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Here s what the balance sheet changes would look like:
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These are the basic flows that we will work with as we continue with our modeling
TLFeBOOK
C H A P T E R
Balancing the Balance Sheet
that we know a bit about accounting, we know that a balance sheet must balance In creating forecast numbers for that financial statement, we have to make sure that our projected balance sheet will also balance We will go over how to build the mechanism in our model to do this
THE USE OF PLUGS
It is easy to set up a model for historical data because, by definition, the balance sheet has numbers that balance However, forecast balance sheets will always need to be balanced, because we forecast the individual items without regard to how the overall totals will add up Accounts receivable, inventory, and accounts payable are likely to be projected at percentages of revenues; capital expenditures may be defined by another measure In the meantime, debt levels will be based on a known amortization schedule, while equity will increase from the net income after dividends The net income itself will be defined by various margin assumptions Other asset and liability accounts will grow at the revenue growth rate, or other rates They may hold constant or drop to zero altogether at some point in the future
Copyright 2004 by John S Tjia Click here for terms of use
TLFeBOOK
7
These varying effects serve to make the balance sheet go out of balance from the first forecast period on Either the assets side will be greater than the liabilities and equity side, or vice versa Either way, we will have to consider the use of a plug number to even out the sides:
Historical balance sheets are balanced by definition
Liabilities Assets
Shareholders equity
Imbalance in forecast years, which needs to be corrected by a liability plug (shown in gray)
Liabilities Assets Shareholders equity
TLFeBOOK
Balancing the Balance Sheet
or an asset plug (shown in gray)
Liabilities Assets Shareholders equity
SURPLUS FUNDS (SF) AND NECESSARY TO FINANCE (NTF)
The plug is a number that appears on either side of the balance sheet and serves to make both sides equal From our discussion in the last chapter, we can think of the balance sheet in visual terms, and the purpose of the plug is to make both sides of the balance sheet equal in height If it is on the left hand side of the balance sheet, let s call the plug Surplus funds If it is on the other side, then we call the plug a Necessary to finance There are other terms we can use for these two plugs For Surplus funds, or SF for short, we can well call it Excess cash This is to make a distinction from the account called cash, which is not a plug number but a specified entry However, as the two terms Excess cash and Cash appear similar, I like to call the plug item Surplus funds to make the distinction more clear For Necessary to finance, another term can be Revolver (a revolver is a debt facility that keeps being renewed, or revolved) However, this glosses over the fact that this new funding required on the right-hand side is not always necessarily debt The funding need can well be for new equity For this reason, the term Necessary to finance, or NTF for short, is closer to the concept that this is really only a funding requirement
TLFeBOOK
7
We will regard it as debt, but we should not be constrained to think of it only as debt If you specify known projected debt levels (from the company s current borrowings and known amortization schedules), the company s total outstanding debt will decrease It is likely that in normal operations the company s assets will increase at a pace that cannot be funded by the increase in shareholders equity alone To keep the balance sheet balanced, we need to assume that it will need additional new debt, and this is where the NTF comes in It can work as an automatic indicator of the company s funding deficit the additional debt that the company needs to maintain its balance sheet growth If you then forecast a level of earnings that allows the company to grow its shareholders equity, the company s cash position will improve This is seen first as a reduction in the NTF number this is so because with more cash, the company has less of a funding deficit and the NTF amount decreases An Important Use of the NTF Number You can also use the NTF number as a way to show a company reducing its total debt outstanding as fast as its earnings and other growth elements allow it Do this by deliberately entering zeroes for the company s debt at the start of the projection year, thus forcing an NTF number to appear to fill in the gap Any earnings in future years, to the extent that they exceed the company s balance sheet needs, will work down the NTF number automatically
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