When Projecting Financial Statements, Don't Plug Cash To Make The Balance Sheet Balance
Often, I am called on to make financial projections, usually in the form of an income statement, balance sheet and, mirroring GAAP requirements, a statement of cash flows.
First an income statement is forecast; then the balance sheet (but not cash or short-term borrowing); and then the statement of cash flows. Cash or short-term debt is projected to be whatever makes the statement of cash flows foot.
The statement of cash flows was formerly called a statement of sources and uses of funds, a more accurate description. The sources of funds are from operations (basically EBITDA and the net change in working capital); the uses are the net cash out (or sometimes in) from investing activities such as capital expenditures, plus the net cash in (or sometimes out) from financing activity.
The net of all of this is the increase or decrease of cash over the period measured. So, beginning cash, plus the increase or decrease of cash over the period, equals ending cash. And the balance sheet will balance; total assets will equal total liabilities plus equity. For accounting statements (which are historical statements) this must always be true.
Problems arise, however, when using the statement of cash flows method to project cash or short-term borrowings. Here, cash or short-term borrowing becomes a plug in the model; it is not projected. It is merely what makes the statement of cash flows foot and that ensures that the balance sheet balances. Which means you can't tell how much of the cash or borrowing is real and how much is a plug for shortcomings in the projection.
One client of mine does this. I was asked to update their projections and used their existing model as a start. High level, everything made sense for the income statement. The balance sheet used simple DSO and days of inventory measures to project working capital.
But cash was whatever made the statement of cash flows work. The model was developed by the company for multi-year projections to raise several equity rounds. It is still in startup mode (a nice description for negative cash flow when significant revenue is on the horizon but not in the bank), and so always in need of more equity as a source of cash. For a start up raising equity, this model is fine. For a more established company and for managing near term cash flow, a better approach is needed. Projecting cash flow directly is the better approach.
If you use the 13-week cash flow approach
- but use time periods appropriate for your needs - you will get a much more accurate projection of cash. As a reminder, that approach models accounts receivables inventories loan availability and borrowing directly. The rest of the balance sheet is then forecast conventionally. Is there a plug with this approach?
Well, truth be told, yes. It is either an addition to current assets or current liabilities. But, now the plug to make the balance sheet balance is not mixed with cash or short-term borrowings and can be evaluated for reasonableness.
I worked with another company that got halfway there... but not close enough. Cash was a plug from the statement of cash flows, but the balance sheet had fairly detailed logic to it. This was a company in trouble with its lender so the need to accurately project cash in the short term was critical. The plug covered wishful thinking and the need to tighten up the logic on the working capital assumptions. Moving to the 13-week cash flow method I espouse led to a more realistic picture and actions to preserve liquidity, such as delaying rent payments, were taken. All in all, plugs look bad in projections; they suggest we haven't projected with sufficient accuracy.
But, for projections of financial statements, some "plug" is a practical necessity.
Financial statements are a result of double-entry accounting and, in theory, if we project all of the accounting transactions, there will be no plug. But, for simplicity and feasibility, we don't forecast every transaction.
Yes, besides A/R and other things that are normally modeled, payroll accruals and more could be forecast. But here as well, for simplicity, we typically stop and forecast just total accrued expenses or a large component of it. Said differently, the simplifications in the model results in some degree of inaccuracy and that inaccuracy will inevitably differ between assets and liabilities.
A client of mine that I have been helping for the last several years, for example, began with a very detailed income statement model. I was brought in to help them get a new bank loan to support their rapid growth. The problem was that there was no balance sheet projection and no cash flow projection. Both are needed to know how much to borrow, to determine that the loan can be repaid and to ensure that the loan covenants would be met.
We whittled down the size of the balance sheet plug by tightening the logic and assumptions behind the projections. Since this is a fast growing, working capital intensive company with near-term compressed EBITDA margins, we wouldn't reliably know if the company could make loan covenants one year out if we had just plugged the loan balance using the statement of cash flows method. Remember, by projecting cash flow directly, the "plug" is easily visible and you can judge its reasonableness.
Are the assumptions right and do the projections need to go into more detail? You won't know if you just plug cash or short-term borrowing. A few pointers:
- The longer the time period being projected (we're talking years here), the greater the inherent inaccuracy in the projection. The macro assumptions in a long-term projection are far more important than the detailed assumptions modeling the balance sheet. The financial statement approach may be sufficient.
- The tighter the cash flow and borrowing availability under the existing credit agreements and the tighter the lender's covenants, the more accuracy is needed. Hence more detail is needed to project the balance sheet.
- If the balance sheet "plug" is too large, examine the logic on working capital assumptions. Is using DSO or days of inventory on hand too simplistic given the nature of the business? If that doesn't work, move beyond working capital to all of the current assets and liabilities.
When working with historical accounting statements, the statement of cash flows is by definition, correct. A problem arises, however, if this accounting approach is used to project cash or short-term borrowings, thereby masking the degree to which the projected cash or borrowing is real or a balance sheet plug. Seek instead to project cash flow directly, so that the balance sheet plug is visible and you can make adjustments accordingly.
Remember, this is a projection. The future will always be different.