm-up terms you are expected to be fluent with
Week 3 assumes you already know core accounting/finance vocabulary (AR/AP/EBIT/EBITDA/EPS/EV, etc.).
Examples emphasised:
- Enterprise Value (EV) = market cap of equity + debt − cash
- Amortisation = intangibles; depreciation = tangibles (conceptual distinction)
- Growth vs value stocks (timing of cash flows)
These definitions recur later (e.g., valuation), so Week 3 is where you should stop hesitating on them.
4) Working capital management: “cash is trapped in operations”
Daily operations can create or absorb cash even before any pro forma work.
- Accounts receivable (A/R): credit sales not yet collected → cash tied up
- Inventory: cash tied up
- Accounts payable (A/P): supplier credit → financing from suppliers
Exam reasoning: if sales grow, working capital often grows too, creating a financing need even if the firm is profitable.
5) Sources & Uses of Funds: reading balance-sheet changes as financing
Common exam format: “Use two balance sheets to identify where cash came from and where it went.”
Classification rules
- Increase in assets = Use of funds
- Decrease in assets = Source of funds
- Increase in liabilities/equity = Source of funds
- Decrease in liabilities/equity = Use of funds
How to answer well on an exam
- Compute each line-item change (Year 2 − Year 1).
- Assign Source/Use using the rules above.
- Check: Total Sources = Total Uses (consistency).
- Interpret the story:
- Was growth financed by A/P (trade credit), bank borrowing, long-term debt, or retained earnings?
- If A/R and inventory balloon, is it higher sales, slower collections, or poor inventory management?
6) Pro forma statements: forecasting and the “GIGO” warning
A) Purpose
- Pro formas are a forecasting tool to plan operations and financing so the firm does not run out of cash.
B) Core pro forma workflow (sequence matters)
- Start from recent Income Statement + Balance Sheet.
- Identify regular dynamics in key drivers (Sales, Inventory, A/R, A/P).
- Set reasonable assumptions for most items, excluding financing components.
- Compute the plug(s) (balancing items; often financing).
- Verify balancing conditions:
- Assets = Liabilities + Equity
- Equity(t) = Equity(t−1) + Net Income(t) (dividends reduce what stays in equity/retained earnings)
C) “Garbage in, garbage out” (what is being tested)
- Pro formas are only as good as assumptions.
- Marks come from assumptions consistent with historical patterns and clear justification.
- Recognise that financing items are often the plug.
- Avoid unsupported “rules of thumb”; account for seasonality in monthly projections; use known policies (e.g., dividends) as given.
D) Monthly forecasting, seasonality, and interlocks (high-yield)
- Seasonality complicates monthly forecasting (different seasonal profiles across businesses).
Two interlocks explicitly emphasised:
7) Cash budgeting: the short-term survival schedule
- Pro formas: profitability and balance-sheet position under assumptions.
- Cash budgets: timing of receipts/disbursements to maintain a cash buffer and plan borrowing/investing.
- Interlock: ending cash balance in the cash budget becomes the cash line on the balance sheet going forward (consistency across schedules).
8) How Week 3 appears on the final (how to score well)
A) Compute and interpret ratios
- Use trend + benchmark; do not over-interpret a single number.
- Reference limitations (accounting differences, snapshot nature, creative accounting).
B) Working capital / cash conversion logic
- Explain what operational policy is implied (credit terms, inventory discipline, supplier terms).
- Explain how that affects financing needs (cash tied up → more borrowing).
C) Sources & Uses from two balance sheets
- Be systematic; avoid sign errors; check sources = uses; interpret the financing story.
D) Build (or interpret) a simple pro forma
- Identify driver assumptions (sales growth, % of sales relationships).
- Plug financing items.
- Check the two balancing conditions.
- Explicitly state that assumptions drive results (GIGO).
9) Ultra-high-yield checklist (Week 3 mastery)
- Explain why single ratios are not enough and what comparisons you need.
- List the four ratio-analysis limitations.
- Distinguish vertical vs horizontal common-size analysis.
- Given two balance sheets, build a Sources/Uses table and interpret it.
- Apply the asset vs liability/equity source/use rule correctly.
- Outline the pro forma process (assumptions → plug → balance checks).
- State the balancing conditions and explain why they must hold.
- Explain the GIGO risk and what “reasonable assumptions” means.
- For monthly forecasting, write the inventory interlock and explain seasonality risk.