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Subject 3. Balance Sheet and Cash Flow Statement Modeling PDF Download
Some balance sheet line items, such as retained earnings, flow directly from the income statement, whereas working capital accounts such as accounts receivable, accounts payable, and inventory are very closely linked to income statement projections.
Working capital accounts are forecasted using efficiency ratios. A common way to model working capital accounts is to hold efficiency ratios constant - working capital accounts will grow in line with the related income statement accounts. Analysts can look at historical efficiency ratios and recent project performance or a historical average to persist in the future.
To project long-term assets such as PP&E, analysts need to project capital expenditures and depreciation. They are less directly linked to the income statement.
- Net PP&E changes result from capital expenditures and depreciation, which are essential components of the cash flow statement.
- Depreciation forecasts are based on historical depreciation and disclosures about depreciation schedules.
- In contrast, capital expenditure forecasts depend on analystsí judgment and future need for new PP&E. An organizationís capital expenditures are divided into maintenance capital expenditures, expenditures needed to sustain the current business, and growth capital expenditures, expenditures required to expand the business. Maintenance expenditures should be higher than depreciation because of inflation.
Analysts can determine return on invested capital (ROIC), which measures the profitability of the capital invested by the company's shareholders and debt holders. The numerator is after-tax earnings but before interest expense. The denominator is invested capital, which is equal to operating assets less operating liabilities. High and persistent levels of ROIC are often associated with having a competitive advantage.
A companyís future debt and equity levels can be forecast using leverage ratios such as debt-to-capital, debt-to-equity, and debt-to-EBITDA.
After projecting the balance sheets and income statements, the future cash flow statement can be projected. The analyst will make assumptions about how a company will use its future cash flows, share repurchases, dividends, additional capital expenditures, and acquisitions.
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