Three Statement Model – Balancing the Balance Sheet
November 6, 2020
Introduction
Everyone who has learned to model knows that modeling a company has many pitfalls and difficulties. One of the first difficulties, usually, is how to get the forecast balance sheet to balance. It’s a great feeling once you do get the model to balance though!
Key Learning Points
- A three statement model allows for forecasts and predictions to be made of a company’s financial data
- The accounting equation states assets equals liabilities plus equity (A = L + E) and this must always be true
- When forecasting, cash is used as a plug for the balance sheet and is calculated from data in the cash flow statement
- A cash flow statement presents the changes in cash balances for two periods and must capture the changes for every item in the balance sheet
How to Balance the Balance Sheet?
Now you will be glad to hear that achieving that feeling is a lot easier than you might think. Let’s have a look at how it’s done. Let’s first assume we have a historical balance sheet (which by necessity will balance) and you have forecasted the entire first-year balance sheet (the forecast balance sheet), except for the cash balance. This should be standard practice when modeling a normal corporate (i.e. not a financial company).
Let’s observe some of the key facts at this point:
- When forecasting a corporate we use cash as a plug for the balance sheet.
- The forecast cash flow statement explains this plug number, capturing all the changes in all assets, liabilities, and equity and applies the rules of cash (asset up, cash down, liability up, cash up, etc.).
Conclusion?
So, in building our cash flow statement, we must make sure that the change in every single balance sheet item is captured. It’s that simple!
If you have a very de-aggregated balance sheet with lots of headings, it easy to forget an item or make mistakes.
Our advice
- Tick off every balance sheet item as you link it into the cash flow statement. Many an analyst has ignored this tip over the years and paid dearly for it.
- Pay extra attention to balance sheet items that affect more than one item in the cash flow statement. For example, PP&E will move up with capex (captured in investing cash flows) and down with depreciation (a non-cash item, added back to net income to arrive at operating cash flow). Other items with similar characteristics are retained earnings and non-goodwill intangibles. Build a BASE analysis (Beginning, Additions, Subtractions, Ending) for these items.
- Before you hit enter in your cash flow formulas, engage your brain and make sure you intuitively know what to expect (asset up, cash down, etc.).
- Do not use a published historical cash flow statement as your starting point for your cash flow statement. Your forecast cash flow statement should be constructed based on the headings in your balance sheet.
Follow these simple steps and you will have a balancing forecast balance sheet and, thanks to the dynamics of the cash flow statement, the model will keep balancing as you change assumptions! Just remember, making the model balance is just one of many challenges in modeling, and just because a model balances it may NOT be error-free!
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