BALANCING THE BALANCE SHEET 1

Most Financial Modelers face difficulties in balancing the Balance sheet, this could be a nightmare for Modelers.

The truth is, it becomes a much more manageable task when you stick to fundamental principles while constructing the model.

Since incorporating these principles into our model build process, maintaining a balanced balance sheet has ceased to be a cause for worry.

Firstly, we need to understand that we have 2 types of line items:

1. A Flow: This represents the amount of value that passes through the balance over time, such as Revenue.
2. A Balance: This signifies a measure of value in the business at a specific point in time, for example, Account Receivables.

A FLOW:

Every line item that goes through the income statement or cashflow statement is a flow.

Here are the fundamental principles:

1. Retained earnings and retained cash serve as your balancing accounts. Therefore, the initial step is to model the balances for retained earnings and retained cash.
2. Every line item classified as a flow must adhere to the double-entry principle. This implies that an entry must be reflected in both the income statement and the cash flow statement, with any difference (if present) allocated to the balance sheet. Alternatively, an entry will go to the cash flow statement, while another entry impacts the balance sheet.

Let’s explore some examples of a flow:

1. Operating Revenue:

Operating Revenue is recorded in the income statement, and the corresponding entry, Cash received from Operating Revenue, is recorded in the cash flow statement. Any variance is recorded in Accounts Receivables.

2. Operating Cost:

Operating Cost is recorded in the income statement, while the corresponding entry, Cash paid from Operating Cost, is recorded in the cash flow statement. Any variance is recorded in Accounts Payables.

3. Tax expense and Tax paid:

Tax Expense is reported in the income statement, and the subsequent entry, Tax paid, is recorded in the cash flow statement. The variance, representing deferred tax, is recorded in the deferred tax balance.

4. Interest due and paid:

Interest Due and Paid are accounted for in the income statement, with the subsequent entry captured in the cash flow statement.

5. Principal repayment:

Principal Repayment is recorded in the cash flow statement, while the corresponding entry impacts the debt balance.

6. Capex purchased:

Total Capex Purchased is recorded in the cash flow statement, and the corresponding entry is reflected in the non-current assets balance.

A Balance:

All balances in the balance sheet have an Upward flow and a Downward flow, and some may have an Initial balance. An Upward flow increases the value of the balance, whereas a Downward flow decreases it. Understanding these basic principles ensures a balanced balance sheet.

Let’s explore some examples:

1. Non-Current Assets Balance: The upward flow includes new additions of assets, while the downward flow is from depreciation or disposals.
2. Account Receivables Balance: The upward flow is from operating revenue, while the downward flow is from cash received from operating revenue.
3. Account Payables Balance: The upward flow is from operating costs, while the downward flow is from cash paid for operating costs.
4. Debt Balance: The upward flow is from additional drawdowns, while the downward flow is from principal repayment.
5.  Share Capital Balance: The upward flow is from capital injection, while the downward flow is from shares buyback or share capital redemption.
6. Retained Earnings Balance: The upward flow is from Profit after tax, while the downward flow is from dividends.
7. Retained Cash Balance: The upward flow is from cash available for dividends, while the downward flow is from dividends.
8. Deferred Tax Balance: The upward flow is from tax expenses, while the downward flow is from tax paid.”

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