MAKING CASH FLOW COME ALIVE AND SENSIBLE IN THE CLASSROOM Developments In Business Simulation & Experiential Exercises, Volume 23, 1996 MAKING CASH FLOW COME ALIVE AND SENSIBLE IN THE CLASSROOM Alan L. Patz, University of Southern California ABSTRACT Cash flow problems are presented often to business students as difficult, abstract enigmas. Nothing could be further from the truth, and this paper presents several different models to demonstrate this conclusion. They range from the simplest accounting identity to the use of linear programming. Moreover, they demonstrate for students that projections of the future, and possible variations of the future, are easily comprehensible procedures. Also, using these models in the capstone business policy course demonstrates how to apply knowledge acquired previously in accounting, economics, and finance courses to total enterprise competitions. INTRODUCTION The purpose of this paper is to present models that simplify the teaching of cash flows in the capstone business policy course, especially for students engaging in total enterprise (TE) simulation competitions. Past experience (Colley, 1984) indicates that accounting and finance courses, while focusing on special cash flows for their particular interests, do not address the issues of importance to senior and general managers. In fact, they do not distinguish among the various levels of cash flow analysis, ranging from simplistic formulations to more complicated analytic and descriptive ones. The key point is that cash flow models are simple and lead easily to an infinite number of alternatives if students are only given a chance to pursue them. STANDARD SIMPLE MODELS An accounting identity provides the simplest definition of cash flow (CF). That is, EndingCash =BeginningCash + Cashlnflows – Cash Outflows Rearranging this identity leads to the following alternative cash flow definitions: CF EndingCash - BeginningCash = Cashlnflows - CashOutflows (1) The problem with this definition of cash flow, however, is that it does not specify the sources and uses of cash. It simply states what everyone knows. DPPATCF += So a more informative view is needed, and standard business school wisdom provides one. That is, CF = PAT + DP where PAT is profit after taxes and DP is depreciation. But, the problem is that the three assumptions that lie behind this wisdom are seldom explained. Nevertheless, they are straightforward. They are that: 1. All revenue is received in cash, 2. All expenses are paid in cash, and 3. There are no balance sheet transactions that affect the cash account. Balance sheet transactions that affect the cash account are obvious. For example, assets are purchased; long term debt is issued or repaid; or, stock is issued or repurchased. Said in another way, it is assumed that there are no balance sheet transactions affecting the cash account that are not included in the income statement. This is hardly ever the case in the short run. But assuming this to be so, the standard income statement in Table 1 can be used to demonstrate this cash flow version. Simply use the definitions given in this statement, and the equation for profit after taxes is: TXDPINRDMKCOSREVPAT −+++−−= )()( TXDPINRDMKGMPAT −+++−= )( (2) (3) Likewise, since DP is not a cash flow, the comparable equation for CF is: TXINRDMKGMCF −++−= )( (4) Subtracting equation (3) from equation (4) yields: DPPATCF =− (5) DPPATCF += (6) 54 Developments In Business Simulation & Experiential Exercises, Volume 23, 1996 When the Assumptions Fail Most students have no difficulty understanding this derivation, but they tend to be baffled by the simplicity, rather than the complexity, of how to handle situations when the above three assumptions do not hold. Moreover, equation (6) still does not provide much information concerning the sources and uses of cash. It is almost never true that all revenues are received in cash, all expenses are paid in cash, and there are no balance sheet transactions that affect the cash account Something has to give, and a realistic formulation can be established using the balance sheets and income statements in Table 2. The unique thing about Table 2 is that any firm’s balance sheets and income statements can be forced into the set of accounts shown there. Some accounts may have to be combined in order to achieve the Table 2 format, but the task is almost always an easy one. Now, changes in accounts receivable, inventory, fixed assets, accounts payable, accrued taxes, tong term debt, and equity can be taken into account as sources and uses of cash. For example, the sources and uses of cash for the previous period to the current period are as follows, assuming a 10% depreciation rate on net fixed assets for the previous period; a constant long term debt to equity ratio of 1 .0; and a dividend payout ratio of 1/6 for the current period. Sources Uses PAT 36 Increase A/R 15 DP 20 Increase INV 15 CashFromOps 56 Increase Fixed Assets 60 Increase Other Assets 5 Increase A/P 10 Pay Dividends 6 Increas A/T 10 Increase LTD 30 Total Sources 106 Total Uses 101 Sources – Uses 5 (7) Beginning Cash 25 Ending Cash 30 (8) Since the new retained earnings in the current period, 30, increase the equity account to 180, there has been no new stock issued and the long-term debt to equity ratio remains at 1 .0. Other assumptions surround this particular model (Colley, 1984) that yield the basic information concerning the sources and uses of cash. However, they are not important for purposes of this paper. Going Beyond History What is important is that the preceding models are all aimed at historical analyses. They cannot be wrong since they are dealing with the data already available. Even the preceding or third one that does take major sources and uses of cash into account is historical. What senior and general managers need, however, are models that are future oriented, ones that allow an analysis of several scenarios of what will or can happen under a given set of assumptions. The discussion in the next session is designed to demonstrate particular kinds of solutions to future cash flow problems. Two kinds of cash flow models are demonstrated --analytical and descriptive. Both go beyond the first three discussed in this paper, and both provide important answers to specific future questions. The discussion will be limited, however, since brevity is a requirement of this article. A FUTURE ORIENTATION Most attempts to project a firm’s financial position into the future are concerned with cash flow, growth, and profitability. Analytical projection models answer a large number of important questions, and descriptive models allow an unlimited look at the future. The tradeoff between the two is that brevity and simplicity in analytical models are sacrificed for flexibility and complexity in descriptive ones. Analytical Models The term “analytical-model” refers to a cash flow formulation that results in one or more equations that yield important cash flow consequences for a firm’s top management. The cash flow consequences of interest are those related to issues such as operating profit, interest on debt, effective tax rates, tong term debt to equity ratios, growth rate, and assets employed. These are worthwhile formulations because they give management realistic projections of their current financial status. For example, a most useful cash flow, growth, and profitability equation has been derived by Colley (1984). It is: ))(()1( )/1)(1)(( GNAG EQLTDDPOIEBTCF −+ +−−= (9) 55 Developments In Business Simulation & Experiential Exercises, Volume 23, 1996 where EBIT = Earnings Before Interest And Taxes = Interest t = Tax Rate DPO = Dividends/PAT LTD/EQ = Long Term Debt to Equity Ratio G = Growth Rate NA = Net Assets = Total Assets - Current Liabilities In this form and in several others that may be derived from it. equation (9) provides answers for many questions of interest to senior managers. Among these are the cash flow consequences of changing dividend, growth, interest and tax rates; LTD/EQ policies and optimum LTD/EQ ratios; cash flow demands on several divisions of a firm or several product lines in a division; efficiency requirements in the use of assets and expense management; and the amount of external funding needed in various combinations of the preceding factors. One simple example of equation (9) applications is provided by the data in Table 2. Using the previous period data in this table and equation (9), the cash balancing growth rate for this firm may be determined. (10) The cash balancing growth rate for the firm, the rate it can finance internally except for any new debt required to maintain a desired LTD/EQ ratio, is determined by setting CF = 0 and solving for G = .2 or 20%. The last sentence, however, reveals one key weakness of analytical models. The user or forecaster is oftentimes constrained by the assumptions that generated a model such as the one given in equation (9). In fact, one of the assumptions behind equation (9) is that the firm maintains a constant LTD/EQ ratio. That is why the phrase “except for any new debt required to maintain a desired LTD/EQ ratio” in the preceding discussion of the firm’s cash balancing growth rate. Very often this sort of difficulty can be overcome with insightful modifications of the equation (9) model. But useful as they are, especially for fast answers to the above noted types of questions, most planners would prefer not to be so constrained. Descriptive Models One point needs to be made, however, before proceeding. That is, there are a infinite variety of descriptive models possible, given the infinite variety of problems that firms encounter. Nevertheless, a few fairly strong generalities that can be made about all of them. First, looking at Table 3, they have four parts--assumptions, income statements, balance sheets, and cash flows. Second, only the assumptions entered into a spreadsheet such as Table 3 should contain numerical values. All other cells should contain formulas based upon the cells preceding them. In the future, it will be more than difficult to determine where in the various cell formulas constants need to be changed. Third, it is oftentimes necessary to use simultaneous equations to derive the necessary cell formulas. (See below.) And fourth, perfect models do not exist. Get one that solves the problem and quit. Generality number one is the most important. It is concerned with the first four parts of Table 3 and the fact that income statements and the asset side of the balance sheet are simple to derive given the preceding assumptions. Current liabilities are equally easy. It is the long term financing of a firm that needs the most attention. Looking back at the basic accounting identity that current assets (CA) plus fixed assets (FA) must be equal to current liabilities (CL) plus long term debt (LTD) plus equity (EQ), the next equation is simple: EQLTDCLFACA ++=+ (11) In other words, if CA, FA, and CL are determined easily, then the difference EQLTDFACLCA +=+− )( (12) concerns choices regarding the long term funding of the firm, LTD + EQ. Since total assets minus current liabilities is net assets (NA) as defined previously; and since (CA - CL) is working capital (WC); equation (12) can be rewritten as EQLTDFAWCNA +=+≡ (13) 56 Developments In Business Simulation & Experiential Exercises, Volume 23, 1996 A Simple LTD + EQ Choice The results in Table 3 and the formulas behind them in Table 4 are straightforward for the most part. They reflect the assumptions in the beginning section, but the desired ending cash in the balance sheets is typically an arbitrary decision. In the case of Table 4, the decision is to use the quick ratio to determine the cash balance. Most quick ratio calculations are as follows: CLepaidsINVCAQuickRatio /)Pr( −−= (14) where IV is the preceding period’s ending inventory. There are no Prepaids in Table 2, so equation (14) reduces to CLINVCAQuickRatio /)( −= (15) But , so the INVRACashCA ++= / CLRACashQuickRatio )/( += (16) Setting the Quick Ratio to some value, say a, then RAaCLCash /−= where is one of the assumptions, and CL and A/R from the previous period are increased by this period’s growth rate. All of this noted, and using the subscripts 0 and 1 for the previous and current period respectively, the final task is to expand equation (1 3) for net assets. Using NA1 = TA1 - CL1 as the current period net assets, and NIi = New Issue (or Buy Back) of stock in any period, it is clear that aRE NINIStockLTDCLTA =+ +++=− 1 100111 (17) where NI1 is the variable that will balance the balance sheets and the cash flows. That is, whatever it takes to balance equations (11), (12) and (13), the purchase/buy-back of stock, NI1, will do it. Then, using RE0 as the previous period’s retained earnings and NRE1 as the current period’s new retained earnings dNRERERE =+= 101 (18) Let , and . This leaves the two unknowns, LTD cNIbStock == 00 , eEQLTD =11 / 1 and NI1, in two equations: (19) The constants a, b, c, d, and e are known quantities programmed into the spreadsheet and its underlying logic in Tables 3 and 4. The model works as can be noted in Table 3 by the facts that the balance sheets balance, and the ending cash in the cash flow statements matches the cash account in the balance sheets. There is one problem however. New Issue, NI1, may be positive or negative, as needs be in order to balance the balance sheets. Looking at Table 5, Period 5, this problem is apparent. Using widely varying growth rates and LTD/EQ ratios in this example, the initial stock value can be forced to a negative 46.46 in line 36, an impossible value. But, this problem can be solved using the constraint structure of linear programming. A More Realistic Solution Beginning again, the net assets equation has to hold: 11 00111 RENI NIStockLTDCLTAa ++ ++=−= which is to say that dcbaNILTD −−−=+ 11 (20) but the LTD/EQ ratio is now an inequality eEQLTD ≤11 / Using equations (18) and (19) equation (21) can be rewritten as ))(())(( 11 dcbeNIeLTD ++≤− (21) Likewise cbNIStockStock +=+= 001 (22) Yet the Stock1 +NI1 at period 1 must be 0, as already noted, so ≤ 011 ≥+ NIStock (23) 57 Developments In Business Simulation & Experiential Exercises, Volume 23, 1996 However, as already noted, NI may be positive or negative, and linear programming solutions require all non-negative values of the variables (Dantzig, 1 963). Therefore, NI1 must be restated as the difference of two positive variables, NI1 = NI11 - Nl21 which means using equation (23) that 021 021 11 111 ≥−++ ≥−+ NINIcb MINIStock or cbNINI +≤− 11 12 (24) Finally, the outcome looks like this: )(21 2 111 111 dcbeeNIeNILTD dcbaNINILTD ++≤+− −−−=−+ cbStock +=1 cbNI +≤+ 2NI− 111 (25) with all variables non-negative, and the objective function is the minimization of the slack variables, S1 and S2, necessary to transform the second and fourth equations in system (25) from inequalities to equalities. SUMMARY Tests of system (25) indicate that it works perfectly, eliminating negative stock values. More important, this is only one of an infinite number of solutions to cash flow problems. The particular situation--mergers, downsizing, compensation packages, and so forth--may all be analyzed using the types of procedures described in this paper. The trouble is that students are not made aware very often of these possibilities. They enter the capstone policy course still thinking that cash flow analyses are a mysterious subject rather than a routine consequence of accounting definitions. For TE simulation users, this presents a difficult problem that must be solved early in the semester in order to enhance the simulation experience. But, as noted above, there is no reason for this problem.. REFERENCES Colley, J. L., Jr. (1984) Corporate and divisional planning: Text and cases. Reston, VA: Reston Publishing. Dantzig, G. B. (1963) Linear programming and extensions. Princeton, NJ: Princeton University Press. TABLE 1 STANDARD INCOME STATEMENT SYMBOLS Revenue REV Cost of Sales COS Gross Margin GM Expenses Marketing MK Research & Development RD Interest IN Depreciation DP Profit Before Taxes PBT Taxes TX Profit After Taxes PAT TABLE 2 STANDARD FINANCIAL STATEMENTS* Previous Period Current Period BALANCE SHEETS Cash 25 30 A/R 25 90 Inventories 75 90 Current Assets 175 210 Net fixed Assets 200 240 Other Assets 25 30 Total Assets 400 480 A/P 50 60 Accrued Taxes 50 60 Current Liabilities 100 120 Long Term Debt 150 180 Equity 150 180 Total liabilities + OE 400 480 INCOME STATEMENTS Sales 500 600 Cost of Good Sold 400 480 Gross Margin 100 120 G & A Expense 20 24 Interest Expense 20 24 Profit Before Taxes 60 72 Profit After Taxes 30 36 *Source: Colley (1984) 58 Developments In Business Simulation & Experiential Exercises, Volume 23, 1996 59 Developments In Business Simulation & Experiential Exercises, Volume 23, 1996 60 Table of Contents Volume 23, 1996 Modeling Advertising Effectiveness Simulation as an Aid to Learning: How Does Participation Influence the Process? Administering Business Simulations in Transitioning Economies: The Introduction of Simulation Gaming to Estonia Business Simulation Games: Current Usage Levels. A Ten Year Update The Relationship Between Interpersonal and Task Cohesiveness and Performance in a Business Simulation Game The Design of an ITS-Based Simulation: A New Epistemology for Learning Correlates of Learning in Simulations How Do We Know where we're going if we don't know where we have been: A Review of Business Simulation Research Making Cash Flow Come Alive and Sensible in the Classroom Enhancing Simulation Learning through Objectives and Decision Support Systems An Analysis of Deliberate and Emergent Strategies Relative to Porter's Generic Differentiator and Cost Leader: A Bias and Variance Modeling Approach Introducing Ethical Dilemmas into Computer-Based Simulation Exercises to Teach Business Ethics CEO Strategic Locus of Control Effects on Game Performance and Playing Behavior The Relational Database As a Link between Operations and Cost Accounting Goal Setting over Time in Simulations Computerized Business Simulations: A Workshop Exploring the Tutor's Role, Task & Needs Strategic Analysis of the Product Portfolio with the COMPLETE PPA Package: A Strategic Market Planning Tool Draft Standards and Registration Procedure for Assessment Instruments Perspectives on a New Generation of Business Games An Economic Multiple Regression Case In Experiential Learning Changing Institutional Norms and Behavior, Not Culture: Experiential Learning Comes to Myanmar Strategic Management and the Case Method: Survey and Evaluation Individual Differences in Internet Attitude and Use Long Live the Plan - or Should It? Examining the Impact of Detailed Strategic Plans on Organizational Performance Do Your Students Really Read the Manual? A Computerized Contextual Tool As A Surrogate for the Traditional Student Manual Pilot Analyses of Self-Peer Evaluations in an Experiential-Exercise Human Resources Management Course Leader Behavior Feedback: A Learning Exercise Dilemma-Dilemma: An Exercise for Teaching Significance Of Communication Computer Mediated Conferencing: Technology and Classroom Learning Multimedia in the Workplace: Who is really using it and where is it Headed? Using Experiential Exercises for Collecting Research Data: Integrating Teaching and Research Interactive Distance Learning as a Tool in a College's Theory and Practice The President's Decision: An Experiential Exercise in Decision Making Integrating Computer Literacy Skills in the Undergraduate Curriculum: The Advanced Accounting Experiment Imperatives for the Transfer of Experience-Based Training Deciding How to Decide The Internet as a Pedagogical Tool Internet Scavenger Hunt Two Management Exercises Based on Committee Work Multimedia in the Year 2000: How Will It Affect Our Lives? Bootstrap Benefit Segmentation: Finally A Way to Teach Benefit Segmentation without Primary Data or Those Fancy Statistical Methods Multimedia and Learning: Is There A Connection? A Changing Business Policy Collaborative Learning Through Real-Life Assignments in Accounting Classes The Necessity Of Incorporating Local Cultural Aspects Into International Business Experiential Exercises Utilizing Cultural and International Landmark Constructs to Assess Business Student's International Awareness Legal Issues related to the Use of Application Blanks: An Experiential Exercise The Family in the Classroom: An Experiential Exercise for Teaching Issues Related To Expatriate Assignments Using Internet Resources to Enhance Teaching of Information Systems Courses: A Demonstration Proposal Chalkboards to Chipboards for Teachers and Consultants How Do We Measure The Learning In Experiential Learning and How Do We Best Simulate It?