Projecting the Balance Sheet: Projecting the future requires carefully evaluating the past. This case study includes 10 years of historical financial performance to encourage subscribers to evaluate what is relevant and demonstrate how information can become stale. As a company grows and evolves, so will its income streams and operating costs, as well as the assets and liabilities it requires to operate. One of the most important skills you can develop in your modeling toolkit is how to evaluate the relationships between the income statement and balance sheet – not just in the present, but also in terms of how they will evolve in the future.

In this lesson, we will take a slightly different approach to projecting the balance sheet and start with two supporting schedules: (1) the Working Capital Assumptions and (2) the property, plant and equipment (“PP&E”) Schedule. Once we have projected both of these supporting schedules, we will then project the full balance sheet. 

In a previous lesson, this order was reversed because it helps provide greater context for the supporting schedules and why they are needed. In trying to project the full balance sheet first, it becomes obvious that working capital line items and PP&E cannot be projected without the supporting schedules. With this knowledge in mind – and given that these schedules are relatively easy to build – we will start with the two supporting schedules listed above to accelerate the model-building process.

Working Capital Primer

Before diving into the Working Capital Assumptions supporting schedule, I thought it would be helpful to explore the significance of working capital dynamics in a business. As it relates to the operating model for BabyBurgers LLC, one of the first things you might notice is that the company does not show a balance for accounts receivable until 1/31/2012 (recall that the company was founded in January of 2011), and the company does not show a balance for accounts payable until 1/31/2013. So why the extra year to establish accounts payable?

This assumption  is neither entirely fictitious nor exclusive to the case of this individual company. In general, vendors are unlikely to extend terms to a startup before they have established confidence in its revenue model. A company, on the other hand, can choose to extend terms to its customers whenever it feels its balance sheet can support these terms. The assumption in this instance is that the company would recognize its balance sheet strength before vendors, and that vendors would be unlikely to extend credit for a product that was otherwise quite novel in the marketplace.

However, it is not always the case that a company would extend terms to its customers before its suppliers would be willing to extend terms on production, particularly if it is selling a more established product. In his book Lying for Money: How Legendary Frauds Reveal the Workings of the World, author Dan Davies explains that “in almost every industry, there is some general recognition of the fact that trade customers need to make and sell their product before they have cash to pay for their inputs, and that their suppliers are often in a better position to provide credit to bridge this gap than the financial system is.” Per Davies, the reasons that supplier credit is so common are three-fold: 

1. Convenience Factor: “If the alternative to making a sale on credit is letting the goods hang around until the customer can raise the cash, there is a saving to be made by getting them moved out of your warehouse and into the customer’s.” (Note: Consider a supplier’s willingness to accommodate a sale on credit for a perishable item, for example.)
2. Increased Sales: If a supplier is willing to extend terms, then the supplier’s potential customer base expands to include entities that might be temporarily short on cash but still able to pay on a reasonable time horizon.
3. Credit Risk: When a bank makes a loan to a company, the use of cash is uncertain. When a supplier provides inputs on credit, the purpose of the loan is known. Consequently, a supplier is likely to perceive less credit risk. 

At the conclusion of this explanation, Davies offers an insight that I found fantastically appropriate for working capital analysis commentary: “You can tell more about the structure of any industry by looking at patterns of payment terms than you can from any ‘five forces’ or ‘SWOT’ analysis.” What I love about this quote is the emphasis it places on analysis of accounts receivable and accounts payable to determine not only the health of a company’s balance sheet, but also the health of an entire industry.

The purpose of this introduction is to encourage you to think through how working capital decisions impact cash flow. As an analyst, you should be comparing a company’s working capital balances to industry standards and to the competition. Consider Amazon and Conn’s Inc. (CONN on Nasdaq), which both have retail operations. In January of 2014, the brilliant Jim Grant noted that both traded at identical multiples of enterprise value to sales but that there was serious cause for concern as it related to Conn’s balance sheet. Citing colleague David Peligal, Grant’s Interest Rate Observer reported the following:

"Very simplistically," Peligal relates, "two things happen at a Conn's store: Merchandise walks out of the building and dollar bills walk in. The rate of change in merchandise walking out is what counts in the comp stores' data. It's the metric that was up by the amazing, aforementioned 32% in November – and by 23.7% in the first nine months.

"Short-sellers focus more on the rate of growth of dollar bills walking in," Peligal goes on. "The essential bear story is that the rate at which these dollars are walking into Conn's locations this year is largely unchanged, surging comps and new-store openings notwithstanding. So something is wrong with this picture. Essentially, Conn's is giving people merchandise and telling them they don't have to pay for it just yet, or they can pay for it slowly, or the company can restructure their loans, etc. With same-store comps rising by double-digits and with 10% to 15% more locations this year than last, cash revenues are essentially flat. What's financed the scorching growth is customer receivables."

In stark contrast, a Barron’s article titled “Amazon’s Profits Are Soaring: Why That Could Be Bad for the Stock,” published in May of 2017, cited the company’s ability to sell inventory effectively and quickly (i.e., high inventory turns) coupled with the ability to demand terms from vendors (i.e., extend accounts payable) as a powerful combination: 

In some ways, Amazon is like Berkshire Hathaway, but with better returns. Berkshire sells insurance, where premium payments roll in long before claims are paid, allowing CEO Warren Buffett to invest other people’s capital free of charge. Amazon sells inventory so quickly that it often collects from customers before it pays suppliers, creating an ongoing free float of cash to use.

That is the power of working capital. With these examples in mind, and with an understanding of the impact that working capital strategy can have on a business, let’s move on to the construction of the corresponding schedule.