Question

Balance sheet consists of elements that represent in ccounting cycles. As a result, the cumulative balances will carry over into the next accounting period. How can be used to project the cash-generating ability of an entity.

Answer 1

A Balance sheet is a great way to analyze a company’s financial position to project the Cash-generating ability of entity. An analyst generally uses the balance sheet with income statements to calculate a lot of financial ratios that help to determine how well a company is performing or how liquid or solvent a company's health.

A balance sheet in conjunction with other statements like income statement and cash flow statement to get a full picture of a company’s health. Changes in balance sheet accounts are also used to calculate cash flow in the cash flow statement.

Liquidity - Comparing a company’s current assets to its current liabilities provides a picture of liquidity. Current assets should be greater than current liabilities so the company can cover its short-term obligations. The Current Ratio and Quick Ratio are examples of liquidity financial metrics.

Leverage – Looking at how a company is financed indicates how much leverage it has, which in turn indicates how much financial risk the company is taking. Comparing debt to equity and debt to total capital are common ways of assessing leverage on the balance sheet.

Efficiency – By using the income statement in connection with the balance sheet it’s possible to assess how efficiently a company uses its assets. For example, dividing revenue into fixed assets produces the Asset Turnover Ratio to indicate how efficiently the company turns assets into revenue. Additionally, the working capital cycle shows how well a company manages its cash in the short term.

Rates of Return – The balance sheet can be used to evaluate how well a company generates returns. For example, dividing net income into shareholders’ equity produces Return on Equity (ROE), and dividing net income into total assets produces Return on Assets (ROA), and dividing net income into debt plus equity results in Return on Invested Capital (ROIC)

Below picture is used by the analyst to link various statement like Income statement, Balance Sheet and Cashflow to arrive at the project cash-generating ability of an entity.

Forecasting the income statement

With the assumptions in place, it’s time to start forecasting the income statement, beginning with revenue and building down to EBITDA (Earnings before Interest Taxes Depreciation and Amortization). At that point, we will require support schedules to be built for capital assets and financing activity

Forecasting capital assets

At this point, we need to forecast capital assets like Property Plant & Equipment PP&E before we can finish the income statement in the model. To do this we take last period’s closing balance, add any capital expenditures, deduct depreciation, and arrive at the closing balance. Depreciation can be calculated in a variety of ways, such as straight line, declining balance, or percent of revenue.

Forecasting financing activity

Next up we have to build a debt schedule to determine interest expense on the income statement. Similar to the section above, we take last period’s closing balance, add and increases or decreases in principle, and arrive at the closing balance The interest expense can be calculated on opening balance, closing balance, or the average balance of debt outstanding. Or, a detailed interest payment schedule can be followed if available.

Forecasting the balance sheet

Working capital items are forecasted based on assumptions around average days payable and receivable, as well as inventory turns. Capital assets like PP&E come from the schedule above, as well as debt balances.