Balance Sheet Forecasting

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During my summer internship at J.P. Morgan, we spent a lot of time focusing the on the balance sheet and the relationship with the interest income, liabilities and our risk-weighted assets. Granted, looking at a balance sheet for a bank is entirely different from a regular corporation. However, most students interested in pursuing a role in the financial sector will almost certainly be asked questions that test their understanding of the relationship between the balance sheet, income statement, and the cash flow statement.

The reason why we are spending a lot of time on the 3-statement-model for our Financial Modeling Workshop is because understanding the balance sheet, income statement and cash flow statement is a vital part of properly building a model for a company.

Unless you are an expert in the industry (which most of us aren’t), you will not have a thesis on how quickly any of the items on the balance sheet are growing (or not growing). However, effective modeling is all about building in default assumptions and features that allows modelers to deviate away from the default assumptions if they wanted to.

For forecasting the balance:

Assets

Accounts receivable (AR)

  • Grow with revenue
  • Driver should be Accounts Receivable as a percentage of Revenue ( AR / Revenue ) or based on the revenue growth rate
  • Days sales outstanding (DSO) should also be used as a projection ( DSO = AR / Revenue * 365 )
  • Ideally, the shorter the days sales outstanding, the quicker a company can collect on its accounts receivable

Inventories

  • Grow with cost of goods sold (COGS)
  • Driver should be inventory as a percentage of cost of goods sold ( Inventory / COGS ) or based on the growth in cost of goods sold.
  • Inventory turnover ( COGS / Average Inventory ) should also be used as a projection

Prepaid expenses

  • Grow with Sales, General, and Administrative (SG&A)
  • May also grow with cost of goods sold, depending on how the expenses are structured

Other Current Assets

  • Grow with revenue if you believe these assets are tied to the operations of the business
  • Straight-line if you believe there is no clear driver.

Property, Plant and Equipment

  • Done by forecasting depreciation as a percentage of capital expenditures ( Depreciation / CapEx ) and capital expenditures as a percentage of revenue ( CapEx / Revenue ).
  • Depreciation can also be used as a function of equipment’s useful life ( PP&E / average useful life of equipment)

Intangible Assets and Goodwill

  • Goodwill as an infinite useful life. As such, we do not forecast any impairments. In the same token, we don’t forecast any acquisitions either.
  • Grow purchases of intangible assets with revenue (or use analyst guidance)
  • Amortization (like depreciation) is a function of the useful life of the assets ( amortizable intangibles / average useful life of assets )

Deferred Tax Assets

  • Straight-line, unless you have a thesis
  • Grow with revenue if you believe these assets are tied to revenue
  • Most companies will provide some disclosures one what makes up the majority of their deferred tax assets
  • Past trends can also be used as a guide for forecasting

Other non-current assets

  • Straight-line, unless you have a thesis that these assets are tied to operations.
  • Majority of the time, financial statements will not provide full disclosure on what assets comprises this category.
Liabilities

Accounts payable

  • Grow with COGS.

Accrued Expenses

  • If tied to operations, grow with SG&A
  • Depending on what is being accrued, COGS may be an appropriate driver

Deferred Revenue

  • Grow with revenue
  • Use the deferred revenue as a percentage of sales as a driver ( deferred revenue / revenue ).

Taxes Payable

  • Grow with the growth in tax expense on the income statement
  • Can also grow with operating taxes or the corresponding balance sheet item ( Operating Deferred Taxes / Operating Taxes )

Deferred Tax Liabilities

  • Straight-line, unless you have a thesis
  • Grow with revenue if you believe these liabilities are tied to revenue

Other current liabilities

  • Straight-line, unless you have a thesis
  • Grow with revenue if you believe these liabilities are tied to operations
  • Majority of the time, financial statements will not provide full disclosure on what liabilities comprises this category.

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Andre

Andre is a senior at Pace University, studying Finance and Economics. His topics of interests include Equity Valuation, Short Ideas, Macro, Monetary Economics, ETFs, Forex and Fixed Income. His sectors of choice involve Technology, Consumer Goods, and Financials. Andre is also a summer intern at JP Morgan Chase & Co, and works as a Financial Analyst for their Corporate & Investment Banking division.