Brief Introduction to the Construction of Financial Statements I
Posted: 4 Mar 2002
Date Written: January 2002
To value a firm or a project, it is necessary to construct estimated financial statements and free cash flows. In this introductory note we will present some basic principles for constructing the financial statements needed for valuation. We will illustrate the ideas with a concrete numerical example. The reader is encouraged to read actively by constructing the financial statements for themselves on a spreadsheet. The relevant financial statements are: the Balance Sheet (BS), the Income statement (IS) and the Cash Budget (CB). The construction of the financial statements starts from policies and/or targets (i.e. accounts receivable policy or target). With these targets or policies we can construct the financial statements. For valuation purposes, the balance sheet and the income statements are important but may be insufficient. For that reason we construct the CB and in future notes we will derive the FCF from the CB.
The first table to be constructed is the table of parameters. This table organizes all of the relevant information. We have constructed the tables in EXCEL. The subsequent tables are linked to the table of parameters via formulas. Before constructing the financial statements, we will construct other supplementary tables that will be used in the construction of the main financial statements. In the main text, we describe the construction of all the tables and statements. The listing of all the tables is given in Appendix A. In these tables we show the table as seen in a spreadsheet with the columns and lines. In columns C and D the reader will find the formula as appears in the spreadsheet in columns E and F. There are a few exceptions, but they will be announced. If the reader wishes to construct the model exactly as we did, she will be able to do that following, step by step, not only the explanations in the body of the chapter but the appendix A as well.
In a future note we will propose a way to construct the FCF from the CB because it is closer to the idea of free cash flows. In fact, the CB records all the cash movements of a firm. We prefer this approach because we can "see" most of the items that are considered as part of the FCF. With this approach the probability of mistakes in the construction of the FCF is reduced. The only item that is not seen in the CB is the tax adjustment or tax savings, as will be seen at the end of this chapter. Another advantage of using the CB to derive the FCF is that you do not disregard a very useful managerial tool such as the CB. We expect the reader will find this approach more intuitive and easy to follow than the traditional.
Keywords: Project evaluation, Financial statements, Free cash flows, Cash budget, Income statement, Balance sheet
JEL Classification: M41, M40, M21, G31, H43
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