Financial modeling encompasses a variety of forecasts that help business leaders make decisions in the present in an attempt to control future outcomes.
A balance sheet forecast is one such projection that is usually completed in tandem with an income statement forecast. Having a comprehensive understanding of balance sheet forecasting is a major skill to hone when perfecting the craft of financial modeling.
In this FAQ we will cover what a balance sheet forecast is, why it is important, and provide a foundational approach to performing balance sheet forecasts.
What Is A Balance Sheet Forecast?
A balance sheet forecast is a projection of assets, liabilities, and equity at a future point in time. It is used to approximate what a business anticipates on owning in the future and also what it expects to owe.
Since the balance sheet represents a businesses financial position at a certain point in time, it stands to reason that the balance sheet forecast is an attempt to predict what the financial position of a business will be in the future under a given set of circumstances.
A balance sheet forecast is one component in a three-statement financial model. The other two components are income statement forecast and cash flow forecast.
The outputs of a three statement financial model are the forecasted statements, where the inputs are the assumptions that drive the changes in the financial model.
It is important to note that the balance sheet is dependent on changes in the income statement.
Why Is A Balance Sheet Forecast Important?
The primary reason for creating forecasts is to understand how decisions made in the present will impact the organization in the future.
The process of analyzing historical data and trying to predict the future is an important accounting process that helps business leaders develop comprehensive plans and learn from past results.
Financial forecasts are used as a sort of roadmap that helps leaders navigate the uncertainty of their particular environments. These forecasts are used to develop strategies that are deployed in an attempt to respond to expected market conditions and business drivers.
The balance sheet forecast is an important accounting tool that can be used to estimate the impact of income statement line items and cash flow expectations on the future financial position of the business.
In most cases it proves useful for understanding future debt obligations and equity value creation.
Balance sheet forecasting is also used to estimate the impact of merging and acquiring new businesses.
When analysts analyze whether an acquisition or merger is beneficial, they forecast the balance sheet in an attempt to understand the impact on certain financial ratios, cash, debt, deferred tax obligations and benefits. and equity among other things.
How To Forecast A Balance Sheet
A balance sheet is broken into three primary components, assets, liabilities, and equity. As a reminder, equity is also commonly referred to as “Net Assets,” since the accounting formula for equity is assets minus liabilities.
While there are various approaches to forecasting a balance sheet there are some primary line items that most analysts focus on in each section of the balance sheet.
Analysts pay close attention to accounts receivable, inventory (if applicable), other current assets, property plant and equipment (PP&E), and long-term assets.
Liabilities are broadly grouped into two primary line items, accounts payable and debt. The distinction between the two is important as they have different accounting treatments with the most obvious being that debt bears interest expense.
In most cases, interest expense is not considered accrued in a financial forecast.
Finally, special attention is paid to shareholders capital and retained earnings. These are the primary components that drive shareholder equity.
Working Capital Items
Line items that are related to working capital include AR/AP and inventory (if applicable). These line items require their own specific methodologies of forecasting.
This is because time is a component in their ending balances, so forecasting is done by utilizing their respective days outstanding.
Accounts Receivable days = average trailing 12-month AR / trailing 12-month sales revenue x 365
Inventory days = average trailing 12-month inventory / prior 12-month COGS x 365
Accounts Payable Days = average trailing 12-month AP / prior 12-month COGS (or purchases) x 365
These formulas can be used to back into the receivables balances by changing the number of days outstanding. For example: AR = days outstanding x annual revenue / 365.
Property, plant, and equipment is forecasted using the formula:
Opening balance + CAPEX – depreciation expense = closing balance
Debt is forecasted using the formula:
Opening Balance + interest expense – repayments = closing balance
Shareholder capital is forecasted using the formula:
Opening balance + new capital issuance – capital repurchases
Retained earnings is forecasted using the formula:
Opening balance + net income – dividends
How To Forecast A Balance Sheet
The process of forecasting a balance sheet can be broken down into four primary steps:
- Project the income statement all the way up to depreciation and interest expense
- Using the formulas above, project the balance sheet up to retained earnings
- Finalize income statement projection by calculating depreciation, interest, and estimated tax expense
- Finally, calculate retained earnings using the net income calculated in step 3 and use it to finalize the balance sheet projection
Using DataRails to Perform Balance Sheet Forecasting
Every finance department knows how challenging building an accurate balance sheet forecast can be. Regardless of the budgeting approach your organization adopts, it requires big data to ensure accuracy, timely execution, and of course, monitoring.
DataRails is an enhanced FP&A solution that can help your team create and monitor budgets faster and more accurately than ever before.
By replacing spreadsheets with real-time data and integrating fragmented workbooks and data sources into one centralized location, you can work in the comfort of excel with the support of a much more sophisticated data management system behind you.
This takes budgeting from time-consuming to rewarding.