Every sensible financial model projects the results of all three major financial statements - the profit & loss, balance sheet, and statement of cash flow. The balance sheet, not the profit and loss, is what drives the cash flow of the business. If the balance sheet is not correctly modelled, then the cash flow forecast is most likely inaccurate and worthless. Yet the balance sheet is the part of the model that is usually the most neglected and least understood.
In order to help get the balance sheet forecasting correct, we have identified three common mistakes that entrepreneurs, CEOs, business owners, and even business financial consultants make: NO balance sheet projections, failure to correlate operating activities on the P&L to changes in the operating assets and liabilities on the balance sheet, and disregard for the debt and equity transactions of the firm.
BALANCE SHEET IS MIA
The most common mistake made is the exclusion of a balance sheet forecast from the financial model. The balance sheet represents the most complex transactions of the company and may be left out of the model because the company lacks the expertise of a CFO or financial executive to assemble this critical part of the model.
CORRELATION OF OPERATING ACTIVITIES AND OPERATING ASSETS AND LIABILITIES
The major operating assets include accounts receivable, inventory, pre-paid items, and more. The major operating liabilities include accounts payable, taxes payable, and other accrued expenses. When sales go up, accounts receivables go up, and cas goes down. But does the model capture that? If sales go up, can we expect our inventory level to stay the same? Most likely it will need to increase. The increments of these changes are dependent upon the relationship between our days sales outstanding and our inventory turnover.
As sales increase, our accounts payable usually increase as well. The timing of our payments against our accounts payable is a major outflow in the cash flow puzzle that is called working capital. We need to define the relationship that payables have with our operating activities and implement this relationship in our balance sheet model.
There are several other operating assets and liabilities that dramatically impact cash flow. We will avoid all of the details of each, but it is fair to say that without properly forecasting them, our cash flow forecast will never be accurate.
DEBT & EQUITY TRANSACTIONS
Are we bringing in any more equity investments during the period we are modelling? What is our dividend policy for shareholders? Is some or all of the active shareholders compensation coming through equity? All of these items can have a significant impact on cash flow, although none of them show up on the P&L.
In addition to equity transactions, the structure of all of the company's debts and obligations need to be correctly reflected on the balance sheet. An interest only line of credit will keep the same balance until more is withdrawn or some is paid back based on the cash flow of the firm. Term loans need to show the correct amount of principal being reduced every month.
Obviously these items can seriously change our cash flow, and they need to be included in the financial model so we can correctly forecast our cash flow.
This list of common mistakes is certainly not comprehensive (you'll notice we did not address capital expenditures at all), but should create a positive foundation to build the balance sheet model. Accurately modeled balance sheets help businesses get a handle on their companies, make the best strategic decisions possible, raise necessary capital, and perhaps most importantly, track their progress so they can correct problem areas and make more valid assumptions in the future.