Understanding the presentation of financial statements and the classes of account is very important in determining how the 3 statement financial information can be linked through financial modeling as they are all interwoven.
In financial modeling, the first task you have to carry out judiciously is linking the three statements together in Excel; therefore, you must understand how they are effectively related to one another.
Linking financial accounts requires specific steps which would guarantee your presentation and modeling would be accurate.
It didn’t just involve the linking of the statements, as you would need to fully integrate accounting policies and principles into the preparation to ensure that they conform accordingly to the model you are trying to build.
To successfully develop a financial model, it would be important that the accountant fully understand accounting methodology’s grasp. More so, if you are looking for a job as an investment banker, a treasury officer.
An accountant etc., it is essential you equip yourself with the relevant excel tools for developing a financial model, which then, in turn, assist you in achieving this goal.
This article would explain the rudiments of financial statements and their correlation which would guide the presentation of economic models.
What is Financial Modeling?
Financial modeling has to do with constructing an abstract representation of a typical or natural financial situation.
It is the mathematical assumption designed to represent a similar version of the financial performance of a project, asset, or any other investment item. It is a task of quantitative nature that relates to either asset pricing or corporate finance.
It involves the translation of hypotheses that relates to the behavior of agents of the market and reflecting them in numerical predictions.
Financial modeling could mean different things to different users as its interpretation depends on the field of use.
The two significant areas include accounting and corporate finance applications to depict real-life situations while maintaining certain assumptions.
There has been some debate in the Accounting industry as to the actual nature of financial modeling as to whether it can be considered tradecraft, such as the art of crafting such as welding, or science of financial numbers; however, the economic modeling task in the accounting world has been gaining ground for general acceptance in recent times and rigor over the years.
In the accounting and corporate finance world, financial modeling entails forecasting financial statements and usually involves preparing detailed models that are company-specific for use in decision-making and analysis of financial statements.
The Applications Include:
- For Business valuation/stock valuation, the use of which is primarily in the process of discounting cash flow while including valuation method.
- It can be adopted for the planning of Scenario and assisting management decision making providing answers to the “what is,”; “what if,”; “what has to be done”questions
- It is essential in Capital budgeting which includes estimating the cost of capital, i.e., the weighted average cost of capital calculations for investment decisions.
- It is also essential for the computation of financial or ratio analysis, which s include measuring all variables that contribute to the success of the company through measurement of profitability, solvency, efficiency ratios and also having of operating- and finance leases, and cost of information
- It is essential in estimating and calculating revenue related forecasting, analysis
- It assists in the preparation of Project finance modeling by estimating the viability of a project and whether or not the company should take it on.
- It assists in cash flow forecasting, measuring the availability of cash to the business and its ability to meet its obligations as and when they fall due.
- It assists in Credit decision-making by analyzing prospective clients and the viability of the investment to which funds are to be allocated by analyzing credit risk that could be experienced from Consumer credit risks while also estimating impairment that may arise from loans that are bound to go wrong.
- It assists in the estimation of working capital and treasury management, which includes but is not limited to asset and liability management
- It is essential in Management accounting as it assists in the computation of Activity-based costing, Profitability analysis, Cost analysis, Whole-life cost
In totality, the nature of these models are essential to be understood because they are built around financial statements, calculations and outputs are monthly, quarterly or annual; more so, the inputs that are used in the computation take the form of “assumptions,” and this is where analyst specifies the values that would be applied in each period for macro variables which includes exchange rates, tax percentage, etc.; may be thought of as the model parameters.
While also considering the internal / company’s specific variables (wages, unit costs, product cost).
Interestingly, both characteristics are reflected, although implicitly, in the mathematical form of these models: The first step is to place the models in discrete time. Secondly, ensure that the inputs are deterministic.
Financial modeling in quantitative finance entails the development of a sophisticated mathematical model. Models under this topic deal with asset prices, market movements, portfolio returns, and other corporate and quantitative finance items.
A significant distinguishing factor between: “quantitative financial management,” models of the financial situation of a large, complex firm; quantitative asset pricing, models of the returns of different stocks; has to do with “financial engineering,” of models of the price or returns of derivative securities which is the element of quantitative corporate finance models which serves as the basis for firm’s financial decisions.
The applications of quantitative finance include;
- Option pricing and calculation of their different alternate price changes
- Computation of derivatives with emphasis on interest rate derivatives, credit derivatives, and exotic derivatives used as a guide in decision making.
- It assists in the modeling of the term structure of interest rates(bootstrapping / multi-curves, short-rate models, HJM) and credit spreads to analyze the expected return and the risk elements.
- It assists in credit scoring of specific instruments and the provision of impairment
- It assists in measuring the Credit risk, counterparty credit risk, and regulatory capital: exposure at default, probability of default, loss given default, potential future exposure to fall short on due repayments
- It assists in resolving Corporate financing activity prediction problems
- A good model would assist in Portfolio optimization
- It helps in the evaluation of Real options
- It assists in Risk modeling (Financial risk modeling) and values at risk
- Financial modeling assist in Credit valuation adjustment, CVA, as well as the various XVA
- Economic can be duly applied to Dynamic financial analysis(DFA), UIBFM, investment modeling
Why is Financial Modeling Important
Financial modeling is considered one of the most desired skills in today’s corporate world due to the extent of its use.
The demand for financial modeling analysts is increasing day by day due to the versatility and the extent to which they can make the most of assumptions to depict real-life situations to improve a firm’s decision-making ultimately.
It is, therefore, no surprise that the essential skill required by finance professionals in recent times is proficiency in financial modeling.
Financial Modelling is now the central core element to take the significant business decisions in a corporate world as it assists in the simulation of real-life situations while taking into consideration multiple variables.
Financial models are valuable tools for executing business choices to get perfect solutions that would result in more profitability for the business.
A model would advise you regarding the grade of risk associated with implementing certain decisions, which can then be simulated to get the best result or ensure that the right decisions are taken; for example, when considering advancing credit to a customer; a bank can measure the cash flow projections of the company to ascertain if the business is viable enough to repay the credit.
Models can also build an effective financial statement that shows the finances and operations to understand the contributors to the business goals.
The models have been of considerable help to online internet businesses to make quick decisions more confidently.
Uses of Financial Modeling:
- The value of financial modeling is increasing rapidly in the finance industry due to its ability to depict real-life situations and guide decision making
- Financial modeling has served as an essential tool that helps businesses estimate ideas and measure risk in the most cost-effective way.
- The use of financial modeling has been known to be of high benefits as it helps a company in creating an attractive representation of the current financial situation of the company.
- Models are expressed in mathematical terms, and they are aimed at representing the economic performance of a business
- Financial Modeling is widely used in Various Sectors like:
- Investment Banks
- Credit Rating Agencies
- Equity Research
- Mutual Funds
- Financial KPOs
- Project Finance companies.
What Are the Elements of Financial Statements?
- Equity (net assets);
- Investments by owners;
- Distributions to owners; and
- Comprehensive income.
In accounting, there are two significant ways of preparing financial statements, and these are either using the cash basis or the accrual basis of financial reporting.
The main difference between the accrual and cash basis lies in when revenue and expenses are recognized. Under the cash method, there is an immediate recognition of income and expenses immediately after cash is received.
In contrast, the accrual method focuses on anticipated revenue and costs, which means payment is recorded only for the period under review, and other aspects of income are deemed receivables.
Accrual accounting indicates that revenue and expenses are recognized and recorded when they occur. The cash basis of accounting holds that line items are not registered until cash exchange for values. Cash basis accounting is much easier to prepare.
In contrast, accrual accounting helps portray a more accurate picture of the company’s financial health by indicating amounts that are yet to be paid or received and carrying the items in the financial statement under accounts payable and accounts receivable.
The most commonly used method of accounting, especially by public-traded companies it assists in smoothing out earnings over the financial periods of an entity.
Cash Basis Accounting
The cash basis of accounting reports only items for which cash has been received and expenditures are only accounted for when the entity parts with money. The cash method of accounting is often used by small businesses and also for personal finance.
The essential advantage of the cash method is it is simple to understand as it only accounts for cash paid or received.
It makes tracking a company’s cash flow easier as an entity can measure its cash more accurately.
However, the disadvantage of the cash basis of accounting is that it has the propensity to overstate the health of a company by making it seem like it is cash-rich even though its account payable is high and outstrips its cash balance.
This might misinform an investor who might conclude that the company is making a profit while losing money.
On the other hand, the advantage of the accrual method is that it includes accounts receivables and payables, which helps to track the payables and receivables of a company and, as a result, is a more depicts a more accurate picture of the profitability of a company, particularly in the long term as the going concern is estimated.
The reason for this timing is that the accrual method records all revenues when they are earned and all expenses when they are incurred regardless of whether cash or its equivalent has been received or paid.
For instance, a company might have sales that were made during the first half of the year but wouldn’t be recorded if the company uses the cash basis of accounting because the revenue has not yet been received in cash.
The same would be recorded in the second half of the year. An investor might conclude the company is unprofitable when, in reality, the company is doing well.
The disadvantage of the accrual method is that it doesn’t keep track of the company’; this might result in it not accounting for a company’s cash shortage in the short time and might not be viable despite looking profitable in the long term.
Another main disadvantage of the accrual method is that it might be more difficult to prepare as it takes into cognizance items like unearned income and expenses paid in advance.
The accrual method is commonly used by companies, most especially publicly traded ones.
The popularity of the accrual basis is its ability to smoothen out earnings and accounts over time as it accounts for all revenues and expenses earned and incurred in the period they occur rather than being recorded when cash is received, which leads to the intermittent recording of financial statements.
For example, a manufacturer of a cyclical item of sales might be performing well during a peak period and would drop during a decline period.
Both methods have their advantages and disadvantages, and each only shows part of a company’s financial health.
However, understanding both the accrual method and the company’s cash flow statement would assist the company in making important investment decisions that would help ensure that a company measures and improves its performance over time.
Accrual Accounting vs. Cash Basis Accounting Example
A typical example is a company manufacturing machinery. If the company sells $10,000 worth of machinery; if this transaction is to be recorded under the cash basis, the amount would not be recorded until cash is received; while under accrual basis, the revenue is recognized immediately, and the amount to be received is identified under the account receivables account until the payment is eventually received.
This same principle is applied to expenses; for instance, If a water bill of $2,000 is received; if this is to be recognized under the cash basis, the transaction would not be recorded until the money is received; however, for the accrual method, the $2,000 is recorded immediately in the expenses, and the outstanding is recorded under current liabilities as an accrued expenses until the payment is eventually made.
Accounting Principles that Affect Linking the Three Financial Statements
The income statement of entities is not prepared on a cash basis. This implies that elements of accounting principles such as recognition of revenue, matching concepts, and accruals would make the income statement of a business defer from the cash flow statement of the business.
A company that prepares its account statements based solely on cash method would have no accounts receivable, and nothing would be capitalized; that is, acquisition of assets would be treated as an expenditure with no depreciation; therefore, its financial statement would have no account receivable and account payable.
It would have no statement of financial position, and the only items to be reported would be shareholder’s equity and cash balance.
Cash flow statements arise due to creating a balance sheet through the rise of the cash flow statement.
Linking the Three Financial Statements
The financial statements have items that relate to one another in the statements; therefore, when preparing a model, the relationship between these statements must be understood when preparing a financial model; below are the process for the establishment of the relationship.
Net Income & Retained Earnings
Net income is also referred to as the profit/loss after tax, and it links from the bottom of the income statement to the balance sheet and the cash flow statement.
When taken on the balance sheet, the net income feeds directly to the retained earnings provides to the starting point of the operations activities section under the cash flow statement.
Property, Plant and Equipment, Depreciation, and Capital Expenditure
It is important to take cognizance of certain factors when preparing a cash flow statement, such as; Depreciation and other capitalized expenses on the income statement need to be added back to net income to calculate the cash flow from operations as capitalized items are not expensed under the accrual basis of accounting as this is not treated as an expense, except for depreciation which is added back to the financial statement because it is a notional item.
For this section linking the three financial statements, a separate depreciation must be built. The Capital Expenditure is utilized for cash under the investing cash flow statement, and they are added to the property, plant, and equipment section of the PP&E account.
Working capital emanates from the difference between current assets and the current liabilities in the statement of financial position.
Modeling the Net Working capital could be confusing as Changes in existing assets, and current liabilities on the balance sheet are related to revenues and expenses on the income statement.
Still, they need to be adjusted on the cash flow statement to reflect the actual cash received or spent by the business.
Therefore to calculate this appropriately, there is a need to create a separate section that calculates the changes in the net working capital, estimating the increases and decreases in the elements of working capital.
This part could be a bit tricky to link during modeling and to link the three statements, and to achieve this, and there is a need to prepare some additional schedules.
There is a need to incorporate financing events such as issuing debt effect on all three statements in the following way: the interest expense appears on the income statement, the principal amount of debt owed would be reflected on the Statement of Financial Position.
In contrast, the change in the principal amount owed to external parties is reflected on the cash from financing section of the cash flow statement as an inflow item.
For this section of linking the three financial statements, you would need to build a model debt schedule to build in the details required for the linkage. This section often needs to model a debt schedule to build in the required detail.
Cash Balance Sheet
This cash balance is the final step in linking the three financial statements. This is treated once all the items mentioned above have.
Once all of the above items are linked up correctly, the sum of cash from operations, cash from investing, thereafter, the cash from financing are added to the closing cash balance of cash and cash equivalents for the prior period.
The addition of these figures becomes the closing cash balance of cash and other cash equivalents to be reflected on the Statement of Financial Position. This is the point when you figure out whether your balance sheet balances.
The Best Ways to Answering the Question in An Interview Regarding Linking Financial Statements
You may get an interview question along the lines of, “How are the three financial statements linked together?”
In such a situation, you are not expected to go into much details ad you can quickly respond with the understated point:
- The Net income from the income statement flows to the balance sheet under retained earnings, and the cash flow statements are the first item under the operating activities.
- The notional item of depreciation is added back to the statement, and the Capital expenditure is deducted under the investing activities on the cash flow statement, which determines PP&E on the balance sheet
- The items for financing activities like debt issued or shares primarily affects the balance sheet and cash from balance except for interest, which is reflected in the income statement and subsequently subtracted from the earnings before interest and tax as seen on the income statement.
- The final solution is to state that the summation of the last period’s closing cash balance and cash from the operating, investing, and financing activities of the company are used added together and this forms the basis of determining the closing cash balance on the statement of the financial position.
Linking of Financial Statements for Financial Modeling
When building a financial model on Excel, the most critical element to adhere to is to link the three statements quickly, which can be achieved through these basic steps.
- Commence by entering at least three years of historical financial information for the three financial statements.
- Accurately calculate the drivers/ratios of the business for the historical period under review to ensure that the estimation is accurate.
- Then proceed to enter the relevant assumptions about what the drivers will be in the future based on trends in the variables affecting the assumptions.
- Then proceed to build and link the financial statements following the principles discussed above then you have your model at the ready.
The model works and is utilized when the past period information is hardcoded for the three statements and guides the calculations of the drivers. Then the forecasts are hardcoded for drivers and the calculations for the financial statements under review.
Financial modeling is essential in today’s corporate world, and its use case transcends investment decision-making, corporate finance, and accounting.
The models are developed using historical data, which are then stimulated with assumptions deemed to affect the statements to ensure that the business is making the right financial decision.
Linking the three financial statements of income statements, Cash flow statements, and the balance sheet requires knowing accounting principles and concepts that would guide the process adopted for the linkage.
A good analyst using a financial model would simulate various scenarios to determine how the company’s finance is affected by any variable affecting the assumptions.
This has made analysts with modeling skills high in demand due to their ability to use numbers to predict a company’s business decisions and ensure continuous profitability.