Steve's Financial Modeling Tutorial

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Model Basics
Income I
Income II
Balance Sheets
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Corporate Tricks II
Balance Sheets

Like I said, there are three parts to a balance sheet:


Here's our first balance sheet:  

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How to tell if you balance sheet works:

Balance sheets must balance. This means that the bold line at the bottom "Equity+Liabilities" must equal the "Total Assets" line. Very few financial models balance and if yours does you will definitely get a raise. Right.


This is where I tell you the difference between equity and liabilities.  The fact is that there is no black and white difference but there is a long continuum of differences. Basically, liabilities eventually have to be paid back so lenders have a call on a portion of the assets of a company while equity holders get everything else.

If you have a pie and you are the only owner and you don't owe anybody anything then you can eat the pie.  If you own a pie and you owe Frank one slice, then you probably shouldn't eat the whole thing since then Frank would never get his slice. But you could eat the whole thing since it's YOUR pie.  So in some ways Frank owns one slice of your pie, but "own" is the wrong term. Since he doesn't actually own it, he's a lender.

There are some forms of equity that look a lot like debt (preferred equity, equity with liquidation preferences, etc.) And there are some forms of debt that look like equity (junk bonds, etc.)  From a modeling perspective it is important to sort the true equity from the debt but its not easy. Sometimes you just have to make a decision on what's equity and what's debt and move on.

So if you take that pie and give Frank back his slice that he is owed (liabilities) and you keep the rest (equity) then the entire pie is accounted for. The pie (assets) must equal Frank's piece (liabilities) and everything else (equity).  If you can get your model to do this, you win the big stuffed panda!

Assets are stuff you own.  If you are running a brothel, the beds and sheets are assets.  If you are running a coke dealing cartel, your scales and private jets are assets.  But in a financial model, your real important asset is in the cash line, because this is what drives your retained earnings and thus your return calculation.

Balance sheet cash is calculated by taking the previous month's (year's, quarter's, whatever) cash and adding it to the "net change in cash figure" from your cash flow statement.  Balance sheet assets are calculated the same way, except you are adding the "cash from investing" from the cash flow statement and subtracting off any depreciation.

Assets are usually divided into short-term assets and long-term assets.  These are also known as current assets and non-current assets.  Cash is considered a current asset and anything that can be converted to cash easily is a current asset, a trait that is also called liquidity (lots of jargon in finance).  What's quickly?  Well, that's more art than science.  Obviously, something like a 90 day T-bill is a current asset.  On your personal balance sheet your wife's engagement ring probably has a current value in a pawn shop of about half it's actual value, so whether a line item called "rings, engagement" is a current asset or not is up to you.

Stuff than can be liquefied in 90 days or less is clearly short-term.   Greater than 1 year seems like long term.  Stuff that's in between is anyone's guess.

There's probably a GAAP rule on what's long term and what's short term, but who really cares?  You're building a financial model, not doing an audit.  On many balance sheets and in some financial models, if the company's debt is very high, you can take the debts that are due in the next quarter and put in a line item called "current portion of long term debt" and put it in current liabilities.  Likewise, you could put the current portion of long-term annuities and put it in current assets, but this would only make sense if the annuities themselves are illiquid, such as income from a restricted cash account.

Receivables are usually considered a short-term asset (you can even liquefy them by borrowing against them via a factoring company), but that's pretty detailed modeling and most people don't bother.

Liabilities are stuff that you owe to other folks.  If you borrow $100 bucks it goes on the balance sheet.  If you borrow $1 million bucks it goes on the balance sheet.

Your liabilities are equal the previous end-of-period's liabilities minus any payments that you have made, as captured on your cash flow statement.  You'll see this on the downloadable Excel file.

Question:  If I put the near-term portion of my long-term debt in short-term liabilities and leave the bulk of the loan in long-term liabilities, then should I put my near term expenses, like salary and stuff in short-term liabilities?

Answer:  Well, you could do that.  This is affected a lot by your modeling time-frame.  If you are modeling a month-to-month start-up, it doesn't really matter how large your long-term vs. short-term liabilities are.  In fact, it doesn't really matter in any case.  Your predictive ability won't affected by your choice here, so don't sweat it.  If your boss (or you) really want to know "what's my exact liquidity ratio1 right now?" then you need to extract your short-term commitments and put them in your short-term liabilities.  These are good things to think about in your spare time, not.

Finance Koan: If you borrow $1 million from a bank and you can't pay it back, you are in trouble.  If you borrow $1 billion from a bank and can't pay it back, the bank is in trouble.

Equity:  Let me repeat some points I've already made.  Here's a tip, liabilities and equity are the same thing.  Sounds crazy, I know, but that's the truth.  Lenders never want to hear it, but really equity is just money you got from investors.  Debt is just money you got from banks. What's the big diff?

OK, the big difference is that debt is an obligation to pay, while equity isn't.  But financial folks have been playing games with debt and equity for years. You've got preferred equity, equity with warrants.  You've also got shareholders' agreements in many private company that make the equity look a lot like debt.

If you are raising money for a start-up, the difference between the equity you raise and debt you got from a bank is pretty much nil, except that the bank would probably ask for a personal guarantee on top of the assets of company as collateral, whereas the private investor will simply ask for a boatload of governance rights and crap to make sure they get the company if you can't pay them back.

The key to the equity section of a balance sheet is that profits that aren't spent get added to something called Retained Earnings.  This is an accounting of how much profit the company is making and has made.  In a financial model, this is where all those huge profits go.

Equity holders own the retained earnings line, while debt holders do not.

If you pay a dividend, it gets taken out of your cash flow from financing section and taken out of your retained earnings. Dividends are a reduction in equity.

How do I deal with stock options?

Answer: You can't.  Stock options suck from an accounting perspective, particularly out of the money ones.  They aren't entitled to share in earnings. They aren't even shares of the company.  Really they are contracts with the company, not equity and not debt.  If they are in the money, especially if they are substantially in the money, you could assume they will get exercised and simply convert them to equity in your model.  Be aware, though, that if they then go out of the money, your model will be very wrong.

With some options, because they are very likely to get exercised (for instance if they'll expire otherwise) you should exercise them in your model just before expiration and add the proceeds to your cash from financing area and increase the equity on the balance sheet, just as if the company had a planned sale of shares.

1Total dollar value of cash and marketable securities divided by current liabilities.

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