A Practical Guide to Financial Statement Forecasts for Business Valuations – Forecasting Balance Sheets

When it comes to future financial performance of a company, most people usually focus on income statement metrics. We discuss the considerations and techniques that you can employ in projecting income statement information in Forecasting Income Statements. However, the impact of changes in a business’s balance sheet over time can significantly impact the true cash flow available to investors. In this section of the guide, our focus will be the core balance sheet items that typically affect a business valuation:

Net working capital;
Fixed assets and capital expenditures; and
Debt.

This article is a continuation of A Practical Guide to Financial Statement Forecasts for Business Valuations and Forecasting Income Statements. We highly recommend that you read these articles first for essential conceptual background for forecasting financial statements. We have included a free, fully functional forecasting model with examples that we will be referencing in this article. Feel free to use it as needed for your own forecasting needs.

This section of the guide will walk through some commonly-used methods to forecast the components of a balance sheet that are most relevant for a business valuation. We will not discuss a complete balance sheet forecast as it is typically unnecessary for a valuation. The examples presented in this article are for illustrative purposes only. The level of detail you may need for your valuation requirement will depend on the facts and circumstances of your company and the expected use of the forecast.

Disclaimer: This article provides general guidance related to forecasting financial statement information for a business appraisal. The discussion provided herein solely reflects the opinions of the author. It is not exhaustive and all-inclusive, and the concepts discussed herein may not be applicable in all situations. Business valuations should consider the facts and circumstances pertinent to the subject company. No guide can predict all potential scenarios.

For CPAs: “Forecast”, “estimations”, “projections”, and other variations of these words will be used interchangeably and without specific reference to the American Institute of Certified Public Accountants’ (AICPA) attestation standards or definitions of these terms. In addition, this guide was not prepared to address the preparation of prospective financial information for an examination engagement under AT-C Section 305. The AICPA differentiates between financial forecasts and projections as follows:

Financial Forecast – Prospective financial statements that present, to the best of the responsible party’s knowledge and belief, an entity’s expected financial position, results of operations, and cash flows. (AT-C Section 305.09)
Financial Projection – Prospective financial statements that present, to the best of the responsible party’s knowledge and belief, given one or more hypothetical assumptions, an entity’s expected financial position, results of operations, and cash flows. (AT-C Section 305.09)

Although many of the concepts will inevitably carry over, the intent of this guide is not to conform to either of the definitions noted above.

How Do Changes in the Balance Sheet Impact Free Cash Flow?

As discussed in A Practical Guide to Financial Statement Forecasts for Business Valuations, free cash flow represents the amount of cash flow available for distribution to a company’s stakeholders. This cash flow metric incorporates a company’s reinvestment requirements in working capital, fixed assets, and intangible assets. Free cash flow to equity also contemplates changes in a company’s debt levels.

See below for a summary of how we calculate free cash flow (balance sheet items are in bold and orange):

As we have explained in prior sections of this guide, free cash flow to invested capital represents the amount of money available to both equity and debt holders after balance sheet reinvestment. Free cash flow to invested capital does not include a provision for changes in the company’s debt levels. Forecasts of free cash flow to equity, on the other hand, require the estimation of future debt balances and related interest expenses. By incorporating debt items in the free cash flow calculation, we can isolate the amount of cash flow remaining for equity holders.

For most companies, the balance sheet tends to increase as business improves and vice versa. For example, a manufacturer that enjoys constant revenue growth may also see an increase in accounts receivable and payable, its inventory balances, and investments in fixed assets to increase production capacity. Increases in a company’s assets represent cash outflows and reduce free cash flow. Conversely, increases in liabilities improve cash flow.

As an example, suppose a company needs to acquire a new piece of equipment (i.e., capital expenditure). The company can pay for that asset in several ways, including:

The company can pay for the new equipment from its operating cash flows. In this case, the level of cash flow available to the equity and debt holders would decline by the equipment cost.
The company can take on new debt to finance the acquisition. There would be no immediate cash flow impact of the equipment purchase (a cash outflow). An increase in debt liabilities (a cash inflow) would offset the cash outflow associated with the equipment purchase. However, the business’s future cash flows would decline due to related interest expense and debt payments.
Although less frequent for financing new equipment purchases, the company could also draw upon additional equity financing. The cash infusion provided by capital contributions from equity holders would neutralize the cash flow impact of the equipment purchase. Free cash flow might be unaffected altogether in this case.

For companies with significant capital requirements, balance sheet changes over time can significantly impact future cash flows and, in turn, influence the valuation of the business.

Where to Start When Forecasting the Balance Sheet

Although we are looking now at the balance sheet, many of the general concepts discussed in earlier sections of this guide are relevant.

See: The five steps to forecasting financial information, first introduced in A Practical Guide to Financial Statement Forecasts for Business Valuations.

The story behind the numbers is arguably the single most essential input. The level of detail needed in your narrative and forecast will vary based on the nature of the business, the purpose of the estimates and valuation, and your ability to forecast said detail.

As discussed in the Forecasting Income Statements section of this guide, historical financial statements will generally provide the best reference point for the future. How the balance sheets are presented historically will certainly impact how you forecast them.

The ideal presentation of your balance sheet for a valuation will be in accordance with U.S. Generally Accepted Accounting Principles (GAAP). However, don’t worry if you do not have audited or reviewed financial statements. Internally-generated accrual-based financial information will work fine as long as it is reliable and accurately depicts the company’s financial condition. The discussion in this article will assume that your company has accrual-based financial statements.

You Have Options When It Comes to Forecasting Balance Sheet Information

There are three general ways that you can forecast a balance sheet for valuation purposes:

Relying on your appraiser to make estimates and guide the process;
A simplified approach using percentages of revenue; or
A more detailed driver-based model.

Yes, you read that correctly. One method is to let your appraiser do the heavy lifting. Many clients stop their forecasting efforts at the income statements and never get into forecasting the balance sheet at all. In these cases, we have developed forecasts (on the clients’ behalf) for the key balance sheet items needed to calculate free cash flow.

When we develop projected balance sheet information for clients, we always review our estimations with the client to confirm that it aligns with their general expectations. Since the management team knows their business better than anyone, it always makes sense to ensure that they are on board with every aspect of the financial statement forecast.

If you choose to forecast the balance sheet on your own (kudos!), there are two general methods to choose from: the simplified approach or a more complex driver-based models. The method you use will depend on your specific situation, as explained below. Remember that a free, fully functional forecasting model is available to you. The examples in the remainder of this article will refer back to the spreadsheets in this model. Let’s get into it.

How to Forecast Capital Expenditures

Capital expenditures tend to the easiest balance sheet item to tackle for most clients. After all, major capital investments are typically addressed in normal capital budgeting processes. There are two major categories of capital expenditures:

Growth capital expenditures – These costs relate to purchases of new equipment, machinery, facility expansions, or any other asset needed to support a business’s future growth. The timing of growth capital expenditures will correlate to a certain degree with future revenue increases. Often, costs need to be assessed on a case-by-case basis related to the purchase of specific fixed assets. This might be a new manufacturing line required to support a newly-developed and forthcoming product or the construction costs related to new retail locations. Growth capital expenditures should be estimated in the context of the story of the company’s future.

Maintenance capital expenditures – These costs relate to purchases required to maintain (or replace) the usefulness of the current fixed asset base. Maintenance capital expenditures can typically be estimated using simplified approaches.

Figure 14 presents three examples that incorporate a projection of capital expenditures using a percentage of revenue, growth rates, and a combination of the two.

In Example 1, capital expenditures are projected using a normalized percentage of revenue from 2021 through 2025. This method works well for capital-intensive companies because the level of ongoing maintenance capital expenditures will depend on how extensively the equipment is used. In other words, the more items a company produces and sells, the more maintenance will be required on its assets. Therefore, you may estimate future maintenance expenditures as a percentage of revenue.

In Example 2, projected capital expenditures are estimated using growth rates. Notice in this example that capital expenditures were higher than typical in 2020. Applying a growth rate to this figure results in an inflated level of capital expenditures over the next five years. Projecting capital expenditures using growth rates can be appropriate for companies that are not as capital intensive. For example, a consulting firm may have computers, desks, printers, and office space. These assets can be used to service one client or one hundred clients. In this case, a growth rate might be the better way to estimate future capital expenditures.

In Example 3, a normalized level of capital expenditures is estimated in 2021 using a normalized percentage of revenue. In subsequent years, revenue is projected based on a growth rate. This method would be applicable when the latest capital expenditure figures do not represent ongoing capital expenditure needs. By applying a percentage of revenue in the first projected year, we can estimate a normalized level of capital spending and then project stable growth from that figure for subsequent years.

How you forecast capital expenditures will vary based on the facts and circumstances of your company. Remember that the methodology you choose is not as important as whether the resulting figures make sense and are consistent with the company’s story.

Pro Tip: Ensure that income or cash flow improves adequately to justify the cost of the projected capital expenditures.

After you forecast capital expenditures, check it for reasonableness. Suppose you forecast a capital purchase of $1 million in Year 1. Is there an improvement in revenue, EBITDA, or free cash flow in subsequent years to provide an appropriate return on the investment? If the future cash flows of the business are unchanged with or without the projected capital purchase, is it prudent to make such a purchase? In most cases, growth capital expenditures should be followed by – you guessed it – growth!

In some scenarios, large capital investments may be necessary to simply stay in business (i.e., company is replacing significant amounts of obsolete equipment, recovering from a disaster that destroyed a facility, etc.). Cash flows may not grow significantly in these cases, but an adequate return should still be generated from the investment.

How to Forecast Net Working Capital – Simplified Approach

The calculation of net working capital involves subtracting current liabilities from current assets. The most simplistic approach for forecasting net working capital consists of using historical percentages of revenue. See Figure 15 for an example.

In the lower half of Figure 15, we present three definitions of net working capital:

Net Working Capital = Current Assets – Current Liabilities
Debt-Free Net Working Capital = Current Assets – (Current Liabilities – Current Portion of Debt)
Debt-Free, Cash-Free Net Working Capital = (Current Assets – Cash) – (Current Liabilities – Current Portion of Debt)

Pro Tip: Define the definition of working capital with your appraiser before you start forecasting.

The definition used in a valuation will depend on several factors, including the nature of the business and the purpose of the valuation. Ask your appraiser what is needed to complete the analysis before you spend time projecting out cash or debt balances.

As you can see in Figure 15, the simplified approach can work for any of the net working capital definitions noted above. All you need is a reference point, which can be the company’s historical financial information or benchmarking data based on relevant peer companies. A percentage of revenue approach is ideal for companies that do not expect significant changes in their working capital needs going forward.

The weakness of the simplified method is its inability to incorporate explicit changes to individual line items. For example, assume that a company has historically held 90 days of inventory and expects to reduce its inventory holdings to a more industry-consistent 60 days. We could adjust the working capital percentage to accommodate this change but by how much? In this case, a driver-based model might be a better approach to forecast net working capital.

How to Forecast Net Working Capital – Driver-Based Modeling

How to Forecast Cash

Cash is one of the more interesting balance sheet items to forecast. It is impacted by virtually every aspect of a company’s financial statements. Most businesses will maintain some cash on the balance sheet to pay the bills. Depending on a company’s goals, you might see businesses carrying large cash balances or the bare minimum.

Pro Tip: Don’t forecast cash balances if it is not necessary to do so.

In a business valuation, the appraiser will determine whether or not a forecast of cash is required. The rationale for when a forecast of cash is needed is beyond the scope of this article – contact us if you would like to discuss this in further detail. Before you estimate future cash balances, check with your appraiser to ensure that this information is required.

As we forecast cash, keep in mind that we are only concerned with projecting the amount required for ongoing operations. We will refer to this as “operating cash.” Any cash generated over the assumed operating cash balance is effectively free cash flow. Operating cash is typically correlated to cash expenses, so we like to look at a company’s historical days cash expense coverage ratios. These ratios express the number of days that a company can pay for its cash expenses from its cash balance.

The formula looks like this:

Let’s look at an example in Figure 16 and break down this formula into its components.

Several things are occurring in Figure 16:

We first examine the relationship between historical cash and cash expenses. Total cash expenses for each year are calculated and then divided by 365 days. This allows us to estimate the company’s average daily cash expenses. In the example above, the company incurred between $2,000 and $3,000 dollars in costs a day.
We then divide the historical cash balances by the daily cash expense figures. This provides us with the number of days of costs that the company could cover with its historical cash balances. In Figure 16, the company maintained a level of cash that allowed the company to pay cash expenses for 21 to 27 days.
Moving to the forecast columns, we estimate a cash expense coverage ratio of 25 days based on the historical ratios analyzed. We reverse the calculations above to get back to the projected cash balances using the projected ratios and cash expenses. See: Forecasting Income Statements for how we projected cash expenses.
As an additional reasonableness test, we also like to compare the historical cash turnover ratios against the projected ratios. Cash turnover ratios are calculated as follows:

The cash turnover ratio indicates how much revenue a company generates per $1 of cash balance. These ratios will give you a sense of consistency in the cash balances relative to total revenues.

Pro Tip: Use financial ratios as you prefer and is appropriate for your company.

For those finance nerds out there (like the author), turnover ratios are usually calculated by dividing total revenue by the average of beginning and ending values of the balance sheet item you are analyzing. The ValuAnalytics platform analyzes companies using ratios calculated in this fashion (and we typically appraise businesses this way). However, we have found it more effective and intuitive to forecast balance sheet items using ratios that consider end-of-period balances. In any case, you can project a balance sheet using ratios based on the averages if that is your preference.

How to Forecast Accounts Receivable

Accounts receivable are typically estimated using days sales outstanding ratios. These ratios measure the speed at which a company collects its accounts receivables. Intuitively, the faster you are paid by your customers or clients, the better. Faster collection speed is also a positive contributor to cash flow. Faster collection speeds imply smaller accounts receivable balances and lower working capital requirements. As indicated previously, smaller asset requirements ultimately translate into increased cash flow available for distribution to stakeholders.

Formulaically, we calculated the days sales outstanding ratio as follows:

Figure 17 below provides an example of this ratio in action.

Here is what is happening in Figure 17:

We first calculate historical accounts receivable turnover ratios by dividing total revenue by the historical accounts receivable balance in each respective year. The accounts receivable turnover ratio indicates the number of times in a year that accounts receivable convert to cash.
Next, we convert the turnover ratio into the days sales outstanding ratio. We do this by dividing 365 days by the accounts receivable turnover ratio calculated historically. The resulting days sales outstanding ratios range from 29 days to 33 days, indicating the average number of days that the company took to collect on accounts receivable in each year.
Under the forecast columns in Figure 17, we assume that the company will collect on its accounts receivable over 30 days. Using these ratios and the company’s projected revenue, we reversed the calculations discussed above to estimate the projected accounts receivable.

How to Forecast Inventory

Efficient inventory management is essential to any business looking to manage its cash flow and maximize returns to shareholders. Companies that can keep their inventory holdings relatively low have more cash flow for distribution to stakeholders.

Inventory is typically forecasted using days inventory outstanding ratios, which measure the average number of days that the company holds its inventory before a sale. Here is how it is calculated:

See Figure 18 for an example.

The process is very similar to how we projected accounts receivable.

First, we calculate historical inventory turnover ratios using cost of revenue and inventory balances. Inventory turnover provides a measurement for the number of times inventory is “turned” or sold in a year.
Next, we calculate the historical days inventory outstanding ratio by dividing 365 days by the inventory turnover ratio. In this example, the company held inventory for 85 to 91 days.
Finally, we estimate the future days inventory outstanding ratio (90 days) based on the historical observations. Using this ratio and the projected cost of revenue, we estimate the future level of inventory that the company expects to maintain.

How to Forecast Other Current Assets and Other Current Liabilities

We can usually forecast other current assets and liabilities based on a percentage of future revenue or some other financial statement metric to which they are tied. You can also apply growth rates for assets and liabilities that do not behave consistently with changes in revenues or expenses. In Figures 19 and 20, we present an example for the projection of other current assets and liabilities.

The calculations in Figures 19 and 20 are relatively simple.

First, we calculate the historical other current assets/liabilities as percentages of total revenue/operating expenses.
We then use these historical percentages to estimate future ratios used to project other current assets/liabilities.
The calculation of the balance sheet items involves multiplying the future income statement metric by the selected ratios.

This approach is appropriate for many assets and liabilities that fall into the “other current” category, including deferred revenue. However, you may have significant line items (such as security deposits) that might be better estimated using a growth rate. If these items are material, you may want to consider forecasting them separately.

How to Forecast Accounts Payable

Businesses typically like to stretch out payables as much as possible to maximize ongoing cash flow. Therefore, higher levels of accounts payable balances tend to impact cash flow positively. As with most things in life, however, too much of a good thing can be harmful. Outstanding payable balances that are too high can be a red flag and may indicate a company’s inability to pay its bills.

Accounts payable balances are typically estimated using days payable outstanding ratios. The days payable outstanding ratio represents the average number of days that elapse before the company pays its vendors. Here is how this ratio is calculated:

Note that you can expand the expense component of the formula above (i.e., cost of revenue) also to include operating expenses. The general goal is to include any expense categories that relate to the company’s accounts payable. An example of an accounts payable forecast is presented in Figure 21.

The calculations here should be familiar at this point from the prior discussion regarding accounts receivable and inventory.

First, we calculate historical accounts payable turnover ratios using cost of revenue and accounts payable balances. Accounts payable turnover provides a measurement for the number of times a company’s payables are satisfied in a year. Again, the historical accounts payable turnover ratios can be calculated using the cost of revenue or any other expense category that aligns with payables.
Next, we calculate the historical days payable outstanding ratio by dividing 365 days by the accounts payable turnover ratio. In this example, the company paid off its payables within 29 to 37 days on average.
Finally, we estimate the future days payable outstanding ratio (30 days) based on the historical observations. Using this ratio and the projected cost of revenue, we estimate the future level of inventory that the company expects to maintain.

How to Forecast Debt

Debt can be one of the more complex balance sheet line items to forecast. The first step in projecting future debt balances is understanding how they will be used. Some questions you can ask yourself are as follows:

Will you be taking on debt to purchase new equipment and how frequently will this be needed?
Are you taking on debt to finance a one-time purchase?
Are you using debt to pay for expenses due to a lack of cash?
Will you need debt to finance working capital needs (i.e., bridge the gap between when you collect your receivables and pay off your accounts payable)?
What kind of debt facility will you be obtaining (i.e., line of credit, term note, mortgage, etc.)?
When will you draw on your debt facilities?
Are there covenants on your existing debt that restrict your ability to take on new debt?

The list of questions above is certainly not all-inclusive. Still, the answers to these questions will determine how you go about forecasting debt. Your story for the company should include the answers to these questions (if not already).

There are many ways to turn debt forecasting into a monumental modeling exercise. We find that it best to stay out of the proverbial rabbit hole and use a simplified approach whenever possible. Figure 22 presents a “simplified” example.

It looks like a lot is going on in Figure 22, so we will break it down into its component calculations. It is a simplistic example once you understand the moving pieces.

At the top of Figure 22, we consider the company’s debt balances historically and the amortization of that debt in the future. In this instance, the company’s debt has a five-year remaining term with a balloon payment at maturity.
Below the existing debt calculations, we then address future debt balances. In the example, we assume that the company’s future capital expenditures will be 50% financed with new The new debt will have a three-year term with ongoing principal payments. Note that this is a simplified example that assumes equal principal payments over the life of each loan. In the real world, debt is unlikely to be structured this way. Ultimately, your model should reflect the reality of how your debt would be structured. There are countless free debt amortization models online to do this. Here is one from Microsoft.
Toward the bottom of the example, we project out the amortized debt balances for each year. Figure 22 assumes a mid-period financing event with half a year’s worth of principal payments paid in the first year.
Total projected debt is the summation of ending existing debt balances and the amortized debt balances associated with future capital expenditures and total projected debt balances.
Finally, we present some comparative ratios to provide a sanity check for our debt assumptions.

The first is a debt-to-EBITDA ratio, which measures the proportion of total debt to a company’s EBITDA. Banks often incorporate a debt-to-EBITDA target within debt covenants, so this metric can be a helpful sanity check to your assumptions. In this case, the company’s future debt balances remain consistent in their proportion to EBITDA. In 2025, this ratio declines due to the assumed payoff of the $200,000 note.

We also calculate the times interest earned, or interest coverage, ratio. It provides a measurement of a company’s ability to pay its ongoing interest expense obligations with its current income. Debt covenants often consider the times interest earned ratio.

When forecasting debt, consider any ratios within the debt covenants that the company would need to satisfy. You can also benchmark your projected debt ratios against the historical ratios of your publicly-traded competitors to test the reasonableness of your assumptions.

Are We There Yet?

We have just projected capital expenditures, working capital, and debt. These are three critical components of the free cash flow calculation. We now want to test the assumptions for reasonableness. Below are some thoughts that you should consider to assess the reasonableness of the projected figures. These lists are not all-inclusive.

Capital Expenditures

Are the projected capital expenditures adequate to support future growth?
Is there adequate cash flow to cover the portion of capital expenditures not financed with debt?
Do you have enough space in your existing facilities to accommodate the new assets to be purchased?
Do you need to incorporate any costs related to expanding facility capacity?

Debt

Is debt driving an increase in free cash flow?
How do your projected debt ratios compare to your historical ratios?
How do your projected debt ratios benchmark against your peers?
Do your projected debt ratios violate your existing debt covenants?

Pro Tip: Keep projected debt balances in check.

Increases in debt balances represent cash in-flows and will naturally increase free cash flow. However, growth in debt balances should not drive an increase in the value of a company. Any cash received from new debt issuance should be offset by cash outflows for capital expenditures, working capital reinvestment, or increased expenses. For these reasons, it is a good idea to maintain some awareness around how debt is impacting cash flow.

Working Capital

Are the changes assumed for accounts receivable collection speed, inventory management, and credit terms on accounts payables reasonable?
How do your selected working capital ratios compare to those of your peers?
How will you attain the projected accounts receivable collection speed without jeopardizing the company’s customer relationships?
Do you need to maintain larger inventory stores to meet the demand of your customers?
Will your lead times accommodate the lower inventory balances?
Does the company’s primary customers have a specific inventory requirement for their vendors and do your projected balances meet those requirements?
How will the company stretch out its payables without losing suppliers that want faster payment?
How will increases in working capital be financed in the future (i.e., through ongoing cash flows or new debts)?

The list could go on and on. Questions will differ with each company’s unique circumstances. The point is to challenge yourself with questions about how you will achieve your projected results. Nobody can answer these questions better than you, so you should keep them in mind as you build your forecast and make adjustments as necessary. The more realistic the projected financial information you develop, the more reliable the valuation will be.

Koji Bratcher is an accredited senior appraiser with the American Society of Appraisers with approximately 15 years of experience serving clientele in the middle-market space. He is the founder of ValuAnalytics, LLC and a director and principal in Helios Consulting, Inc.

ValuAnalytics provides clients with the ability to quickly and affordably benchmark companies against publicly-traded companies to support internal valuation processes and financial analyses. ValuAnalytics can benchmark your company’s historical and forecasted financial results against your publicly-traded competitors.

Need a valuation performed for your company or its assets? Helios Consulting, Inc. is a full-service valuation firm located in Los Angeles, CA and can assist you with your valuation requirements. We service clients worldwide for a variety of purposes. If you require assistance with preparing a financial statement forecast, give us a call!