You can only accurately value or project a business by factoring in the working capital. And you can only do this by investing in a 3-statement financial model.
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By Abdullah Karayumak, CFA
Verified Expert In Finance
Abdullah is a Chartered Financial Analyst and an expert in financial modeling, capital raising, and valuations. He has advised clients, from startups at the early stages to large enterprises. Most recently, he worked for KPMG.
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Knowledge can save companies money. It is essential to have accurate company valuations and projections of cash flow for equity holders, not only during mergers & acquisitions but also at any time, if you want to know a company’s financial status. It’s not uncommon for companies to rely solely on the income statement when attempting to predict what will happen. However, this can lead to inaccurate valuations and projections. This is why I recommend the financial models. It’s a three-statement system that includes the cash flow statement , balance statement, and Income statement.
Why accurate financial projections are essential
Financial forecasts are useful to business leaders in planning and budgeting near-term and forecasting the performance of their company under different conditions. These projections can also be used to identify the need for investment and help value a business. Projected surpluses, for example, may suggest opportunities for reinvestment. Conversely, projected shortfalls could indicate the need for retrenchment and course changes. Investors use projections of financial data to question assumptions in a business plan or prospectus.
Formulas for valuing also require projections. Values are essential for mergers and purchases, for developing contingencies, and for decision analysis. Modeling the impact of significant decisions on future value can help leaders make the right choice when evaluating a change in direction or significant investment. Major enterprise decisions must be backed up by accurate before and after valuations.
Discounted Cash Flow is the most commonly used valuation technique. DCF, when used with an income statement alone, is a proxy for Cash Flow. It works when Working Capital, the metric for liquidity, which represents the difference between a company’s current assets versus current liabilities, is neutral or slight compared to cash flow calculated on income. This method may not detect significant cash outflows when the working capital ratio is high.
Working capital can significantly impact cash flow, which the income statement does not capture. I have created three-statement models as a valuation adviser for KPMG for clients looking to raise money and value acquisition targets. I’ve learned from experience that DCF using the three statements will provide you with the best results, regardless of your goals.
What the Income Statement Does Not Include
Financial analysts who perform projections are most likely to make a mistake by treating the income statement as cash flow.
The income statement is solely focused on profit and losses. Although you may think that the more profitable the company, the better it is, there are more factors to consider than just a dollar amount. Not all sales are made in cash. Some deals are recorded as receivables and made on credit. Second, COGS is one of many cost of goods sold. These costs may be covered by the purchases made on credit. These transactions (changes to accounts payable and receivable) are not recorded on the income statements, so a forecast that only relies on the message does not give a complete picture of cash inflows.
Three statement models include all critical aspects of a company’s operations. These models and other balance-sheet items project the projected balances of various working capital components, such as accounts payables, inventory, and prepaid expenses. These factors influence the cash flow that is available to the business. It is essential to understand this because a company with high cash flow requirements can appear profitable at first glance but be negative once the cash flow picture is revealed.
The Benefits of 3-statement Modelling for Business Leaders: A Better Insight into their Companies
The value of a company is not always obvious to its leaders. I was asked to create a three-statement model with a valuation study for an aluminum recycling plant that had just been built. The CEO was confident that the facility would be profitable due to the high EBITDA profit margins in the income statement. She was shocked to learn that the valuation came in below her expectations.
The facility had a high volume of sales: Scrap Aluminum was bought with cash, was recycled in the facility and was sold for two months. It took a large amount of cash to cover the operating costs. This information was not included in the income statements but only in the Cash Flow Statement. It details the movements of cash and its equivalents into and out of the business.
The CEO would have missed this crucial aspect of her company if she had focused only on the income and profitability statement. She was able, by using the insights from a three-statement financial model, to plan for future working capital cash flows.
It’s clear that leaders need to know how much their business is worth, what they will earn, and how much it’ll cost to run them, even if they aren’t thinking about an exit. Had I used a single-statement-based valuation that confirmed her biases, the CEO might have been in for a nasty shock down the road.
