In a finance and investment banking interview, candidates will almost certainly be asked questions that test their understanding of the relationship between the balance sheet income statement, and cash flow statement. The reason is that on-the-job modeling is heavily predicated on a deep understanding of this relationship.
In our self study programs and live seminars, we spend a lot of time talking about how to build DCF, Comps, M&A, LBO, and Restructuring Models effectively in Excel. We spend a lot of time making sure that our trainees understand the inter-relationship of the balance sheet, income statement, and cash flow statement because it is so vital to properly understanding these models.
Accordingly, we decided to list some basic best practices for projecting balance sheet line items below. As a warning, what you’ll read below is inevitably a simplification but we hope that it is a helpful one for many of you. For complete training on this program, please enroll in our self study program or a live seminar.
2017 Update: Click here for the new Balance Sheet Projections Guide
Imagine that you are tasked with building a financial statement model for Wal-Mart. Based on analyst research and management guidance, you have projected the company’s revenues, operating expenses, interest expense and taxes – all the way down to the company’s net income. Now it is time to turn to the balance sheet. Now unless you have a thesis about a company’s accounts receivable (often you will not), the default assumption should be to link receivables to your revenue growth assumptions. In other words, if revenues are expected to grow 10% next quarter, so should receivables UNLESS you have a thesis to the contrary. Effective modeling is all about building in default assumptions, and incorporating features that enable modelers to sensitize away from those default assumptions. Below is a list of balance sheet line items, along with guidance on how they should be projected. Enjoy!
Assets
Accounts receivable (AR)
- Grow with credit sales (net revenues)
- Using an IF statement, model should enable users to override with days sales outstanding (DSO) projection, where days sales outstanding (DSO) = (AR / Credit Sales) x days in period
Inventories
- Grow with cost of goods sold (COGS)
- Override with inventory turnover (Inventory turnover = COGS / Average inventory)
Prepaid expenses
- Grow with SG&A (may include COGS if the prepaids are cycled through COGS)
Other Current Assets
- Grow with revenues (presumably these are tied to operations and grow as the business grows)
- If reason to believe that they are not tied to operations, straight-line projections
PP&E
- PP&E – beginning of period (BOP)
- + Capital expenditures (grow historicals with sales or use analyst guidance)
- – Depreciation (function of depreciable PP&E BOP divided by useful life)
- – Assets sales (use historical sales as guide)
- PP&E – end of period (EOP)
Intangibles
- Intangibles – BOP
- + Purchases (grow historicals with sales or use analyst guidance)
- – Amortization (amortizable intangibles BOP divided by useful life)
- Intangibles – EOP
Other non-current assets
- Straight-line (unlike current assets, lower likelihood these assets are tied to operations – could be investment assets, pension assets, etc.)
Liabilities
Accounts payable
- Grow with COGS
- Override with payables payment period assumption
Accrued Expenses
- Grow with SG&A (may also include COGS depending on what is actually accrued)
Taxes Payable
- Grow with the growth rate in tax expense on income statement
Taxes Payable
- Grow with the growth rate in tax expense on income statement
Other current liabilities
- Grow with revenues
- If reason to believe that they are not tied to operations, straight-line projections
How do you recommend forecasting deferred tax assets and income tax recoverable?
Samantha:
I would probably forecast them to change with income taxes on the income statement.
Best,
Jeff
Can you demonstrate the appropriate debit/credit for a restructuring expense / charge on the income statement and how to account for it in the future on the cash flow statement and balance sheet? A part of me assumes it deals with making the following adjustment entry: Beg. Retained Earnings +… Read more »
Jay:
If this is a cash restructuring expense then debit restructuring expense, credit cash. Otherwise, credit some liability account.
Best,
Jeff
Straight lining means assuming the same for the forecast? So if its 5 in 2019 its 5 in 2029? Or do i grow with CPI
Liam:
Straight-lining means keeping the same number throughout your forecast period, so in your question the projection would be 5.
Best,
Jeff
How about items like provisions, employee benefit obligations, current tax liability and deferred income tax
Francis:
Forecasting any additional provisions or pensions is extremely difficult (much of it due to the underlying accounting) so we typically recommend straight-lining these items. Any tax liability of deferred tax you can usually assume will grow with taxes on the income statement.
Best,
Jeff
when you say “Straight line” what do you mean exactly?
Fabrice:
Straight-lining is keeping the last actual data the same across the forecast period.
Best,
Jeff
what happens if i want to do this but not on an annual but instead a monthly basis? and then aggregate my monthly forecast numbers to annual?
You can still do the same analysis and model structure regardless of whether it’s a monthly model or an annual model. For any “days in period” calculation you would use days in the respective month, but can still set up your model the same way.
Best,
Jeff
Thank you for the immediate reply Jeff! still, i have an issue forecasting working capital items when the number of days e.g. receivable or inventory or payable days are more than the no of days in periods. let’s say i have the monthly model but the inventory days are 76.… Read more »
I would probably forecast inventory and A/P to grow with COGS, as opposed to forecasting them using a “days” metric.
Best,
Jeff