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Each sensible financial model projects the results of the three main financial statements: the profit and loss account, the balance sheet and the cash flow statement. The balance sheet, not the profit and loss, is what drives the cash flow of the business. If not modeled correctly, the cash flow forecast will most likely be inaccurate and worthless. However, it is the part of the model that is often the most neglected and least understood.
To help get the balance sheet forecast right, we’ve identified three common mistakes entrepreneurs, CEOs, business owners, and even business financial consultants make: NOT making balance sheet projections, not correlating operating activities in the P&L with changes in operating state. assets and liabilities, and disregard for the company’s debt and equity transactions.
THE BALANCE IS MINE The most common mistake made is the exclusion of a balance sheet forecast from the financial model. The balance sheet represents the company’s most complex transactions and may be left out of the model because the company lacks the expertise to properly address and assemble this critical part of the model.
CORRELATION OF OPERATING ACTIVITIES AND OPERATING ASSETS AND LIABILITIES Major operating assets include accounts receivable, inventory, prepaid items, and more. Major operating liabilities include accounts payable, taxes payable and other accrued expenses. When sales increase, accounts receivable increase. But does the model capture that? If sales increase, can we expect our inventory level to stay the same? Most likely you will have to increase. The increments of these changes depend on the relationship between our days of sales outstanding and our inventory turns.
As sales increase, our accounts payable tend to increase as well. The timing of our payments against our accounts payable is an important output in the cash flow puzzle called working capital. We need to define the relationship that accounts payable has to our operating activities and implement this relationship in our model.
There are several other operating assets and liabilities that dramatically impact cash flow. We’ll avoid all the details of each, but it’s fair to say that without forecasting them properly, our cash flow forecast will never be accurate.
DEBT AND EQUITY TRANSACTIONS Are we incorporating more capital investments during the period we are modeling? What is our dividend policy for shareholders? Does some or all of the compensation of active shareholders come from shares? All of these items can have a significant impact on cash flow, although none of them appear in the P&L.
In addition to capital transactions, the structure of all debts and obligations of the company must be correctly reflected in the model. An interest-only line of credit will keep the same balance until more is withdrawn or something is paid off based on the business’s cash flow. Term loans must show the correct amount of principal that is reduced each month.
Obviously, these items can seriously change our cash flow and must be included in the financial model so that we can correctly forecast our cash flow.
CONCLUSION This list of common mistakes is certainly not exhaustive (you’ll notice we don’t address capital expenditures at all), but it should create a positive foundation for building your balance sheet model. Companies that have complete financial models run their businesses better, make the best possible strategic decisions, raise the necessary capital, and, perhaps most importantly, track their progress so they can correct problem areas and make more valid assumptions in the future. future. Business finance consultants and other professionals alike agree that balance sheet modeling is one of the most critical financial functions in the entire enterprise.