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We all know the accounting equation i.e.,
As per this equation the Balance sheet should always match, i.e., Assets should always be equal to the Liabilities + Equities.
It is quite often to see the balance sheet in the valuation models, showing what the assets are of a particular company and how they are being financed i.e., whether using debt or equity.
And the debt-equity mix tells us about the beta of that particular company i.e., Equity and Asset Beta which eventually affects the valuation of the company (as it is being used in calculation of Weighted Average Cost of Capital (WACC) - In DCF Valuation method).
Hence, Balance Sheet plays a crucial role in valuation and should satisfy the accounting equation above.
Balance Sheet should always match, but often we get carried away and it got unbalanced. In 99.99% of the cases, it is because any metric is affecting the cash flow. But in real life there are so many metrics in cash flow statement, and we cannot check each and every one of them, Therefore, here are some things to do and some metrics to check if balance sheet is not balancing:
- Dynamically connected Balance sheet: First of all, Check if financial model is dynamically interconnected (interconnected as per accounting equation above) so that when all the inputs, calculation and interconnection of all the schedules has been done, the balance sheet should automatically balance i.e., there should not be any hardcode (manually entering data) in the financial model to knowingly making the balance sheet balance.
And this process can be done faster using row and column differences feature in Excel as the financial model is of several years into the future. If even after this, it does not balance then check the below metrics.
- Assets held-for-sale: These are those non-current assets, which a company plans to sell. And as per both IFRS and USGAAP these assets should be sold within a period of 12 months of classification as held for sale, in general the 12 months period subsequent to the last balance sheet date (subject to limited exceptions which we will take it on some other day).Therefore, if you do not take this into account while preparing the balance sheet in the model then your balance sheet will not get balanced.
Solution: Show these assets in Proceeds from sale of Property, Plant and equipment in Investing activity of Cash Flow Statement as sold at their last balance sheet value and also adjust the liabilities associated with the assets held-for-sale as per the last balance sheet and do this for the first year of the forecast of the financial model.
- Working Capital Metrics: As you probably know the types of financial forecasting methodology used in financial modeling i.e., Incremental, Value based, zero based, Activity based. Out of these, Incremental is mostly used. i.e., historical financial metrics are calculated and then CAGR trend is discovered, and forecast is made on this trend.
And while calculating historical financial metrics for working capital items we sometimes take average of the metrics like, inventory, receivables and payables, which is correct while performing the financial analysis i.e., ratio analysis because it shows: On an average, how many days are inventory outstanding with the company. But while forecasting balance sheet metrics we are not looking for how much on an average inventory is in the stock with the company, rather we are looking for how much inventory is in the stock at a particular date. i.e., Balance sheet items are at a point of time and not on an average.
Solution: Calculate the historical metrics of the working capital items by using the "as at balance sheet date values" rather than taking average of it, and your balance sheet will be balanced.
- Debt Schedule: In Debt Schedule, the most important part is calculating the ending balances as they will be reflected in the balance sheet, and it will affect the accounting equation above and eventually the valuation.
You should also be cautious about how you will treat the current maturities of long-term borrowings, which eventually effect the closing balance of debt schedule.
Here is the snapshot from the financial model on Tata Motors Ltd. prepared by
Mohit Bhatnagar
, to give you a glimpse of what a presentable and understandable debt schedule looks like:
- Revolving Credit: Revolving credit is a line of credit that remains open even as you make payments. You can access money up to a preset amount, known as the credit limit. When you pay down a balance on the revolving credit, that money is once again available for use, minus the interest charges and any fees. (Source: Investopedia)
It does not affect the accounting equation but if we do not incorporate and take into account the revolving credit while building debt schedule, then the Cash balance on the Balance sheet might show negative figure, which in theory means: There is a credit balance in its cash account. This happens when the business has issued checks for more funds than it has on hand. When a negative cash balance is present, it is customary to avoid showing it on the balance sheet by moving the amount of the overdrawn checks into liability account and setting up the entry to automatically reverse; doing so shifts the cash withdrawal back into the cash account at the beginning of the next reporting period. (Source: accountingtools)
But while building financial model we are not making books of accounts hence we create a revolving credit and in general all the businesses do have a revolving line of credit. If you can clearly identify the line of credit i.e., separate from debt in the annual report of company then make separately adjustment using that amount in the debt schedule or if you can't identify it separately from the debt then adjust the amount in the short-term borrowings as
Mohit Bhatnagar
did in the financial model he made. Snapshot given below:
- Cork-Screw Calculations: It is constructed as a series of rows: the top row is the opening balance; the middle rows movements; and the last row the closing balance. The opening balance is simply the closing balance from the previous period – and this is what gives it that “corkscrew” shape. For example, Long-term borrowings and short-term borrowings calculations in the revolving credit image snapshot are the example of corkscrew calculations. You should be cautious with calculation of the movements between the corkscrew calculations. There might be chances of unbalanced balance sheet due to this.
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Author: Mohit Bhatnagar, FMVA? #ValuationInsights
