Business people are sold on the usefulness of financial statement projections for company financial management purposes. Pro forma financials are the staple of corporate financial analysis. In addition, these pro forma projections form the basis for credit analysis and estimation of how much debt or equity financing the firm will need in the future.
You can run ‘what-if’ scenarios to see what types of pressure the company will experience should some key financial and sales parameters change. This is an excellent way to reveal potential risks facing the business.
Business valuation is about assessing future returns and levels of risk for the company. So financial modeling is at the heart of business value analysis, especially when you use the valuation methods under the income approach, such as the discounted cash flow technique.
Most financial forecasting models are sales driven, in other words they assume that majority of balance sheet and income statement items are in some way related to sales. For example, accounts receivable are typically set as a percentage of sales. The fixed assets can be modeled as a function of the sales level they are intended to support.
In your financial forecasts, you should distinguish between the items that are functionally related to sales and those that are driven by policy decisions. For example, the asset levels are typically assumed to be functionally related to the sales. You need to have certain assets to generate sales, such as levels of inventory.
On the other hand, the proportions of long term debt and equity can be seen as a policy decision made by the firm’s management.
To make sure your financial forecast can be used in business valuation, you need to handle the so-called plug in your model. That is the balance sheet item that is needed to make the model work. It meets the following financial statement requirements:
- Making sure the balance sheet, i.e. assets and liabilities, are ‘in balance’
- Ensuring the model correctly represents the company’s planned investments
Usually, the model plug will take one of these forms:
- Cash and cash equivalents
- Owners’ equity
Let’s say you choose cash and cash equivalents as the model’s plug. Mathematically, the balance sheet is in balance if the cash and cash equivalents plug equals the difference between the firm’s total liabilities and equity and its other current and fixed assets.
In the financial sense, this approach states that the company will not sell its stock, repay or raise additional debt. Instead, the business is expected to be financed by its own cash. This, of course, assumes that the company has enough cash on hand to fund its operations.