3 common mistakes when modeling your balance sheet

Every sensible financial model projects the results of the three main financial statements: profit and loss, the balance sheet, and the cash flow statement. The balance sheet, not profit and loss, is what drives the company’s cash flow. If not modeled correctly, the cash flow forecast is most likely inaccurate and worthless. However, it is the part of the model that is usually the most forgotten and least understood.

In order to help make the balance sheet forecast correct, we have identified three common mistakes that entrepreneurs, CEOs, business owners, and even commercial financial consultants make: NO balance sheet projections, failure to correlate operating activities in profit and loss with changes in operations. assets and liabilities, and disregard for the company’s debt and equity transactions.

BALANCE SHEET IS MIA The most common mistake made is the exclusion of a balance forecast from the financial model. The balance sheet represents the most complex transactions in the business and may be left out of the model because the business lacks the expertise to properly address and assemble this critical part of the model.

CORRELATION OF OPERATING ACTIVITIES AND OPERATING ASSETS AND LIABILITIES Top operating assets include accounts receivable, inventory, prepaid items, and more. The main operating liabilities include accounts payable, taxes payable and other accrued expenses. When sales increase, accounts receivable increase. But does the model capture that? If sales increase, can we expect our inventory level to stay the same? Most likely it will need to increase. The increments of these changes depend on the relationship between our daily pending sales and our inventory turnover.

As sales increase, our accounts payable generally increase as well. The timing of our payments against our accounts payable is an important exit in the cash flow puzzle called working capital. We need to define the relationship that accounts payable have with our operating activities and implement this relationship in our model.

There are several other operating assets and liabilities that dramatically impact cash flow. We will avoid all the details of each, but it is fair to say that without proper forecasting, our cash flow forecast will never be accurate.

DEBT AND EQUITY OPERATIONS Are we bringing in more capital investments during the period we are modeling? What is our dividend policy for shareholders? Does part or all of active shareholder compensation come from share capital? All of these items can have a significant impact on cash flow, although none of them appear in profit or loss.

In addition to capital transactions, the structure of all debts and obligations of the company must be correctly reflected in the model. An interest-only line of credit will keep the same balance until more is withdrawn or part is repaid based on the company’s cash flow. Term loans must show the correct amount of principal that is being reduced each month.

Obviously, these elements can seriously change our cash flow and must be included in the financial model so that we can correctly forecast our cash flow.

CONCLUSION This list of common mistakes is certainly not exhaustive (you’ll notice that we don’t address capital expenditures at all), but it should create a positive foundation for building the balance sheet model. Companies that have complete financial models have better management of their companies, make the best possible strategic decisions, obtain the necessary capital and, perhaps most importantly, track their progress so that they can correct problem areas and make more valid assumptions in the future. Business finance consultants and other similar professionals agree that balance sheet modeling is one of the most critical financial functions in the entire company.