CFPAM™ 3: Building

the Operating Model;

The Balance Sheet

wallstreetprep.com
What is the Balance Sheet? Assets: FY2021
Cash 50.0
Accounts Receivable 100.0
Prepaid Expenses 75.0
Inventory 150.0
Current Assets 375.0

• Shows the Assets owned, the Liabilities Plant, Property, & Equipment, Net 500.0
Intangible Assets, Net 150.0
owed, and the Shareholder’s equity balance Other Long-Term Assets 125.0
Goodwill 200.0
at a point in time Total Assets 1,350.0

Liabilities:
• Does not answer what happened during the Accounts Payable 125.0
Accrued Expenses 75.0
period; only at start and end Deferred Revenue 50.0
Short-term Debt 100.0
Other Current Liabilities 25.0
• Each section begins with current or short- Current Liabilities 375.0

term accounts and moves towards long- Long-term Debt 450.0

Other Long-term Liabilities 75.0
term account values Total Liabilities 900.0

Shareholder's Equity:
Common Shares 150.0
Retained Earnings 300.0
Total Liabilities & Shareholders Equity 1,350.0
A=L+E TRUE

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Why Is It Important?

• Allows us to see how many assets are owned and

liabilities owed (i.e., company’s net wealth)

• Gives view into how much the company skews towards

short-term vs. long-term assets and liabilities Balance Sheet
tells us how
• Gives glimpse into the capital intensity of the business, much we own
and how company chooses to fund those capital needs and owe (i.e., net
• Provides insights into company’s lifecycle and
wealth at end of
fundraising needs, as well as future capital expenditure
period)
requirements

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 While the balance sheet isn’t
typically a large focus for FP&A,
sections such as Working Capital,
Fixed Assets, and Debt garner a lot
of attention

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Balance Sheet – Current Assets

Assets readily converted into cash within 12 months or 1 Assets: FY2021

operating cycle, whichever is longer.
Cash 50.0
• Cash & Equivalents – cash & highly-liquid investments Accounts Receivable 100.0
with original maturities < 90 days Prepaid Expenses 75.0
Inventory 150.0
• Accounts Receivable (A/R) – sales extended on credit to Current Assets 375.0
customers. Often presented “net” of an allowance for
doubtful accounts, an estimate of potential credit losses

• Prepaid Expenses – prepayment for expenses expensed

over time (e.g., annual insurance premiums billed once,
but expensed monthly over the year)

• Inventory – goods available for sale and raw materials

used to produce goods available for sale

• Other – deferred tax assets, restricted cash, short-term

investments, etc.

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Balance Sheet – Long-term Assets

Assets with useful lives greater than 12 months or 1 Plant, Property, & Equipment, Net 500.0
operating cycle, whichever is longer. Intangible Assets, Net 150.0
• Property, Plant & Equipment – long-lived buildings, factory, Other Long-Term Assets 125.0
computers, or office furniture. Generally presented “net” of Goodwill 200.0
accumulated depreciation Total Assets 1,350.0

• Intangible Assets – non-physical long-lived assets, such as

trademarks, patents, copyrights, customer lists, etc.

• Can be either “Finite” (amortizable) or “Indefinite”

(non-amortizing) and are also presented “net”

• Goodwill – represents what companies have paid to acquire

another company over and above the fair value of the
identifiable assets and liabilities of the target

• Other – long-term notes receivable, equity method

investments, etc.

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Balance Sheet – Current Liabilities

Expenses which have been incurred but not yet paid, Liabilities:
and which are expected to be paid in the greater of 12 Accounts Payable 125.0
months or 1 operating cycle. Accrued Expenses 75.0
Deferred Revenue 50.0
• Accounts Payable – invoices received from vendors for Short-term Debt 100.0
products received and services provided Other Current Liabilities 25.0
Current Liabilities 375.0
• Accrued Expenses – expenses which have been incurred
but not invoiced. Common examples include salary and
taxes payable, interest payable, etc.

• Deferred Revenue – receipts from customers for

products or services not yet delivered, such as an up-
front annual payment for a monthly subscription

• Short-Term Debt – debt that is owed and repayable

within the greater of 12 months or 1 operating cycle.

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Balance Sheet – Long-term Liabilities & Shareholder’s Equity

Long-term Liabilities – All payment outflows Long-term Debt 450.0

Other Long-term Liabilities 75.0
expected to be paid in the greater of 12 months
Total Liabilities 900.0
or 1 operating cycle.
Shareholder's Equity:
• Long-term Debt – money that is borrowed from Common Shares 150.0
banks, private or public lenders with maturities Retained Earnings 300.0
greater than 12 months or 1 operating cycle Total Liabilities & Shareholders Equity 1,350.0
A=L+E TRUE
• Other – items such as environmental
remediation obligations, capital lease
obligations, etc.

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Balance Sheet – Long-term Liabilities & Shareholder’s Equity (cont.)

Long-term Debt 450.0

Shareholder’s Equity – The residual
Other Long-term Liabilities 75.0
ownership claims of the business. Total Liabilities 900.0

• Common Shares, Preferred Shares, Shareholder's Equity:

(Treasury Stock) –amount of capital Common Shares 150.0
Retained Earnings 300.0
invested in the business, less any shares
Total Liabilities & Shareholders Equity 1,350.0
repurchased in the secondary market A=L+E TRUE

• Retained Earnings – cumulative amount of

undistributed firm earnings (losses)

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 While this represents a standard
Balance Sheet presentation, there
will always be additional line items
specific to your own industry

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Balance Sheet – Learning Plan

• Accruals & Reserves

• Balance Sheet Rollforwards

• Working Capital
• Fixed Assets & Liabilities

• Common Ratios

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What are Accruals & Reserves?

• Accruals are revenues earned or expenses Accruals vs Reserves?

incurred, but not yet settled in cash
• Accruals are known and estimable at the time
• Customer promises to pay for goods they are recorded
already provided (Accounts
• We know how many customers purchased
Receivable)
on credit when accruing Accounts
• Salaries owed but not yet paid out Receivable
(Salary Payable) • Reserves are not known, but still need to be
estimated when they are recorded
• Reserves are estimates of uncertain future
conditions • Not sure how many customers might end
up not paying us (Bad Debt Reserve)
• Uncollectible accounts receivable,
warranty liabilities, sale returns
allowances, etc.
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 Both Accruals and Reserves
are completed as part of the
month- and year-end accounting
process known as Close.

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 In some organizations this is
Accounting’s responsibility with
FP&A as reviewer, while in others
FP&A is the responsible party

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Timing & Partners in the Process

• Accruals & Reserves are estimated during Accounting Close

Accounting Close at the end of each month
and quarter • The first few business days of each month are
known as Accounting Close
• Accounting & Finance pull together all
• Accounting finalizes all accounting entries,
accruals and estimate reserves
including all accruals, reserves, and any
• Accounting enters the data into the necessary journal entries
financial reporting system while FP&A • Once the accounting books are closed, it is
reviews it for reasonableness and generally not possible to correct past
completeness accounting mistakes

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The Accounting team is likely to be
all hands on deck during Close.

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 Keep this in mind when building
project timelines requiring
Accounting input, and be extra nice
to them around this time.

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Common Accrual Accounts

• Asset Accruals Accrual Sources

• Accounts Receivable • Data Systems

• Interest Receivable • Accounts Receivable or Deferred

Revenues (Revenue system)
• Prepaid Expenses
• Accounts Payable (Disbursement
• Liability Accruals systems)
• Salary Payable (Payroll systems)
• Accounts Payable
• Accounting Schedules or Contracts
• Accrued Expenses
• Accrued Expenses
• Deferred Revenues • Prepaid Expenses
• Interest or Dividends Payable • Interest & Dividend Payables

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Reserve Accounts

• Important: Accruals are definite & known, Common Reserve Accounts

while Reserves are probable but not known
with certainty • Allowance for Doubtful Account
• Accounts Payable Breakage
• Reserves are generally estimated using
ratios or historical experience • Sales Returns
• Sales Allowances
• Example – Sales Returns Allowance history
tells us that over the past 12 months an • Sales Discounts
average of 2.5% of sales are returned • Warranty Expenses

• We estimate Sales Returns as 2.5% of

current period sales

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Example - Sales Return Allowance Exercise

• Estimate a Sales Return Allowance using an average of the last twelve months of actual returns

Sales Return Allowance

Period (t) 1 2 3 4 5 6 7 8 9 10 11 12
Sales Returns (Actual) 25 50 0 25 25 50 25 0 25 25 0 50
Total Period Sales 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000
% Sales Returned

Estimated Sales
Returns Allowance

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Example - Sales Return Allowance Answer

• Estimate a Sales Return Allowance from the last twelve months of actual returns

Sales Return Allowance

Period (t) 1 2 3 4 5 6 7 8 9 10 11 12
Sales Returns (Actual) 25 50 0 25 25 50 25 0 25 25 0 50
Total Period Sales 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000
% Sales Returned 2.5% 5.0% 0.0% 2.5% 2.5% 5.0% 2.5% 0.0% 2.5% 2.5% 0.0% 5.0%

Estimated Sales 2.5%

Returns Allowance

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 We’ll look at examples of
forecasting Accruals & Reserves
later in this chapter, but it’s helpful
to understand how the actual
month-end Accruals and Reserves
are calculated.

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Balance Sheet – Learning Plan

• Accruals & Reserves

• Balance Sheet Rollforwards

• Working Capital
• Fixed Assets & Liabilities

• Common Ratios

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What is a Balance Sheet Rollforward?

• A Balance Sheet Rollforward tracks the

change in Balance Sheet accounts during
Beginning Balance
the period + Additions
• All follow the same underlying structure, - Subtractions
though the specific inputs vary by account
= Ending Balance
• Some accounts will have multiple Additions
or Subtractions

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Is It Necessary? What Is the Benefit?

• Showing all the steps is not necessary Modeling Best Practices

• Entirely possible to combine individual • Include calculation steps in the model
items into a single equation
• Do not merge drivers & components
• Breaking out the details provides more • Makes formulas difficult to craft
information and insights
• Less intuitive for others to follow
• Makes the model much easier to audit • More error-prone

• We can isolate and target individual • Increases risk of accidentally including

components to forecast & sensitize inputs directly in formulas

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It’s always better to make the model
easier to follow with simple
formulas.

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How Does It Work?

Let’s look at an example using Accounts

Payable (A/P)
Beginning Balance
• Beginning Balance comes from the prior
+ Invoices Received
period’s Ending Balance - Vendor Payments
• A/P increases when new invoices are = Ending Balance
received for expenses already incurred

• A/P decreases when invoices are paid out

to vendors in cash

• Ending balance aggregates these quantities

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Table of Balance Sheet Accounts & Rollforward Drivers

• Each Balance Sheet account has items that Rollforward Examples

either increase or decrease the balance
• On the next slide is a table of Asset, Liability,
• The rollforward equation adjusts the and Equity accounts, along with which
balance sheet accounts based on forecasts transactions may increase or decrease each
account
• Relationships are logical
• Not every item will be necessary for each
• Example: Accounts Receivable increases company; if it is, include it, otherwise, keep
when a customer buys on credit; reduced your model simple and exclude it
when the customer pays in cash
• ‘Other’ are items that occur less frequently but
might be needed in certain circumstances

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Asset Accounts and Rollforward Drivers

Asset Account Increase Decrease Other

Cash - - Net Cash Flow (+ or -)

Accounts Receivable Credit Sales Cash Received Write-Offs / Bad Debt

Prepaid Expenses Prepayments Amortization of Prepaid Expenses Cancellations / Refunds

Inventory Purchases & Overhead Allocation COGS / CORS -

Property Plant & Equipment Capital Expenditures Sales of PP&E PP&E Write-down / Impairment

(-) Accumulated Depreciation Depreciation Expense Sale of PP&E PP&E Write-down / Impairment

Acquisition or Capitalized Intangible Impairment / Write-

Definite-Lived Intangibles Software
Sale of Intangible
down
Intangible Impairment / Write-
(-) Accumulated Amortization Amortization Expense Sale of Intangible
down
Intangible Impairment / Write-
Indefinite-Lived Intangibles Acquisition Sale of Intangible
down

Goodwill Acquisition Impairment Sale of Acquired Company

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Asset Accounts and Rollforward Drivers

Liability or Equity Account Increase Decrease Other

Accounts Payable Invoices / COGS / CORS Payments to Vendors Breakage

Accrued Expenses SG&A Expenses Cash Payments

Short-Term Debt Borrowing Repayment -

Deferred Revenues Customer Subscriptions Earned Revenues Customer Cancellations / Refunds

Long-Term Debt Borrowing Repayment -

Common Stock Issuance of Common Stock Share Retirement (extremely rare) -

Treasury Stock Shares Repurchased Resale of Treasury Stock -

Retained Earnings Net Income (from IS) Dividends -

Accounts Payable Invoices / COGS / CORS Payments to Vendors Breakage

Accrued Expenses SG&A Expenses Cash Payments

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 The key is to understand
the relationship between these
accounts (e.g., credit sales increase
accounts receivable, while
collections reduce it).

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Modeling Implications

• Beginning + Increase – Decrease = Ending Key Takeaways

• Multiple ways to forecast ending balances • Forecasting depends on availability of and
confidence in our data
• Estimate the missing item and sum all
the individual elements together • If cash payments to vendors are easier to
assess, forecast that item directly and then
or… calculate the ending balance

• Estimate the ending balance first and • If ending balances is easier to assess, forecast
back into the missing item them directly and then calculate the payments
to vendors

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Different Modeling Processes

Forecast Expense Forecast Cashflow Forecast Ending Balance*

Beginning Given Given Given

Forecasted, perhaps as % Linked to Cost of Revenues Linked to Cost of Revenues

(+) Invoices (CORS)
of known cash payments in the Income Statement in the Income Statement

Forecasted here, perhaps

Linked to a schedule of
(-) Cash Payments as % of Invoices in the Calculated
Cash Payments
current or prior period

Estimated using Days

= Ending Calculated Calculated
Payable or A/P Turnover

* Most common approach

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The metric we forecast is most often
the one that has the most stable
ratio, or is the metric the company
is targeting in their operating plan

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Rollforward Equations & How to Model

• Most working capital accounts (e.g., A/R, Quick Examples

Inventory, A/P) are forecasted by
calculating a ratio to the account driver • A/R Turnover of 12x (times or turns) means
(credit sales, COGS, and credit purchases, that the average A/R balance is collected 12
respectively) times over during the year
• Days Receivable is the inverse of the A/R
• Turnover Ratio = The average amount of
Turnover ratio, multiplied by the number of
times the account balance converts into
days in the period (365 for annual)
cash during the year
• For an A/R turnover of 12x, the Days
• “Days” Ratio = The average amount of time Receivable would be 365/12 or ~30 Days of
before the account converts to cash Receivables

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 We’ll introduce a few ratios
in this chapter as they
pertain to forecasting balance
sheet accounts…

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… but we’ll cover more ratios and
what they mean in Chapter 8 when
we pull the completed model
together

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Balance Sheet Projections – “Days” Ratios

• Days in period depends on whether

we’re looking at monthly or annual Credit Sales
A/R Days = Ending A/R ÷ # of Days in Period
data, as we’re trying to back into the
average daily Credit Sales (for A/R)

• Here we use 30 as our data is shown COGS

Inventory Days = Ending Inventory ÷ # of Days in Period
monthly; annual would use 365

• A/P Days are based on Credit

Invoices
Purchases, but often use SG&A A/P Days = Ending A/P ÷ # of Days in Period
expenses or Invoices as a proxy

• Cash Conversion Cycle shows how Cash Conv. Cycle = Inv. Days + A/R Days − A/P Days
long it takes to convert one full cycle
of cash

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Balance Sheet Projections - Turnover Ratios

• Each of the “Days”

ratios can also be A/R Balance 365
A/R Turnover = Credit Sales!# Days in Period = A/R Days
expressed as a
Turnover ratio by
dividing 365 by the
“Days” ratio Inventory Balance 365
Inventory Turnover =COGS!# Days in Period = Inventory Days

A/P Balance 365

A/P Turnover =Credit Purchases!# Days in Period = A/P Days

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Now that we have a framework
for the rollforward and
an understanding of the
relevant ratios …

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… let’s work through an example
using the Accounts Payable
rollforward.

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A/P Example Exercise

• Our first exercise is to develop the account 1. Open the source file & navigate to the
rollforward for Accounts Payable ‘Balance Sheet’ tab, and the section
titled ‘Liabilities’. Then find the
• The relevant line items are Beginning Balance, ‘Accounts Payable’ section beginning at
Invoices (in this case ‘Purchases’ and ‘Credit Card line 127
Processing Fees’), Payments, and Ending Balance
2. For both historical & forecast periods,
• Some formulas are the same for both Actual and set the beginning balance equal to the
Forecasts (Beginning, Purchases, Credit Card prior period’s ending balance, link
Processing Fees), while others are different Purchases to Inventory Rollforward line
73 from the Balance Sheet and Credit
(Payments, Ending)
Card Processing Fees from line 61 of the
• We will forecast the Ending Balance using expected ‘Expenses’ tab

A/P Days (discussed on next slide) 3. For Historical periods, the Ending
Balance is an input

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A/P Example Exercise

• The formula for A/P Days is:

4. Calculate the historical A/P Days. Here,
Invoices
A/P Days = Ending A/P Balance ÷ # of Days in Period # of days = 30 as we’re looking at
monthly data. If this were annual, we’d
• At this point we have the beginning balance, use 365 instead.
invoices, and ending balance values
5. Calculate both the historical and
• We then need to solve for the ‘Payments’ term. forecast Payments using the formula on
Using the rollforward formula the left

Ending Bal. = 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝐵𝑎𝑙. +𝐼𝑛𝑣𝑜𝑖𝑐𝑒𝑠 − 𝑃𝑎𝑦𝑚𝑒𝑛𝑡𝑠

• Isolating the ‘Payments’ term we get:

Payments = 𝐼𝑛𝑣𝑜𝑖𝑐𝑒𝑠 + 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝐵𝑎𝑙. −𝐸𝑛𝑑𝑖𝑛𝑔 𝐵𝑎𝑙.

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A/P Example Exercise

• Using our historical A/P days as a baseline, develop

an assumption around forecasted A/P days from 6. For the Forecast period, develop an
history, business partner input, or competitor assumption for A/P days. Let’s again use
the prior year month’s rate
benchmarking
7. Calculate the Forecasted Ending Balance
• Next, rearrange the A/P days formula
using the formula to the left
Invoices
A/P Days = Ending A/P Balance ÷ # of Days in Period

• Solve for the Ending Balance

Invoices
Ending A/P Balance = A/P Days× # of Days in Period

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 A/P Example – Balance Forecast & Rollforward Exercise

Accounts Payable Jan-21A Feb-21A Mar-21A Apr-21A May-21A Jun-21A Jul-21F Aug-21F Sep-21F Oct-21F Nov-21F Dec-21F
Beginning Balance 1 1,321.3 1,587.5 1,019.1 1,206.8 1,395.4 1,810.6
+ Purchases 269.7 57.1 112.1 282.4 331.8 385.4
2
+ Credit Card Processing Fees 111.3 97.3 92.1 133.1 120.8 129.4
- Payments 3 114.7 722.9 16.5 226.9 37.4 540.7 1. Open Operating_Model.xlsx and
Ending Balance 1,587.5 1,019.1 1,206.8 1,395.4 1,810.6 1,784.7
4 navigate to tab ‘Balance Sheet’ to
Days Payable 125 days 198 days 177 days 101 days 120 days 104 days ‘Liabilities section’ and work through the
problem

1• Beginning Balance is the prior period’s Ending 3• In our example, the formula for payments is
Balance for both historical and forecasted periods consistent throughout the historical and forecast
periods (this is the plug)
2• The main drivers for A/P here are Purchases and
Credit Card fees, which were forecasted as part of 4• Historical Ending Balance is a given value, i.e. an
the Inventory rollforward and Income Statement, input. This Ending Balance, along with Cost of
respectively. Link both historical and forecasted Revenues are used to calculate the actual Days
purchases to the respective ‘Balance Sheet’ and Payable to provide us a reference for determining
‘Expense’ sections our Forecasted Days Payable

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 Check
A/P Example – Balance Forecast & Rollforward Your Work

Accounts Payable Jan-21A Feb-21A Mar-21A Apr-21A May-21A Jun-21A Jul-21F Aug-21F Sep-21F Oct-21F Nov-21F Dec-21F
Beginning Balance 1,321.3 1,587.5 1,019.1 1,206.8 1,395.4 1,810.6 1,784.7 1,980.7 1,031.4 1,132.2 1,071.0 1,080.8
+ Purchases 269.7 57.1 112.1 282.4 331.8 385.4 151.6 15.4 37.6 150.7 102.9 450.1
+ Credit Card Processing Fees 111.3 97.3 92.1 133.1 120.8 129.4 117.3 101.3 90.5 89.9 88.3 119.7
- Payments 114.7 722.9 16.5 226.9 37.4 540.7 72.9 1,066.0 27.4 301.8 181.4 4.3
Ending Balance 1,587.5 1,019.1 1,206.8 1,395.4 1,810.6 1,784.76 1,980.7 1,031.4 1,132.2 1,071.0 1,080.8 1,646.4

Days Payable 125 days 198 days 177 days 101 days 120 days 5
104 days 221 days 265 days 265 days 134 days 170 days 87 days

5 • Using actual Days Payable as a reference 6• Once we forecast Days Payable, we plug that
point, we develop a Days Payable forecast. value into our equation and solve for the
The values for each month fluctuate quite a Ending Balance.
bit, indicating the potential for seasonal
(Purchases ! CC Fees)
impacts. Let’s use the prior year’s monthly Ending A/P Balance = A/P Days× # of Days in Period
rate

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 Here we utilized A/P Days to
Forecast the Ending A/P Balance,
allowing A/P to fluctuate higher or
lower depending on the forecasted
level of purchases & credit card fees

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 After forecasting Accounts Payable,
a working capital account, it might
be a good time to stop and discuss
just what working capital is and why
it is important

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Balance Sheet – Learning Plan

• Accruals & Reserves

• Balance Sheet Rollforwards

• Working Capital
• Fixed Assets & Liabilities

• Common Ratios

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What is Working Capital?

• Capital that is tied up in business operations

on a day-to-day basis

• Most commonly refers to Cash & Equivalents,

Accounts Receivable, Inventory, Accounts
Payable, and Deferred Revenue balances

• Net Working Capital = Current Assets –

Current Liabilities

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But What Does That Actually Mean?

Week
• As an example, what happens if we want to grow 1 2 3 4 5 6 7 8 9
sales?
Accounts Payable

• Purchase added Inventory on Credit

Inventory

• Pay the vendor in cash

Accounts Receivable
• Sell the inventory on credit
Net Working Capital
• Collect the Cash from the customer

• Net Working Capital covers all of our capital

needs from the time we pay the vendor in cash
until we receive cash back from our end
customer

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Working Capital Formulas

Current Current Net Working Working

Operating Operating Capital Capital / Cash
Assets Liabilities Conversion
= Current Operating
Assets
Cycle
= Cash & Equivalents = Accounts Payable
= Accounts Receivable
+ Accounts Receivable + Accrued Expenses – Current Operating
Days
Liabilities
+ Prepaid Expenses + Deferred Revenue
+ Inventory Days
+ Inventory – Accounts Payable
Days

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Why is Working Capital Important?

• Managing WC efficiently can greatly Value of Working Capital

improve the cash generating ability of the
business • Negative Working Capital is when a business
collects cash from the customer before they
• If a company can quickly sell inventory, even purchase inventory
collect accounts receivable, and take a long
• Typical of Software-as-a-Service (SaaS)
time to pay their vendor, it can collect cash
businesses, where customer pays an upfront
from the customer before paying the
subscription and the business provides service
vendor
for the next 12 months
• The company has ZERO working • Rather than requiring more working capital to
capital requirements expand, the business generates cash up-front
by growing!
• Can grow without the need for
additional cash

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Strong working capital management
reduces the investment needs of a
business, allowing it to generate
more sales for the same amount of
invested capital

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Working Capital Cash Flow Impact

• The larger (more positive) Net Working Working Capital Takeaways

Capital is, the more capital the company
requires in order to grow revenues • For young firms, growth targets require
working capital, and often drive fundraising
• On the flip side, if a company carries a needs
positive Net Working Capital balance and
• For aging firms, reduced working capital can
the business is in decline or shrinking, the
be freed up for other more productive uses
company will be able to reduce its working
capital over time, allowing the company to • For all firms, improving working capital
pay down debt, or distribute to owners of management can significantly impact Cash
the firm Flows

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Working Capital & Growth are Related

• Firm A needs $50 of additional working Growth Isn’t Free

capital to support $100 of additional
Revenues • Firm A has the largest need for additional
funding, so they might be:
• Firm B operates very efficiently with its
• Extending more credit to customers,
working capital, and only requires an
additional $5 to support $100 of additional • Holding higher levels of inventory to meet
Revenues customer needs,
• Making prompt payment to its vendors
• Firm C collects payment from their
customer at the start, and therefore • Firm A will need more funding to grow, or it
receives $50 in cash to support $100 of will need to grow more slowly than Firms B or
additional Revenues C

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Oftentimes Working Capital is
treated as a given during the
forecast.

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 However, as we’ve seen, any
opportunity to improve its
efficiency can drive significant
added value for the business.

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Working Capital Ratios

• Covered in more detail in Chapter 8 when Important Note on Ratios

we pull the whole operating model
together and look at the most common • Provides a sense of a company’s ability to
ratios repay current liabilities with current assets on
hand
• Working Capital Ratio or Current Ratio
• For companies in financial distress, this is very
important
= Current Assets⁄Current Liabilities
• Ratios alone need more context to be useful

• Quick or Acid-Test Ratio

(Current Assets −Inventories)

=
Current Liabilities

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Working Capital Cycle & Benchmarking

• Working Capital needs can vary greatly by Benchmarking Notes

industry and target market segment
• Achieving industry average working capital
• Benchmarking vs competitors, industry cycles is important to a company’s operating
average, or peers highlight opportunities to efficiencies
improve components of the Working
• However, the best companies compare not just
Capital Cycle
to the industry average but to the best in class
• Improving collections can reduce A/R Days for each working capital item, looking for new
ways to increase operating efficiency
• Moving to just-in-time inventory will
reduce Inventory Days

• Reaching extended payment terms with

vendors can increase A/P Days

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 Now that we’ve covered basic
rollforwards and working capital,
let’s hop into our model and
forecast these items

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With that out of the way, we’ve
forecasted all
balance sheet accounts except
Capital Expenditures, Contra
Accounts, and Debt.

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Let’s jump into a discussion of those
last few items now and then we’ll be
able to finish up the balance sheet
forecast.

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Balance Sheet – Learning Plan

• Accruals & Reserves

• Balance Sheet Rollforwards

• Working Capital
• Fixed Assets & Liabilities

• Common Ratios

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Fixed Assets / Liabilities vs Working Capital

• While Working Capital covers short-

term capital needs, organizations
Property, Plant
generally have longer-term Operating
Asset needs as well
& Equipment

• These long-term assets can be funded Capitalized Internal-Use

through equity or liabilities Software
• Best to match the funding of long-term Intangible Assets
assets with long-term debt or perpetual
equity Short- and Long-Term Debt

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How Are They Defined?

• Assets with useful lives beyond 1

year or 1 operating cycle (whichever Short-term –
is greater) are considered long-term recognize
assets immediately

• Liabilities that are not repaid within

1 year or 1 operating cycle
this time period are long-term
liabilities

• Long-term assets are charged to

expense over their useful lives as Long-term –
depreciation or amortization Recognize over time

• Long-term liabilities are written off

as they are repaid

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Capitalized vs Expensed

• Whether to capitalize or expense in the Where Does This Matter?

period is based on the matching principle
• Expenses will be forecasted on the Income
• Capitalized expenses are expected to Statement, while Capital Expenditures and
provide benefits for multiple periods, while other Long-Term Assets and Liabilities are
expenses benefit the current period only Forecasted through the Balance Sheet

• Capitalized expenses do not show up on the

Income Statement until they are • Capital Expenditures are typically large
depreciated or amortized upfront investments, and therefore these are
forecasted at a detailed level
• Cause of timing differences between cash
outflow and expense recognition

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 The distinction between
capitalizing and expensing can
drastically alter current business
profitability.

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 As such, it is important to
ensure any capitalized expenses
are appropriate.

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Asset Levels & Capital Intensity

• The more Long-Term or Fixed Assets a Why Does This Matter?

company requires, the more “capital
intensive” it is • Providers of capital expect a return on their
investment
• For a given amount of revenues, operating
income, or net income, a company needs a
larger up-front investment • Need to balance capital investment needs with
the ability to generate an appropriate return
• If a firm needs more capital, it can fund it on that capital
with:

• Issuance of Shares (Equity) • Particularly important for long-term capital

allocation decisions, such as Capital
• Issuing Debt (Liability)
Expenditures or Acquisitions

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 Not all growth is good growth
especially if the company is not able
to earn a sufficient return on the
additional investment for its
investors.

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Capital Asset Forecasting Process

• Capital Expenditures are not very common Keys to Successful Forecasting

items during the quarterly forecasting
process • Business Partnering is critical here, as FP&A
will not be the experts on the extent and
• Critically important for startups and timing of capital investment needs
companies with long project lead-times
• Capital investment models are necessarily
• Requires an understanding of the level of
more detailed and typically are built as stand-
capital investment to the level of operations
alone models in conjunction with the business
• Growth expectations typically drive leader
additional levels of investment to support
that growth • We will cover this in more detail in Chapter 9
where we dig in deeper into a sample capital
project model

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Depending on the stage of company
and product line, Capital Assets can
be forecasted based on assumed
Revenues, or Revenues can be
forecasted based on assumed
Capital Asset levels.

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Capital Asset Forecasting Process

• The forecast driver for the Capital Asset Business Partnering Note 2
will depend on what the capital asset does
for the business • It becomes quickly apparently why FP&A
needs to partner with business & function
• Ex. For physical servers, the driver experts when considering factors like server
might be website visitors capacity and visitor loads

• Identify the inflection point where

incremental investment is needed • Always beneficial to check with the owners
and operators of assets to better understand
• Analyze how long to get the asset up and
the purchase and setup process, and how that
running and use that time frame to
impacts the capex forecast
determine when it needs to be purchased

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Maintenance vs Growth Capex

• Capex can be one of two types: Timing Matters

• Maintenance Capex • For large capital projects, very important to
understand the timing of anticipated expenses
• Growth Capex

• Capex that supports new products or • Timing of expense capitalization should

initiatives subject to more scrutiny, and coincide with operational plans and milestones
need higher levels of business owners for developing and launching the underlying
support when forecasting and planning product or service

• Timing greatly impacts an organization’s

outside funding needs, which is an important
consideration for FP&A

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We can’t talk about PP&E or other
Capex without talking about
everyone’s favorite… Contra
Accounts!

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What are Contra Accounts?

• Contra Accounts are special accounts that sit PP&E, Accumulated Depreciation, and
contra, or opposite, to another account Net PP&E Over Time
Series1 Series2 Series3
• Most common example is Accumulated
Depreciation (Contra Asset) and Property, Plant,
& Equipment (Asset)

• Accumulated Depreciation holds the cumulative

depreciation expense associated with PP&E,
reducing the “net” value of PP&E

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Common Contra Accounts

Contra Account Type Related Account Charge Off

Allowance for Doubtful Accounts Contra Asset Accounts Receivable Bad Debt Expense

Reserves for Inventory Obsolescence Contra Asset Inventory Cost of Goods Sold

Property, Plant, &

Accumulated Depreciation Contra Asset Depreciation Expense
Equipment

Accumulated Amortization Contra Asset Intangible Assets Amortization Expense

Discount on Bonds Payable Contra Liability Short or Long-Term Debt Interest Expense

Bond Issue Costs Contra Liability Short or Long-Term Debt Interest Expense

Treasury Stock Contra Equity Equity (General) N/A

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How are Contra Accounts Forecasted?

• With their own rollforwards, just like other Contra Notes

accounts
• Accumulated depreciation is the most common
• Accumulated depreciation aggregates contra account
forecasted depreciation expense over time,
which is directly driven by the level of
PP&E • Balance increases as the asset depreciates, and
is only reduced if the asset is sold

• Accumulated Depreciation cannot exceed the

value of the related PP&E item

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 Integral to understanding
and forecasting these Contra
Account balances, and especially
with Accumulated Depreciation, is
the forecast of Depreciation
Expense itself.

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 You’ll recall this was one of the few
expenses we did not forecast as part
of the Income Statement.

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Depreciation & Amortization Methods & Calculations

• Depreciation & Amortization are then Depreciation Calculation

forecasted based on the timing and value
Asset 10,000
and PP&E and Intangibles, respectively (-) Salvage Value 1,000
= Depreciable Base 9,000

• Asses the asset’s useful life and salvage Useful Life 30 yrs
= Annual Depreciation 300
value (if any), and use this to determine the
= Monthly Depreciation 25
annual (or monthly) charge to depreciation
& amortization expense Depreciation Waterfall
Purchase Depreciable
• Often done using a waterfall approach to Year Base 2020 2021 2022 2023 2024 2025
separate assets with different useful lives 2020 1,000 25 50 50 50 50 50
2021 1,500 38 75 75 75 75
and by the year purchased 2022 1,000 25 50 50 50
2023 2,000 50 100 100
2024 1,500 38 75

Depreciation Expense 25 88 150 225 313 350

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 The detailed breakdown of
Depreciation Expense is called a
waterfall because of the way the
depreciation expense for each year
cascades down like a waterfall.

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This is not the same as a waterfall
chart, which we’ll talk about in the
last chapter.

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Keys to Depreciation & Amortization Forecast

• Different Depreciation & Amortization Depreciation & Amortization

techniques include:
• When forecasting, do not depreciate the asset
• Straight-Line (most common and more than its depreciable value
what we use here)

• Sum of Year’s Digits • Keep in mind that certain assets (Land,

Indefinite-Lived Intangibles, etc.) do not
• Accelerated Depreciation
depreciate
• Units of Production Depreciation

• For deeper dive into alternative techniques,

please check out the Wall Street Prep
Accounting Course

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Now that we’ve covered Fixed Assets
and Contra Accounts, let’s dive into
the last piece of the balance sheet
puzzle… Debt and Equity

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Long-Term Capital Assets Drive Long-Term Financing Needs

• Long-term assets are typically funded with Equity vs Debt

long-term capital
• Pros and cons will be discussed further in
• Avoids problem of needing to return short- Chapter 10: Corporate Finance Principles
term capital to investors while the money is
• Equity
tied up in long-term, illiquid assets
• Perpetual - does not need to be refinanced
• Long-term capital comes from issuing new
• Reduced risk of bankruptcy
shares (Equity) or from issuing Long-term
Debt (Liabilities) • Reduces shareholder control
• Debt
• Funding available is often based on the
stage of the company and the riskiness of • Maintains control
the underlying investment • Increases riskiness of the business

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What IS Debt?

• A contractual promise to repay borrowed Debt

funds
• Debt typically includes periodic interest
• Bank loans, bonds issued to the public payments, though not all do:
markets, or loans from individuals
• Zero coupon bonds
• Penalties for not repaying include • Payment-In-Kind (PIK)
bankruptcy or loss of control of the
organization
• Bank Loans are the most common form of
• Lenders (and the lending market) set lending, followed by Bonds
interest rates

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Interest Rates & What Drives Them?

The drivers of interest rates on debt are Lower Interest Rates Higher
several, including:
Market / Industry Early-
Mature
• Market / Industry Stage

• Collateral Asset Collateral

Covered None

• Seniority
Seniority
Senior Junior
• Financial Health

• Lender Competition Strong

Financial Health
Weak

Lender Competition
High Low

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 Debt can also include equity-like
features such as conversion rights
or attached warrants, but these are
beyond the scope of this course and
are pretty uncommon in FP&A.

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Debt Discounts & Premiums

• Principal (Par Value) – the amount of Discounts & Premiums

debt to be repaid at maturity
• If a company is loaned $900 but must repay
• Borrowed Amount – the amount of funds $1,000 in 5 years (discount issue), the effective
received. Can be less or more than principal interest is increased by $100/5 or $20 per
if the bond is issued at a discount or a year
premium, respectively
• If a company is loaned $1,100 but only needs
• Discount – the amount borrowed is less to repay $1,000 in 5 years (premium issue),
than the Principal to be repaid. Increases the effective interest is decreased by $100/5
the effective interest rate paid or $20 per year
• If a company is loaned $1,000 and must repay
• Premium – the amount borrowed is
the same $1,000 in 5 years (par value issue),
greater than the principal to be repaid.
the effective rate is the same as the stated
Decreases the effective interest rate paid
interest rate on the loan
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Debt Terms

• Term – Time before the debt needs to be Note on Debt Terms

repaid
• Terms on bank loans tend to be shorter (3-5
• Coupon / Interest – stated rate of interest years) than those of publicly-issued bonds (7+
to be paid, usually on a semi-annual basis years)

• Prepayment – In some circumstances debt

• Coupons can be fixed at a certain % (Bonds),
can be repaid before maturity, with or
or floating, stated as some spread over a
without a penalty
benchmark such as Libor, such as L+300 (Bank
• Amortization – mandatory principal Loans)
repayment due each year
• Mandatory Amortization is specific to bank
• Issuance Fees – A % of the loan paid to the
loans
lender at the beginning of the loan

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Financial Modeling – Revolvers and Cash Sweeps

• Possible to build a model that will

automatically issue or repay debt
depending on the cash flow generated by
the business (Cash Sweep)

• More common in modeling Private Equity

investments

• See Wall Street Prep’s courses on both

Financial Modeling and Leveraged Buyouts
(LBOs) that cover this topic in great depth
Wall Street Premium Package
Financial & Valuation Modeling, M&A, Comps, LBO

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 That wraps up the last of our
account deep dives, so let’s get back
into our model and finish it up!

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And with that, one more piece of our
full operating model is complete.
The last thing we’ll touch on before
jumping into Cash Flows are a few
common Balance Sheet ratios

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Balance Sheet – Learning Plan

• Accruals & Reserves

• Balance Sheet Rollforwards

• Working Capital
• Fixed Assets & Liabilities

• Common Ratios

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Common Balance Sheet Ratios

• Liquidity and Solvency Ratios – includes Usefulness

Current and Quick
• Helpful to compare versus industry averages
• Capitalization Ratios – whether the or to trends over time
company is funded with Debt or Equity

• Working Capital Ratios – how the • Solvency and Capitalization Ratios most useful
organization converts operating assets to to debt investors
cash

• Common Size Ratios – highlights the • Common Size Ratios helpful for comparing
makeup of a balance sheet over time versus competitors or industry peers

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Common-Size Balance Sheet
XYZ Common-Size Balance Sheet for FY2021-22

Assets: FY2021 FY2022

Cash 3.7% 5.0%
Accounts Receivable 7.4% 6.6%
• Common-Size Balance Sheets take every account Prepaid Expenses 5.6% 5.4%
Inventory 11.1% 12.4%
balance and divide by that period’s Total Assets Current Assets 27.8% 29.5%

Plant, Property, & Equipment, Net 37.0% 34.9%

• Standardizes all balance sheets, making trends Intangible Assets, Net
Other Long-Term Assets
11.1%
9.3%
10.5%
9.7%
over time easier to spot Goodwill
Total Assets
14.8%
100.0%
15.5%
100.0%

• Example, Long-Term Debt is decreasing as a % Liabilities:

Accounts Payable 9.3% 11.6%
of Total Assets, Debt is being used to fund a Accrued Expenses
Deferred Revenue
5.6%
3.7%
6.6%
5.0%
smaller portion of Asset purchases Short-term Debt
Other Current Liabilities
7.4%
1.9%
3.9%
1.6%
Current Liabilities 27.8% 28.7%

• Very useful for comparing internally across time, Long-term Debt 33.3% 31.0%
Other Long-term Liabilities 5.6% 5.0%
or externally versus industry averages or Total Liabilities 66.7% 64.7%

competitors Shareholder's Equity:

Common Shares 11.1% 11.6%
Retained Earnings 22.2% 23.6%
Total Liabilities & Shareholders Equity 100.0% 100.0%

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Congratulations! We’ve wrapped up
one more section of our financial
statement forecast!

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Next up we’ll dive into the Cash Flow
Statement, which is basically one
very detailed rollforward for the
Cash account.

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