10.3 Building the Balance Sheet and Cash Flow Statement

Building the Stocks, Then Reconciling Cash

The balance sheet is a snapshot. Every forecast year must still satisfy Assets = Liabilities + Equity. CFI's linking article is specific about which stocks carry the income-statement and cash-flow traffic: working-capital accounts, PP&E, debt, retained earnings, and cash.

Cash is calculated. You do not independently forecast it as a percent of sales in this chapter. The exception is a minimum-cash plus revolver structure, where excess cash or a short-term draw absorbs the residual so cash never falls below a floor. That structure creates a circular reference: interest depends on debt, debt depends on cash, cash depends on interest via NI. Chapter 11 covers circularity and iteration. Until then, ending cash = beginning cash + CFO + CFI + CFF, and that amount is the cash line on the balance sheet.

CFI also reminds you that the balance displayed is always the closing balance. Forecast the closing stocks. The cash flow statement uses the changes in those stocks.

Operating Working Capital: AR, Inventory, AP, and Other NWC

Operating net working capital in a compact FMVA model is:

NWC = Accounts receivable + Inventory − Accounts payable

A fuller model adds other operating current assets (prepaids, other current assets) and other operating current liabilities (accrued expenses, deferred revenue). Exclude cash and interest-bearing debt. Cash is the plug the cash flow statement explains. Debt is the debt schedule. Mixing them into NWC double-counts financing.

Clearwater uses a simple percent-of-sales structure that matches Year 0, which is the invert: historical percents become forecast drivers.

Year 1 ΔNWC = 132,000 − 120,000 = +$12,000, a use of cash. Year 2 ΔNWC = 142,560 − 132,000 = +$10,560. An increase in NWC is always a cash outflow on the indirect CFS; a decrease is a source.

If the case specifies days instead of percents: AR = DSO × revenue / 365, inventory = DIO × COGS / 365, AP = DPO × COGS / 365. Percents of sales are acceptable when the case is silent and the historical ratios are stable. What is not acceptable is holding AR, inventory, and AP in dollars while revenue grows 10%. That silently assumes a massive tightening of the cash conversion cycle and overstates cash.

Other NWC (prepaids, accruals, deferred revenue) follows the same rule: forecast the stock on the BS, then take the change on the CFS. An increase in prepaids is a use of cash. An increase in accrued expenses or deferred revenue is a source of cash. Clearwater's stub has none of these, so the ΔNWC line is a single number. In a case that has them, do not dump them into "other" on the BS without a matching CFS line — that is a classic cash break point hiding as a formatting choice.

PP&E Roll-Forward

Ending net PP&E = Beginning net PP&E + Capex − D&A

If assets are sold, subtract book value of disposals; any gain or loss goes to the income statement and is reversed on the CFS. Clearwater has no disposals.

Capex adds to PP&E and is a CFI outflow. D&A reduces PP&E, reduces EBIT on the income statement, and is added back on the cash flow statement because it was non-cash. All three D&A cells — P&L, CFS add-back, PP&E schedule — must be the same $42,000 in Year 1. Capex of $60,000 appears in the PP&E schedule and in CFI, not on the income statement.

Year 1 check: 400,000 + 60,000 − 42,000 = $418,000. This is the first of the three common break points from 10.1. If you expense capex on the P&L, NI is too low, PP&E does not rise, and CFI still subtracts capex — a triple error. If you add D&A to PP&E instead of subtracting it, assets are $84,000 too high.

Debt Roll-Forward and the Debt Schedule

Ending debt = Beginning debt + draws − repayments

Interest lives on the income statement. Principal lives on the balance sheet. The change in principal lives in CFF. You need a debt schedule; you cannot infer principal from the interest line alone (the coupon could change, or the firm could have drawn and repaid inside the year).

Year 1 CFF includes −$20,000 of principal. Interest of $16,000 is already inside NI, so you do not put interest in CFF in a standard US GAAP indirect presentation (interest paid is an operating item in the starting NI). Putting interest in CFF and leaving it in NI double-counts the cash cost. Dividends, by contrast, are never an expense; they belong only in CFF and in the RE roll-forward.

Retained Earnings Roll-Forward

Ending RE = Beginning RE + NI − Dividends

CFI's projecting guidance is explicit: you do not forecast retained earnings as a percent of sales. You forecast NI (from the income statement) and dividends, then compute the closing RE. Dividends are not an expense. They do not hit EBIT. They reduce RE and they are a CFF outflow.

Clearwater pays 30% of NI: Year 1 dividends = 0.30 × 121,500 = $36,450. Year 2 = 0.30 × 133,650 = $40,095.

Year 1: 120,000 + 121,500 − 36,450 = $205,050. This is the second common break point. Forgetting dividends leaves RE at $241,500 and the BS will not balance by $36,450. Using EBITDA of $220,000 instead of NI leaves RE even further off.

Common stock is hardcoded at $250,000 in this stub (no issuance, no buybacks). If a case issues equity, the increase is CFF inflow and an increase in the equity stock, not income.

Indirect Cash Flow Statement

CFI models use the indirect method for CFO:

CFO = NI + D&A − ΔNWC (plus other non-cash and operating-accrual adjustments as the case requires)

Then CFI ≈ −Capex, and CFF = Δdebt − dividends (plus equity issues or buybacks if any).

Change in cash = CFO + CFI + CFF

Ending cash = Beginning cash + change in cash

Year 1: 121,500 + 42,000 − 12,000 = $151,500; 151,500 − 60,000 − 56,450 = $35,050; 50,000 + 35,050 = $85,050. That $85,050 is the cash line on the Year 1 balance sheet. It is not a forecast assumption. This is the third common break point from 10.1.

Notice the quality gap the three statements were built to show: Year 1 NI is $121,500, EBITDA is $220,000, CFO is $151,500, and cash after capex, debt paydown, and dividends rises only $35,050. Those four numbers answer four different questions. Treating any one of them as "cash" is the accrual error from 10.1.

The Year 1 Balance Sheet Must Balance

Year 1 assets $701,050 = liabilities and equity $701,050. The plug test passed: CFS ending cash equals BS cash. RE rolled. PP&E rolled. Debt rolled. That is a finished Year 1 three-statement model, not a formatted income statement with a disconnected balance sheet.

Year 2 cross-check: cash $138,045 + AR $118,800 + inventory $95,040 + PP&E $428,000 = $779,885. AP $71,280 + debt $160,000 + common stock $250,000 + RE $298,605 = $779,885.

What Cash Is Not

Do not forecast cash as 5% of sales (Year 1 would be $55,000, not $85,050). Do not set cash equal to NI. Do not set cash equal to the change in RE. The only time you target a cash number is when you introduce a minimum cash balance and a revolver (or cash sweep) that draws or repays to hit the floor. That is Chapter 11, because interest, NI, cash, and the revolver all depend on each other. For the FMVA core three-statement build, cash is an output.

If the Year 1 sheet is off by $36,450, look at dividends in RE and CFF. If it is off by $12,000, look at the sign of ΔNWC. If it is off by $60,000, look at whether capex hit PP&E and CFI once each. If it is off by $42,000, look at whether D&A is the same on the P&L, the CFS, and the PP&E schedule. Articulation errors in this stub are almost always one of those four amounts — the exact dollars you already computed.