11.2 Building Integrated Financial Statement Models
4 min read•july 30, 2024
Building integrated financial statement models is crucial for accurate financial forecasting. These models link the , , and , allowing for dynamic relationships between financial data. Understanding how changes in one statement affect others is key to creating robust financial projections.
Forecasting techniques for revenue, expenses, and balance sheet items form the foundation of these models. By connecting and ratios to financial statement line items, analysts can create flexible models that update automatically. This enables scenario analysis and helps in making informed financial decisions.
Integrated Financial Statement Modeling
Linking the Three Primary Financial Statements
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- An integrated financial statement model connects the income statement, balance sheet, and cash flow statement in using cell references and formulas to create dynamic relationships between the statements
- The income statement reports revenues, expenses and profitability ()
- The balance sheet reports assets, liabilities and shareholders' equity at a point in time
- The cash flow statement reports cash inflows and outflows from operating, investing and financing activities over a period of time
Key Concepts for Building Integrated Models
- Building an integrated model requires understanding the interrelationships and accounting equations that link the financial statements together
- Net income flows to retained earnings on the balance sheet
- Depreciation expense is added back on the cash flow statement
- Assumptions for growth rates, profitability ratios (gross margin), turnover ratios ( turns) and other metrics are entered in a separate assumptions section and cell referenced to applicable line items to create a dynamic model
- Circular references can occur in integrated financial statement models when cell references create a continuous calculation loop
- Must be resolved using techniques like enabling iterative calculations or using a copy/paste macro
- Integrated financial statement models are used for forecasting, , scenario modeling (base case, downside), and valuation (discounted cash flow)
- Allow the impact of changes in assumptions to flow through to all of the statements
Forecasting Income Statement Items
Sales Revenue Forecasting Techniques
- Forecasting sales revenue is often the starting point for building a financial model
- Common techniques include:
- Using historical growth rates
- Regression analysis
- Industry benchmarks
- Tying to underlying demand drivers (GDP growth, housing starts)
Forecasting Expenses
- Variable expenses like cost of goods sold and certain operating expenses are often forecasted as a percentage of sales based on historical or expected future ratios
- This creates a dynamic link where they automatically adjust with sales
- Fixed expenses may be forecasted based on historical trends, inflation, known future changes, or as a fixed percentage of sales if sufficient operating leverage exists
- Depreciation is forecasted based on the existing fixed asset schedule and accounting depreciation method (straight-line, accelerated) plus depreciation on future capital expenditures
- Amortization of intangibles is forecasted similarly
- Interest income and interest expense are tied to the cash balance and debt balance from the balance sheet and projected forward using expected interest rates on excess cash and borrowings
- Income tax expense is calculated by applying the marginal tax rate to taxable income
- Permanent and temporary book tax differences must be considered
Projecting Balance Sheet Items
Balance Sheet Items Linked to the Income Statement
- Certain balance sheet items are tied directly to the income statement
- Retained earnings is linked to net income
- Accumulated depreciation is linked to depreciation expense
- is driven by credit sales and the accounts receivable collection period in days
- Increasing sales or slower collections will increase accounts receivable
- Inventory is projected based on inventory turnover ratios or days inventory outstanding and cost of goods sold
- Higher inventory relative to COGS reduces turnover
- is tied to inventory purchases and the payables payment period
- Increasing inventory or stretching payables increases the accounts payable balance
- Accrued expenses are typically based on a certain number of days of the underlying expense (wage accruals based on days of compensation expense)
Fixed Assets and Debt Projections
- Fixed assets are rolled forward each period for capital expenditures, depreciation and any disposals or impairments
- The fixed asset schedule must be maintained to calculate depreciation
- Debt may be tied to an interest coverage ratio or leverage ratio (debt/EBITDA) and is increased or paid down based on funding needs
- The model must account for mandatory debt repayments and new borrowings
Cash Flow Statement Forecasting
Cash Flow from Operating Activities
- The cash flow statement starts with net income from the income statement and makes adjustments to convert from accrual accounting to a cash basis
- Depreciation and amortization are added back to net income as non-cash expenses
- Deferred income taxes are also added back if using straight-line depreciation for book and accelerated for taxes
- Changes in operating assets and liabilities are calculated based on the beginning and ending balances from the balance sheet to determine the impact on cash
- An increase in an asset like accounts receivable is a use of cash
- An increase in a liability like accounts payable is a source of cash
Cash Flow from Investing and Financing Activities
- Cash flows from investing activities include:
- Capital expenditures as a use of cash
- Proceeds from fixed asset sales as a source of cash
- These are linked to PP&E on the balance sheet
- Cash flows from financing activities include:
- Debt borrowings as a source of cash
- Debt repayments as a use of cash
- These are tied to the change in the debt balance on the balance sheet
- The net change in cash flows is added to the beginning cash balance to arrive at the ending cash balance for each forecasted period, which links to the balance sheet
Key Terms to Review (20)
Accounts Payable: Accounts payable refers to the amounts a company owes its suppliers for goods and services received but not yet paid for. It is considered a liability on the balance sheet and plays a vital role in managing cash flow, impacting both accrual and cash accounting. Monitoring accounts payable helps businesses ensure they maintain good relationships with suppliers and effectively manage their short-term liquidity.
Accounts Receivable: Accounts receivable refers to the outstanding amounts owed to a company by its customers for goods or services delivered on credit. This financial asset is crucial in assessing a company's cash flow and liquidity, as it represents funds that are expected to be collected in the future. The management of accounts receivable directly impacts revenue recognition, cash management, and financial reporting, making it a vital component in various accounting practices.
Assumptions: Assumptions are the underlying beliefs or statements taken for granted when creating financial forecasts and integrated financial statement models. They provide the necessary foundation upon which models are built, influencing projections and analyses. By establishing these assumptions, analysts can simulate different scenarios and make informed decisions about a company's future performance.
Balance Sheet: A balance sheet is a financial statement that provides a snapshot of a company's assets, liabilities, and equity at a specific point in time. It helps stakeholders understand the financial position of the business and is crucial for evaluating its liquidity and solvency.
Cash flow statement: A cash flow statement is a financial report that summarizes the inflows and outflows of cash within a business over a specific period of time, providing insights into its liquidity and overall financial health. This statement breaks down cash transactions into operating, investing, and financing activities, which helps stakeholders understand how cash is generated and utilized within the company.
Circular reference: A circular reference occurs when a formula in a spreadsheet refers back to its own cell either directly or indirectly, creating a loop that can lead to calculation errors or infinite loops. This concept is particularly significant when building integrated financial statement models, as it can disrupt the logical flow and accuracy of financial projections and calculations.
Comparables analysis: Comparables analysis is a valuation method used to evaluate a company's worth by comparing it with similar businesses in the same industry. This approach often involves analyzing key financial metrics, such as price-to-earnings ratios, to assess how a company stands against its peers. By identifying comparable companies, analysts can derive insights on market trends and investor expectations, which are essential for making informed investment decisions.
DCF Model: The DCF (Discounted Cash Flow) Model is a financial valuation method used to estimate the value of an investment based on its expected future cash flows, which are adjusted for the time value of money. This model is essential in integrated financial statement modeling as it provides a systematic approach to assess the profitability and potential return on investment by calculating the present value of projected cash flows, considering risks and returns over time.
Excel: Excel is a powerful spreadsheet software developed by Microsoft that allows users to organize, analyze, and visualize data efficiently. It provides various tools such as formulas, charts, and pivot tables that help in performing complex financial analyses and building integrated financial models. Excel's versatility makes it an essential tool for financial information analysis, enabling users to create detailed reports and forecasts.
Free Cash Flow: Free cash flow (FCF) is the cash generated by a company's operations after accounting for capital expenditures needed to maintain or expand its asset base. It represents the cash that a company is able to generate after spending the money required to maintain or grow its business, providing insight into the company’s financial health and its ability to return value to shareholders.
Income Statement: An income statement is a financial report that summarizes a company's revenues and expenses over a specific period, ultimately showing the net profit or loss. It plays a crucial role in assessing a company's performance and financial health, connecting revenues with expenses to determine profitability.
Inventory: Inventory refers to the goods and materials that a business holds for the purpose of resale or production. It plays a crucial role in financial statements as it affects both the balance sheet and the income statement, influencing a company's liquidity and profitability. Proper management of inventory is essential for ensuring that a company meets customer demand while minimizing holding costs.
Net Income: Net income is the total profit of a company after all expenses, taxes, and costs have been deducted from total revenue. It serves as a critical indicator of a company’s profitability and overall financial health, impacting various aspects such as financial reporting, investment decisions, and performance evaluations.
Non-recurring items: Non-recurring items are financial transactions that are unusual and not expected to occur regularly in a company's operations. These items can significantly affect financial statements, as they may distort the true performance of a company when assessing its ongoing profitability and cash flows. Understanding non-recurring items is essential for evaluating the quality of cash flows and building accurate financial models, as they can mislead investors if not properly identified and analyzed.
Plug figure: A plug figure is an estimated number inserted into financial models to balance equations and ensure that all components of the financial statements align correctly. This figure helps analysts fill gaps in data or incomplete calculations, allowing for a smoother flow in building integrated financial models that reflect a company’s performance and financial position accurately.
Precedent transactions: Precedent transactions refer to the analysis of previous mergers and acquisitions to establish a benchmark for valuing a company. This method involves examining similar transactions in the same industry to identify valuation multiples and trends that can inform current valuations. The relevance of precedent transactions lies in their ability to provide insights into market behavior and pricing dynamics, which are crucial when building integrated financial statement models.
Pro forma adjustments: Pro forma adjustments are modifications made to financial statements to present an alternative view of a company's financial performance, often excluding irregular or nonrecurring items. These adjustments help analysts and investors understand the underlying trends in a business's operations without the noise of one-time events, facilitating better decision-making and forecasting.
Return on Equity: Return on equity (ROE) is a financial ratio that measures a company's ability to generate profits from its shareholders' equity. It indicates how effectively management is using a company’s assets to create profits, providing a clear insight into financial performance and the potential for growth.
Sensitivity Analysis: Sensitivity analysis is a financial modeling technique used to determine how different values of an independent variable will impact a specific dependent variable under a given set of assumptions. This technique helps assess the risk and uncertainty in financial forecasts, enabling decision-makers to evaluate how changes in input variables can affect outcomes such as cash flows, valuations, and investment decisions.
Three-statement model: A three-statement model is a financial modeling framework that integrates the income statement, balance sheet, and cash flow statement into a cohesive structure. This model allows users to understand the relationships between these statements, providing a comprehensive view of a company's financial health and performance over time.