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Chapter 6_ Balance Sheet Projections

Chapter 6_ Balance Sheet Projections

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16 views

Chapter 6_ Balance Sheet Projections

Chapter 6_ Balance Sheet Projections

Uploaded by

Elaa Yaakoubi
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Chapter 6: Balance Sheet Projections

1. Overview:

In financial modeling, projecting the balance sheet is a critical component that helps estimate a company's
future financial position. This process relies heavily on linking the balance sheet to the cash flow statement,
ensuring that all projections are internally consistent.

Key Concept:

● The balance sheet must remain balanced at all times: Assets−Liabilities=Shareholders’ Equity
● Imbalances are common in financial models but can be corrected through a structured projection
process.

2. Two Approaches to Modeling Balance Sheets:

1. Balance Sheet Drives Cash Flow Statement:


○ Year-over-year changes in the balance sheet determine the cash flow statement.
○ Problem: This method can obscure the exact sources of cash flow changes, potentially leading
to inaccuracies.
2. Cash Flow Statement Drives Balance Sheet (Preferred):
○ The balance sheet is derived from cash inflows and outflows recorded in the cash flow
statement.
○ Advantage: This approach provides a clearer picture of cash movements, reducing errors and
simplifying the projection process.

3. Example – Property, Plant & Equipment (PP&E):

Scenario: PP&E increases by $1,000.

● Question: How much of this change is CAPEX (capital expenditure) and how much is depreciation?
● Possible Scenarios:
○ CAPEX = $1,000, Depreciation = $0
○ CAPEX = $1,500, Depreciation = $500
○ New Assets = $2,000, Asset Write-Down = $500

By relying on the cash flow statement, analysts can directly see the breakdown between CAPEX and
depreciation, ensuring accuracy in balance sheet projections.

4. Keeping the Balance Sheet Balanced:

Why It’s Important:

● Imbalances in the balance sheet can lead to errors in valuation, misleading stakeholders or investors.
● Analysts can spend hours reconciling discrepancies, but with the right process, this can be avoided.

Key Formula:

Assets−Liabilities=Shareholders’ Equity

Common Challenges:

● Projecting Each Line Item: Every asset, liability, and equity item must align with changes in the cash
flow statement.
● Error-Checking: The process must ensure that every cash movement is accounted for without
duplication.

5. Linking Cash Flow to Balance Sheet Projections:

● Cash Spending: Results in higher assets (except cash) or lower liabilities/equity.


● Cash Receipts: Results in lower assets (except cash) or higher liabilities/equity.

Two Essential Questions for Projections:

1. Which cash flow item affects this balance sheet item?


2. Does the cash flow increase or decrease the balance sheet item?

6. Asset Projections – Examples and Formulas:

1. Cash Projection:

● Formula: 2021 Cash=2020 Cash+Change in Cash (CF Statement)2021


● Example:
○ 2020 Cash: $1,000
○ Cash Flow Change: +$500
○ 2021 Cash: $1,500

2. Inventory Projection:

● Formula: 2021 Inventory=2020 Inventory−Change in Inventory (CF Statement)2021


● Example:
○ 2020 Inventory: $1,500
○ 2021 Inventory Change: -$250
○ Projected 2021 Inventory: $1,750

3. Accounts Receivable (A/R):

● Formula: 2021 A/R=2020 A/R−Change in A/R (CF Statement)2021


● Example:
○ 2020 A/R: $1,000
○ 2021 Change: +$250 (collections)
○ Projected 2021 A/R: $750

7. Liabilities and Equity Projections:

1. Accounts Payable (A/P):

● Formula: 2021 A/P=2020 A/P+Change in A/P (CF Statement)2021

2. Accrued Expenses:

● Formula: 2021 Accrued Exp.=2020 Accrued Exp.+Change in Accrued Exp.2021

3. Retained Earnings:

● Formula: 2021 R/E=2020 R/E+Net Income+Stock-Based Compensation2021

8. Formula Consistency:

● Assets (except cash): 2021 Asset=2020 Asset−Related Cash Flow Item2021


● Cash: 2021 Cash=2020 Cash+Total Change in Cash2021
● Liabilities and Equity: 2021 Liabilities/Equity=2020 Liabilities/Equity+Related Cash Flow Item2021

9. Common Errors and Fixes:

1. Missing Links:
○ A cash flow item is not linked to the balance sheet.
2. Duplicate Links:
○ A cash flow item is linked to multiple balance sheet items.
3. Wrong Direction:
○ An asset or liability is increasing when it should decrease (or vice versa).
4. Calculation Errors:
○ Totals are miscalculated, creating discrepancies.

10. Error Checking (NYSF Method):

1. Create a Differences Column:


○ Subtract 2020 from 2021 for each line item.
2. Match to Cash Flow Statement:
○ Ensure each balance sheet difference aligns with a cash flow item.
3. Check for Duplicates or Omissions:
○ Cash flow items should only link once.

By following this structured process, you’ll ensure your balance sheet projections are accurate, consistent, and
error-free.

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