I created my first ‘real’ financial model when my employer was thinking of taking a run at Country General, one of the largest farm store chains in America. Regrettably, I didn’t have access to Pillar, which Hyperion and Oracle later acquired.
In that first model, I spent as much time on the balance sheet as I did with the P&L. That’s because that’s the only way to nail down operating and free cash flow. More importantly, focusing on one statement is dangerous because we should never think in financial parts but holistically.
When CFO friends ask if I always project balance sheets, even for burping out small, simple models, the answer is almost always ‘yes’ because it’s more muscle memory than anything. To not do so would be like writing with my left hand.
Projecting Balance Sheets Don’t Need to be Hard
I generally start with P&L modeling, which gives way to working capital. I already know those key numbers for AR, Inventory, and AP. Next, I look at CapEx, contractual debt payments, and any other unusual items on the balance sheet. Nailing down the balance sheet projections is no more difficult than the P&L.
One More Time, Why Model the Balance Sheets?
I’ll skip the part where I say it’s easy. That’s not always true, but it’s close.
- If you don’t include balance sheet modeling, you’ll never know your max capacity for your LOC. I’d also encourage you to check out this post on minimum cash balances.
- If you don’t model the balance sheets, it’s extremely difficult (not impossible) to nail down operating and free cash flow. Those are the dollars that allow you to make investments, pay down debt, pay taxes, and distribute earnings. Did you notice there was no reference to EBITDA in the video? EBITDA serves no purpose in this context.
- You already know most of the key drivers behind your balance sheets, so why not go ahead and complete those while you are at it?
Financial Modeling Coaching Tips
When I created my first model, I was on my own. Here’s what I would have told that 27-year-old at the time:
- Don’t worry about perfection. All models are wrong. Modeling is about business learning, business pivots, and business liquidity.
- Update the model frequently. Better yet, never budget again because it’s a culture killer. Model and update with everyone who has a stake in the action.
- Plan the way you think or the way a CEO thinks about planning. Throw accounting out the window, which means never planning at the general ledger account number level.
- If modeling isn’t your thing, get a coach to help you when you get stuck (mine was Rand Heer a few years later).
- 80% of your model should be spent where our biggest issues and strategic sticking points exist. Remember, the model is a business tool to quantify our thinking – it’s not an accounting exercise.
I hope you gathered in the video that I’m not saying balance sheets are more important than the P&Ls. Then again, cash flows are not more important than the other statements.
We need to purge that thinking from our minds. Think of financial statements as a system or as a whole. We need top-line sales growth that leads to a durable, competitive advantage in the marketplace. We cannot sustain that growth without profitable cash flow (think free cash flow). We’re wasting our time if our returns on investment are marginal at best.
If you think holistically, your entire mindset will change when you go back to your business modeling.