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Now that we know a bit about accounting, we know that a
balance sheet must balance. In creating forecast numbers for
that financial statement, we have to make sure that our projected
balance sheet will also balance. We will go over how to build the
mechanism in our model to do this.


THE USE OF ˜˜PLUGS™™
It is easy to set up a model for historical data because, by defini-
tion, the balance sheet has numbers that balance. However, fore-
cast balance sheets will always need to be balanced, because we
forecast the individual items without regard to how the overall
totals will add up. Accounts receivable, inventory, and accounts
payable are likely to be projected at percentages of revenues;
capital expenditures may be defined by another measure. In
the meantime, debt levels will be based on a known amortization
schedule, while equity will increase from the net income after
dividends. The net income itself will be defined by various
margin assumptions. Other asset and liability accounts will
grow at the revenue growth rate, or other rates. They may
hold constant or drop to zero altogether at some point in the
future.
119



Copyright © 2004 by John S. Tjia. Click here for terms of use.
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These varying effects serve to make the balance sheet go out
of balance from the first forecast period on. Either the assets side
will be greater than the liabilities and equity side, or vice versa.
Either way, we will have to consider the use of a ˜˜plug™™ number
to even out the sides:



Historical balance sheets are balanced by definition



Liabilities


Assets


Shareholders™
equity




Imbalance in forecast years, which needs to be
corrected by a liability ˜˜plug™™ (shown in gray). . .




Liabilities


Assets


Shareholders™
equity




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Balancing the Balance Sheet 121




or an asset ˜˜plug™™ (shown in gray)




Liabilities


Assets


Shareholders™
equity




SURPLUS FUNDS (SF) AND NECESSARY
TO FINANCE (NTF)
The plug is a number that appears on either side of the balance
sheet and serves to make both sides equal. From our discussion
in the last chapter, we can think of the balance sheet in visual
terms, and the purpose of the plug is to make both sides of the
balance sheet equal in height. If it is on the left hand side of the
balance sheet, let™s call the plug Surplus funds. If it is on the other
side, then we call the plug a Necessary to finance.
There are other terms we can use for these two plugs. For
Surplus funds, or SF for short, we can well call it Excess cash. This
is to make a distinction from the account called cash, which is not
a plug number but a specified entry. However, as the two terms
Excess cash and Cash appear similar, I like to call the plug item
Surplus funds to make the distinction more clear.
For Necessary to finance, another term can be Revolver (a
revolver is a debt facility that keeps being renewed, or revolved).
However, this glosses over the fact that this new funding
required on the right-hand side is not always necessarily
debt. The funding need can well be for new equity. For this
reason, the term Necessary to finance, or NTF for short, is closer
to the concept that this is really only a funding requirement.




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We will regard it as debt, but we should not be constrained to
think of it only as debt.
If you specify known projected debt levels (from the com-
pany™s current borrowings and known amortization schedules),
the company™s total outstanding debt will decrease. It is likely
that in normal operations the company™s assets will increase at a
pace that cannot be funded by the increase in shareholders™
equity alone. To keep the balance sheet balanced, we need to
assume that it will need additional new debt, and this is where
the NTF comes in. It can work as an automatic indicator of the
company™s funding deficit”the additional debt that the company
needs to maintain its balance sheet growth.
If you then forecast a level of earnings that allows the
company to grow its shareholders™ equity, the company™s cash
position will improve. This is seen first as a reduction in the NTF
number”this is so because with more cash, the company has
less of a funding deficit and the NTF amount decreases.

An Important Use of the NTF Number
You can also use the NTF number as a way to show a company
reducing its total debt outstanding as fast as its earnings and
other growth elements allow it. Do this by deliberately entering
zeroes for the company™s debt at the start of the projection year,
thus forcing an NTF number to appear to fill in the gap. Any
earnings in future years, to the extent that they exceed the com-
pany™s balance sheet needs, will work down the NTF number
automatically.

TWO WAYS TO BALANCE
THE BALANCE SHEET
We now proceed to the task of balancing the balance sheet. There
are two ways to balance the balance sheet:
1. Through the cash flow statement
2. Through the balance sheet
I recommend the balance sheet method, simply because it is
simpler and less prone to errors. However, let™s go over the
cash flow statement method first.




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Cash Flow Method
The first approach uses the cash flow statement to bring together
(1) the net income number from the income statement, which is
really the change in the retained earnings, and (2) the changes
between the current year and the prior year in every account of
the balance sheet, except the retained earnings account. As we
add together all these changes, we get a net number. If this net
number is a positive number, then this is the Surplus funds plug
on the current balance sheet; if it is a negative number, then it is
the NTF plug.

SCHEMATIC OF THE CASH FLOW BALANCING METHOD

Net income from the income statement
þ
Changes in every asset account
(increases in assets are negative ¬‚ows;
decreases are positive ¬‚ows)
þ
Changes in every liability and equity account, except the
retained earnings account
(increases are positive ¬‚ows;
decreases are negative ¬‚ows)
¼
Net cash available in the year
Positive number is the Surplus funds plug
Negative number is the NTF plug


The cash flow method is the more difficult of the two because:
1. We have to make a lot of calculations to get to the final
net number. We have to look at the flows from the
income statement and also the changes in each account
on the balance sheet from one year to the next.
2. We have to know how to create a cash flow statement,
which is the trickiest statement to build of the three
financial statements.
3. This approach does not give an indication of what the
final number of the plug should be. Essentially, we would
be making all the calculations in the cash flow statement




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blindly, with no real indication of what the final target net
number should be.
4. The ending net cash available from the cash flow
calculations represents the change in the plug for the current
year, because it is derived from the net changes for the
current year. In order to use the net cash available as a plug,
we have to add it to the prior year™s plug numbers on the
balance sheet.
If we arrive at the correct solution at the first try, well and
good. However, if the net number is not the correct one for
balancing the balance sheet, there is no one definitive clue
about what the number should be, or where we should look
for it.
With this approach, we would also not be able to balance
the first year of the model. Since the cash flow method requires
two balance sheets, the current one and the one from the prior
year, there is no ˜˜prior™™ when the current one is the first year.
Of course, the first year in the model is typically a historical
year and there would be no need to balance those numbers, so
this may be an unimportant point.
Either method will give the same set of numbers for
the model. But in addition to being the more difficult of the
two, it is also possible that the cash flow approach makes it
more difficult to see and understand how a model and its
accounting are working. This is because the direct relationship
of one side of the balance sheet to the other, very clearly seen in
the visual representation of two columns next to each other,
gets blurred when you have to run the numbers through a
third format, the cash flow statement. Now let™s look at the
balance sheet method.


Balance Sheet Method
To use the balance sheet method, look at the numbers on the left-
hand and right-hand sides of the balance sheet. Find the dif-
ference. It is better to subtract the left-hand side (assets) from
the right-hand side (liabilities and shareholders™ equity) simply

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