Understanding financial health is essential for companies to make informed business decisions and project future growth. While different financial statements offer valuable insights, the balance sheet provides a clear overview of a company's assets, liabilities, and equity at a specific point in time.
Forecasting a balance sheet has multiple purposes; it helps assess the impact of financial decisions on a company's overall financial health, and it plays a critical role in attracting investors, by showcasing a company's potential for future growth and its ability to generate returns on investment.
In this guide, we’ll explore the key components of a balance sheet, explain why forecasting a balance sheet is important, and provide practical tips to effectively do a balance sheet forecast.
What is a balance sheet?
A balance sheet is a financial statement that provides a snapshot of a company's financial position at a particular point in time. It reports the company's assets, liabilities, and shareholder equity, providing a basis for investors to evaluate the company's financial health.
In simpler terms, the balance sheet shows what a company owns and owes, as well as the amount invested by shareholders. It’s often used in conjunction with other financial statements to conduct fundamental analysis and calculate financial ratios.
The balance sheet can be generated automatically by bookkeeping software, and it's imperative to ensure that the balance sheet is accurate. Inaccurate balance sheets can misrepresent a company's financial position and cause serious problems. Inaccuracies can create confusion and lead to misguided financial decisions.
To avoid this, companies should regularly review their balance sheets, verify the accuracy of the data, and make corrections if necessary. By doing so, they can rely on their balance sheets to provide an accurate picture of their financial health and make informed decisions.
Why the Balance Sheet Is the Most Important Part of the Three-Statement Financial Model
The three-statement model provides a comprehensive view of a company's financial health with these financial statements: the income statement, balance sheet, and cash flow statement. Each of these statements provides different, key information about a company's financial performance.
The income statement shows a company's revenues, expenses, and profits over a period of time. It provides information about the company's ability to generate profits from its operations and can help investors evaluate the company's profitability.
The cash flow statement shows a company's inflows and outflows of cash over a period of time. It provides information about a company's ability to generate cash from its operations, investments, and financing activities. The cash flow statement can help investors evaluate a company's liquidity and financial flexibility.
However, of the three financial statements, the balance sheet is often considered the most crucial, because it provides a snapshot of a company's financial position at a particular point in time. It reports the company's assets, liabilities, and shareholder equity, providing a basis for investors to do a financial forecast of the company's financial health.
The three financial statements in the three-statement model are all closely related; the income statement provides information about a company's profits, which is used to calculate the change in shareholder equity on the balance sheet. The cash flow statement provides information about a company's inflows and outflows of cash, which can then impact the cash balance reported on the balance sheet.
The balance sheet allows investors to assess a company's solvency and financial flexibility. If a company has more assets than liabilities, it’s considered solvent and has a lower risk of bankruptcy. On the other hand, if a company has more liabilities than assets, it may struggle to meet its financial obligations and be at a higher risk of insolvency.
Forecasting a Balance Sheet
By estimating the assets, equity, and liabilities at a specific point in the future, companies can make informed decisions about their capital, debt, and other financial aspects. This forecasting process is typically conducted using historical data and financial software to project the future state of the balance sheet.
Here's how you can utilize financial data to forecast a balance sheet:
Forecast Net Working Capital
Net working capital includes the total current assets and liabilities of a company. This first step is important, because by reviewing past financial data, businesses can project a realistic net working capital figure for their balance sheet forecasts. This step helps in determining the liquidity and short-term financial health of the company.
Project Fixed Assets
Fixed assets, which are long-term tangible assets owned by the business, play a significant role in supporting a company's operations, generating revenue, and maintaining its productive capacity. Predicting fixed assets in balance sheet forecasting involves estimating the future value and composition of a company's long-term tangible assets. To accurately predict fixed assets, factor in depreciation, by subtracting depreciation from the sum of the fixed assets and capital expenditure:
Projected Fixed Assets = Fixed Assets Last Year + Capital Expenditure – Depreciation
Financial Debt Projection
Financial debt projection is the third step in forecasting a balance sheet. This step ensures accurate reporting of liabilities, helps with cash flow management, estimates interest expenses, assesses financial risk, aids in capital planning and budgeting, and enhances investor confidence and credit-worthiness. Here's how to calculate financial debts:
Projected Financial Debt = Financial Debt Beginning of Year + Change in Financial Debt
Forecasting the Equity Position
Forecasting the equity position provides valuable insights into a company's financial health, capital structure, and overall stability. Equity represents the residual interest in the company's assets after deducting liabilities, and it reflects the shareholders' ownership in the business. By forecasting equity, businesses predict the retained earnings and funds contributed to the company. Here’s the formula:
Projected Equity = Equity Last Year + Net Income – Dividends + Change in Equity
Forecasted Cash Position
The forecasted cash position helps assess liquidity, manage working capital, make investment and financing decisions, and mitigate risks. It provides insights into a company's ability to meet immediate and short-term obligations, supports effective working capital management, guides investment and financing choices, aids in risk management, and enhances transparency for stakeholders. The formula is as follows:
Projected Cash Position = Last Year's Cash Position + Change in Cash
Forecasting the balance sheet from net zero is an approach used on accounts with significant fluctuations, like accounts payable. By starting the forecast with no balance and using financial ratios, businesses can achieve a more consistent view of their cash balance.
Maintaining a balance sheet forecast requires projecting net working capital accurately, which reflects the company's short-term financial health. Furthermore, major one-off events that impact cash, such as funding rounds or significant cash outlays, are incorporated into the balance sheet forecast using event-based planning. This enables businesses to account for these events and provides visibility into their cash balance.
How Forecasting Balance Sheets Helps Businesses
By providing a comprehensive view of a company's financial position, forecasting the balance sheet enables proactive management, informed decision-making, and effective communication with stakeholders. Here are some of the benefits of balance sheet forecasting:
- Financial Planning: Businesses can develop a comprehensive financial plan by projecting the company's assets, liabilities, and equity over a specific period, enabling better budgeting and resource allocation. Data in the forecasted balance sheet serves as a roadmap for financial decision-making and facilitates long-term planning.
- Capital Management: Insights from the balance sheet forecast paint a picture of the company's capital structure and help determine the optimal mix of debt and equity. Businesses can evaluate their capital requirements, plan for future capital investments, and make informed decisions regarding financing options.
- Performance Evaluation: Businesses can compare their projected financial position with actual results, enabling performance evaluation. By analyzing the discrepancies between the forecasted and actual balance sheets, companies can identify areas for improvement, assess the accuracy of their projections, and make necessary adjustments to their strategies and operations.
- Risk Assessment: By projecting future assets, liabilities, and equity, businesses can identify potential vulnerabilities and take proactive measures to mitigate risks.
- Decision-Making: Forecasted balance sheet information provides a foundation for informed decision-making. It assists businesses in evaluating the financial impact of various decisions, like new investments, acquisitions, or changes in capital structure. With a clear understanding of the projected balance sheet, companies can assess the financial feasibility and implications of different choices, supporting strategic decision-making processes.
- Compliance and Reporting: Many regulatory authorities require businesses to submit financial statements, including balance sheets, at regular intervals. By forecasting the balance sheet, companies can ensure compliance with reporting requirements and streamline the financial reporting process. It enables businesses to prepare accurate and timely financial statements, avoiding penalties and maintaining regulatory compliance.
Forecasting the balance sheet helps businesses with financial planning and capital management. With the right financial software, businesses can conduct risk assessments, evaluate performance, enhance decision-making, and meet compliance requirements.
Jirav transforms your financial forecasting by providing real-time insights into business performance. Jirav automatically generates 3-way financial statements for historical and future periods from your model, including Income Statement, Balance Sheet, and Statement of Cash Flows. Book a Demo today, and start making accurate projections about your company's financial health.