Core Financial Modeling
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Learn moreIn accounting, the Balance Sheet provides a snapshot of a company’s Assets (its resources) and Liabilities and Equity (its funding sources) at a specific point in time; Assets must always equal Liabilities + Equity. The Balance Sheet is widely used in financial models, valuations, returns-based metrics, and liquidity ratios.
The Balance Sheet: Real-Life Examples and How It Works in Financial Models and Interviews
Balance Sheet Definition: In accounting, the Balance Sheet provides a snapshot of a company’s Assets (its resources) and Liabilities and Equity (its funding sources) at a specific point in time; Assets must always equal Liabilities + Equity. The Balance Sheet is widely used in financial models, valuations, returns-based metrics, and liquidity ratios.
The Balance Sheet is a central part of almost any financial analysis, including 3-statement projection models, credit analyses, leveraged buyout models, M&A models, and more.
You can find plenty of online sources that present boring definitions, so we’ll focus here on the real-life implications and uses of the Balance Sheet, including how it works in financial models and what you need to know about it in interviews.
Here are the files and resources we’ll be using in this tutorial:
As stated above, a company’s Balance Sheet shows its resources (Assets) and how it funded those resources (Liabilities + Equity).
The Balance Sheet has many purposes, including:
The famous “Balance Sheet equation” is:
Assets = Liabilities + Equity.
In other words, if a company has resources, it must have funded those resources with something.
This equation is based on the main sections of the Balance Sheet:
The Assets and Liabilities sections are usually split into Current (less than 12 months) and Long-Term (more than 12 months) to reflect the length of time each item will last.
For example, “Current” Debt is due in less than 12 months, while “Long-Term” Debt is due in more than 12 months, such as in 3, 5, or 10 years from now.
Monster Beverage has a good, simple example of a Balance Sheet:
Here’s an image of the company’s version:
And here’s our version with some simplifications and changes:
Whenever you work with a real company’s financial statements, it’s critical to consolidate and simplify the Balance Sheet because many line items are insignificant, and trying to link everything gets cumbersome when there are dozens of line items.
We normally aim for 5 – 10 items on each side of the Balance Sheet.
Common items in each section of the Balance Sheet include:
We won’t explain all these items here because each one could be a separate article on this site.
But at a high level, most of the “Current” items relate to the company’s day-to-day business, such as collecting cash from customers, paying suppliers and the government, and purchasing supplies and product inventory.
Most of the “Long-Term” Assets relate to investment and growth, such as the buildings and equipment required to expand.
Finally, most of the “Long-Term” Liabilities relate to financing, such as the Debt and Leases required to buy major assets or rent buildings.
Many of these items could have “short-term” and “long-term” versions; classic examples are Deferred Tax Assets and Liabilities, Debt, and Deferred Revenue.
As a modeling convention, we almost always combine the short-term and long-term versions to make the projection process easier.
Also, we normally combine the first 5 items within Equity into “Common Shareholders’ Equity” and list only Preferred Stock and Noncontrolling Interests separately – once again, for ease of modeling.
Learn accounting, 3-statement modeling, valuation/DCF analysis, M&A and merger models, and LBOs and leveraged buyout models with 10+ global case studies.
Learn moreIn financial models, such as 3-statement projections, you must forecast the Balance Sheet and estimate how individual line items will change over time.
There’s an example of this from the Monster Energy model below:
The projection methodology varies based on the specific line item, but in general, we use the following methods for different sections of the Balance Sheet:
Many people get flustered over the exact Income Statement links, but the specifics matter less than the overall impact.
Specifically, you want to ensure that the Change in Working Capital remains in a reasonable range over time, consistent with the historical levels.
If you can do that, almost anything works for these percentage-based assumptions.
On the Assets side of the Balance Sheet, whenever you link to something on the CFS, always start with the item in the previous period on the BS and subtract the CFS line item.
For example, the New PP&E equals the Old PP&E minus CapEx minus Depreciation.
On the Liabilities & Equity side of the Balance Sheet, when linking to the CFS, always start with the BS line item in the previous period and add the CFS line item.
For example, New Debt equals Old Debt + the Change in Debt from the CFS.
Finally, for the Equity or Common Shareholders’ Equity (CSE) section, you generally do the following:
New CSE = Old CSE + Net Income from CFS + Stock Issuances from CFS + Stock Repurchases from CFS + Dividends from CFS + Miscellaneous Other Items from CFS.
You add each item because some have positive signs on the CFS, while others have negative signs, which reflects whether they are cash inflows or outflows.
Adding a negative is the same as subtracting, which explains how Dividends and Stock Repurchases work correctly.
They are both cash outflows that reduce the company’s Equity, and since they are both negative on the Cash Flow Statement, they are effectively subtracted in the Equity calculation.
Here’s a quick summary of the rules for the most common Balance Sheet line items and their links:
In investment banking interviews, you should know the basic definitions, the Balance Sheet equation above, and the most common line items in each section.
But the main significance is that you typically finish answering accounting questions based on changes to the Balance Sheet.
If you walk through an accounting interview question and find that your Balance Sheet does not balance, you’ve done something wrong – so it’s critical to end with the Balance Sheet to check yourself.
For example, consider the classic “What happens when Depreciation goes up by $20?” question.
You would start by walking through the Income Statement and Cash Flow Statement:
At this point, you have no idea if your answer is correct.
To tell for sure, you need to walk through the Balance Sheet and verify that it still balances.
On the Balance Sheet, Cash on the Assets side is up by $5, and PP&E is down by $20 due to the Depreciation, so Total Assets are down by $15.
On the L&E side, Equity is down by $15 due to the reduced Net Income, which flows into Equity, so both sides are down by $15 and balance.
The intuition is that it’s a reduction of $15 rather than $20 because of the tax savings from the Depreciation.
Even for much more complicated questions, you should always finish with the Balance Sheet.
Even if it balances, you could still be wrong – but your chances of being correct are much higher.
Brian DeChesare is the Founder of Mergers & Inquisitions and Breaking Into Wall Street. In his spare time, he enjoys lifting weights, running, traveling, obsessively watching TV shows, and defeating Sauron.