Forecasting Balance Sheet Items in a Financial Model

How to Forecast Balance Sheet Items in a Financial Model?

Forecasting financial balance sheets are a must for any management team as it helps determine how the company will perform in the future.

To establish solutions for overcoming future obstacles, prospective analysis for the long term is of the highest importance. Therefore, it is critical for the majority of businesses to have a financial model that enables management to oversee value development.

Management can implement management based on value by creating cash flows from the balance sheets and having a permanent appraisal of the business's worth.

It is helpful to assess in advance and foresee the economic impact of a decision using a consistent financial model. Sensitivity analysis, scenario analysis, and simulation can all be used to accomplish this.

Financial models are flexible tools that may be used for various tasks, such as when we want to raise money for a start-up business or a new initiative within an existing company.

Understanding the balance sheet

In the financial forecasting model, the balance sheet forecast comes after the income statement and cash flow estimates. A predicted statement of projection and assumptions for the future of the business is the result of integrating those three phases.

The Balance Sheet is a list of the company's current assets and rights, debts, and other short- and long-term obligations with third parties (Liabilities), and the difference between the two, or what belongs to the owners, known as Equity.

Equity = Total Assets - Total Liabilities

It is comparable to a momentary snapshot of the company. The list of the firm's assets appears in the Balance Sheet's first section.

The financing of the assets is shown in the second section, which includes the liabilities (debt and any other obligations the company has) and owner's Equity.

The balance sheet forecast is an attempt to project what the financial situation of a business will be in the future under a specific set of circumstances since the balance sheet shows a corporation's financial status at a particular point in time.

The Double Entry Principle alerts the model builder when a component is missing, or a mistake has been made, indicating that the balance sheet does not match. Traditionally, the plug has been used to alleviate this issue.

The financial statements should be closed and matched using a plug on corporate finance, forecasting, and budgeting.

A plug is a formula that adjusts the Balance Sheet to accommodate variances in some items mentioned while maintaining the accounting equation.

A plug, in other terms, is something that ensures that assets equal total liabilities plus Equity. The pin is a financial asset like cash, debt, or common stock.

Total Assets = Total Liabilities + Equity

Importance of Forecasting Balance Sheet Items

Leaders utilize financial predictions as a road map to help them negotiate the ambiguity of their specific circumstances.

The plans implemented to react to anticipated market conditions and company drivers are developed using these forecasts.

The balance sheet projection is a crucial accounting technique that may be used to calculate the impact of expected cash flows and income statement line items on the company's future financial situation.

Balance sheet forecasting offers business leaders the financial information they need to make wise decisions, together with income and cash flow statements. But, first, let's examine in detail the three BS components described in the previous equation:

1. Assets
Assets are any things that a firm has that have a monetary value. Depending on their liquidity, assets are further divided into current and non-current categories. 

• Current assets: the things that your company has accumulated through time as existing assets are those that will be consumed or turned into cash within a year or a business cycle of the date on the BS. Examples: cash on hand, accounts receivable, and inventory.

• Non-current assets: in contrast, don't have a lot of liquidity. Additionally, they cannot be exchanged for cash within the following year, such as warehousing. Examples: supplies, real estate, land, long-term investments, equities, and bonds.

2. Liabilities

Does the business owe the debts to its creditors? Obligations have current liabilities and non-current liabilities, just like assets do.

The commitments that the business must meet in the upcoming year are known as current liabilities. In comparison, long-term debt is non-current liabilities, such as loans the corporation takes.

3. Equity

Equity is known as owner's Equity if you are the single proprietor of your company. It's also known as stakeholder's Equity if your company is a corporation.

Equity is what remains after deducting all liabilities from your company's assets.

Paid-in capital and retained earnings make up Equity:

• Paid-in capital: the sum each shareholder initially paid for their shares of stock. 
• Retained earnings: are the funds that your company didn't distribute to shareholders but instead invested back into itself.

Your net working capital is made visible to you by these essential line items. Additionally, fundamental overviews of financial modeling will advise you to project the line items.

• Using your income statement forecast, excluding depreciation and interest costs
• Leaving retained earnings out of the balance sheet planning
• Utilizing insights from the balance sheet to complete the income statement's depreciation, interest, and taxes

As you construct your financial model, it's crucial to keep the balance sheet prediction in mind. Every model assumption you make will impact the balance sheet, and all of those implications come down to one blatant fact.

What are the uses of Forecasting Balance Sheet (FBS)

FBS is important for several reasons, as we have already explained. First, they stand for important financial data that is utilized during business transactions.

Here are some implementations for BS.

1. To facilitate tax preparation

Maintaining correct business records for tax preparation and planning is critical. To complete accurate tax returns, the IRS advises small business owners to keep organized and current financial records.

Your auditor or tax preparer will be able to appropriately prepare your returns and ensure you aren't paying more taxes than necessary if your financial accounts are in order.

In the case of an IRS audit, you will be expected to provide a complete set of financial documents for inspection, including financial statements and receipts.

2. Making long-term business decisions:

By monitoring your company's finances, you can spot possible problems before they grow into larger ones. Most small businesses fail due to cash flow issues that can be detected early and resolved with accurate and current balance sheets.

Small business founders frequently undervalue the value of budgeting, overspend on beginning expenditures, and put off applying for finance for too long.

These typical financial issues can be avoided by developing a solid business strategy and using financial statements to inform business choices.

3. To avoid potential issues

Making a profit is a business's primary objective. Therefore, a well-run company should display rising Equity. If your company isn't accomplishing that, you can determine why by looking at particular assets and liabilities on your balance sheet.

For instance, if most of your assets are stock, it may add needless risk. Unsold inventory can quickly turn into a huge liability.

4. Health of investors and loans

Looking at your balance sheet, people can easily comprehend your company's financial situation. FBS assesses a business's economic health and creditworthiness; most lenders demand a balance sheet.

Your financial accounts might show lenders that you will pay your bills on time if you seek a loan. In addition, balance sheets are used by potential investors to determine where their money will go and when they may expect to receive a return.

5. To determine return and risk

Your company's assets and liabilities are listed on a balance sheet. Therefore, your capacity to create cash and maintain operations is reflected in your current and long-term assets.

Your short and long-term debts prioritize your financial commitments. Therefore, you should ideally have a positive net worth, which is indicated by having more assets than liabilities.

If your company's current liabilities are more than its cash position, lenders or investors will probably be needed to provide additional working capital. Additionally, an unsustainable level of debt can be shown on a balance sheet.

How to evaluate your company against another

You must evaluate your circumstances by utilizing those elements to determine whether you are on the proper path to your goal or not to know exactly what your strengths and weaknesses are compared to your competition.

1. Ratio Analysis

In Ratio analysis, you establish the relationship between two or more combinations by using the quantitative analysis technique to represent a numerical ratio of one number to the other or as a percentage of one to the other. 

This technique will utilize a BS or only one of the income and cash flow statements. This will assist you in FBS in assessing your productivity, profitability, solvency, and business operations.

2. Common Size Statement

It makes it easier to compare two or more companies or two or more times in a company's history so you can predict the next. In this, the percentages of assets and liabilities can be seen.

Common-size statements play a crucial role in the tools and techniques of financial statement analysis utilizing a balance sheet to help you forecast the balance sheet to assure you are always one step ahead.

3. Cash Flow Statement Analysis

It provides instructions on completing various Profit and Loss Accounts and FBS components. In addition, it enumerates the factors that contributed to changes in a corporate entity's cash position between the dates of the two balance sheets.

The pros and cons of balance sheet

A balance sheet is a step of a financial model that will assist you in understanding your company's status and what you can expect from it, but everything has its challenges, so you should be aware of how to prevent them.

The Pros are:

1. The balance sheet's most crucial feature is that it adds up the obligations and Equity to reveal the exact value of your assets and assists you in identifying the problem's source to fix it.
2. By employing the equations of financial ratio approaches, investors, lenders, and regulators can learn how they compare to their rivals, where they need to develop, and how to spot any financial issues like liquidity shortages.
3. Because the balance sheet reflects your creditworthiness, the stability of your business status, and your plans, it will allow companies or small enterprises to acquire loans or investments because it will provide the lender's confidence. Consequently, you must constantly update your balance sheet to avoid loan rejection.

The Cons are:

1. Using plugs on BS will create a challenge for forecasting financial statements because it always indicates that the balance sheet is balanced or matched, making it difficult to see errors if the analyst makes them. As a result, one of double-entry accounting's key benefits is gone.
2. Because the Balance Sheet determines the value of long-term assets by book value, it limits the measure of long-term investments' importance. This means that BS didn't determine the value of the assets by the primary time and only provided you with the historical significance of the assets at the time of purchase. Thus, BS does not reflect the increase or decrease in the value of your help.
3. The balance sheet represents only the monetary assets, excluding every other type of asset that will affect the value of your holdings in indirect ways. Such as powerful machinery that will help retain a lot of different data that your analysts can retrieve to help them analyze many possibilities that will affect decision making.

Conclusion

The balance sheet is only one of numerous financial statements that investors and businesses alike can use to assess a company's financial situation.

When used in conjunction with other financial statements, you can gain even more understanding if you wish to examine its balance sheet, cash flow statement, and income statement.

You will then have access to all the data and knowledge required to make an informed decision.

A company's financial health can be more accurately depicted by the sum of the three financial statements than by each one alone.

Forecasting the balance sheet is an easy task if done carefully and utilizing the methods to reduce the likelihood of unintended errors.

A projected balance sheet is a beneficial tool since investors frequently want to know how much cash or debt will accumulate over the anticipated period.

The balance sheet will demonstrate your creditworthiness and facilitate lending decisions.

Researched and authored by Ranad Rashwan | LinkedIn