November 9, 2015
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.
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.
As manual punching leads to mistakes in projections and also leaves huge scope for manipulation.
Sometimes wrong cells are linked and the error is dragged all over the model.
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.
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.
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.
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.
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.
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.
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
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 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.