Balance Sheet Modeling

Some balance sheet items, such as retained earnings, flow directly from the income statement. Others, such as accounts receivable, inventory, and accounts payable, are closely linked to income statement projections.

Working capital accounts are forecasted using efficiency ratios. For example, accounts receivable are forecast by estimating the number of days of sales outstanding and combining this assumption with a sales projection. Days sales outstanding are the average number of days a company takes to collect revenue from its customers. For example, if credit sales are $25 million and it usually takes a company 50 days to collect this amount from their customers, accounts receivable would be estimated to be $2.05 million ($15 million × 50/365). An analyst can forecast inventory by calculating an inventory turnover ratio and combining that with the cost of goods sold projection. The inventory turnover ratio measures how much inventory a company keeps on hand. Analysts can look at historical efficiency ratios and recent project performance or a historical average to persist in the future.

Projections for long-term assets such as property, plant, and equipment (PP&E) are less directly linked to the income statement. Net PP&E changes result from capital expenditures and depreciation, which are essential components of the cash flow statement. Depreciation forecasts are based on historical depreciation and disclosures about depreciation schedules. In contrast, capital expenditure forecasts depend on analysts’ judgment and future need for new PP&E. An organization’s capital expenditures are divided into maintenance capital expenditures, expenditures needed to sustain the current business, and growth capital expenditures, expenditures required to expand the business. Maintenance expenditures should be higher than depreciation because of inflation.

A company’s future debt and equity levels can be forecast using leverage ratios such as debt-to-capital, debt-to-equity, and debt-to-EBITDA. Analysts should consider historical practices, management’s strategy, and capital requirements when projecting the future capital structure.

After projecting the balance sheets and income statements, the future cash flow statement can be projected. The analyst will make assumptions about how a company will use its future cash flows, share repurchases, dividends, additional capital expenditures, and acquisitions.

Question

Which of the following is least likely a ratio used to forecast working capital accounts such as accounts receivables and inventory?

1. Days sales outstanding.
2. Inventory turnover ratio.
3. Sensitivity analysis.

Solution

The correct answer is C.

Sensitivity analysis is a tool that involves changing only one assumption at a time to determine its effect on the estimate of the intrinsic value.

A is incorrect. Days sales outstanding is an efficiency ratio used to measure the average number of days a firm takes to collect revenue from its customers. It is used to forecast accounts receivable.

B is incorrect. The inventory turnover ratio is an efficiency ratio used to forecast inventory. It measures how much inventory a company keeps on hand.

Reading 17: Financial Statement Modeling

LOS 17 (f) Describe approaches to balance sheet modeling.