Financial statements include the Balance Sheet, Profit and Loss Statement and Cash Flow Statement. The financial model projections depend on the individual forecasting of these financial statements. The collective projections give the forecasted value of the company used for taking appropriate investment decisions.
We have already in our earlier topics discussed how to invest in a right company which indicated all the factors that are to be considered while selecting a company. Generally we will get enough guidance and literature on how to make that perfect financial model but rarely do we actually consider what we need to keep in mind that will help us avoid errors in our model. In this topic, we shall discuss the things that one should be conscious about while projecting financial statements, which is the rationale for any investment idea.
Things to avoid while preparing a financial model:
After one has already put in the past numbers in the model, the projections of the future numbers needs to be done. It is very essential that one should check the actual data, as it would form the base for future projections. Once the model with the past data is duly checked, we move on towards the future workings.
As per the requirement for the future years to be projected, (generally 3 years future numbers are projected) one needs to put the formulae for the same.
The prime requisite of any projection is the right input of formulae. The model prepared should be done in such a way that every number is formula based.
- Never have manual punching for any future projections
As manual punching leads to mistakes in projections and also leaves huge scope for manipulation.
- Never drag the formulae, always check for the cells under reference
Sometimes wrong cells are linked and the error is dragged all over the model.
- Never put all the data in one sheet
Separate sheets should be maintained which should all be linked to the master sheet which reflects any change made in any of the sheet in the model. It is best to form a template before beginning the projections.
- Never make projections as a thought for the moment
Always have the habit of putting comments. As after all, its human assumption, so some data should be there to fall back on if one needs to know the base of assumption.
- Never make a blunder in the currency to be followed
Always keep a tab of the currency in which the numbers are reported and the one being used in the model. As mistakes in crores or millions or billions can send the model for a toss.
These are some of the key points one needs to keep in mind while building a financial model using the different financial statements. Now we shall look into projecting the financial statements individually.
Things to avoid while preparing Profit and Loss statement:
Profit and Loss statement presents the results of a company’s operations for a given reporting period. Generally, the projections begin with projecting the income statement of any company.
- Never get confused with Total income and Net income (Net Sales) reported differently by different companies. One has to know the components of the total income and their placement in the projections
- The expenses are never to be taken as a single entry. Always prepare a breakup of the expenses as each would impact the bottom-line. A combined number could lead to wrong projections
- The model with operating profit as the key trigger should never have depreciation as part of the expenses. Depreciation should always be below the EBIDTA line as it is just a book entry.
- Never combine all the taxes (current, deferred, MAT) together. The actual tax impact can be gauged when the taxes are separated and worked as different heads
- The exceptional / extraordinary gains and losses are not to be part of the profits / losses. These parameters are to be dealt separately on occurrence basis.
- The appropriations are not to be taken as a part of the P&L.
- Appropriations are to be taken as a separate schedule and projected accordingly
One needs to keep these minor points in mind, which if not considered correctly can lead to the P&L projections go haywire.
Once the P&L is projected, it is linked to the balance sheet with the assets and liabilities projected in correlation to the total income and expenses of the P&L.
Things to avoid while preparing Balance sheet:
A balance sheet (also called the statement of financial position) is defined as a statement of a firm’s assets, liabilities and net worth.
There could be difference in the format in which the balance sheet is reported by the company and that taken up for projection.
- One should not change the format for the projections, in comparison to the actuals which could be the company format as the linking is based on it. Keep uniformity in the template of the actual and projected balance sheet.
- Never forget the concept of liabilities and shareholder’s equity and not to be taken in assets side. They are to be separately projected under the liabilities head.
- Never separately calculate and punch in numbers of the balance sheet (this is often done to adjust the cash).Every head of the balance sheet is to be linked to the P&L and projected as a ratio to the number of days or averages calculated
The projections of the balance sheet done after considering the above points should be without much of an error.
After the P&L and balance sheet, numbers have to only flow into the Cash Flow Statement
Things to avoid while preparing Cash Flow Statement:
The cash flow statement can be projected once it is linked to the P&L and Balance sheet. No head of the cash flow has any separate calculation. All numbers just flow-in from the above.
- One should never have any manual scope in the cash flow. All has to be linked to P&L and BS
- Avoid the blunders that generally happen with representing the increase or decrease of a line-item.
One needs to be careful with the signs (positive / negative) used in the different line items as that would lead to the net cash value at the end of the cash flow.
The above mentioned points may look to be not that important, but once we sit to project a model and any mismatch or error in any of the above mentioned happens, it can make a person struggle for days to tally the balance sheet or rectify the cash blunder. That is why, for a smooth transit from actual reported to the projected, it is better to proof read, be cautious with the minutest data avoiding any error and then have a model that is almost close to 100% accuracy.