Asset and financing models
The asset model grows the operating assets the business needs, which sets net investment. The financing model asks who pays: financing needs = change in operating assets − change in non-debt liabilities − retained earnings. Cash, debt or equity fill the gap, changing free cash flow to equity (FCFE).
Before this: Expense models: margins, itemization and operating leverage
On the exam
- Explain the rationale, construction, and uses of financial statement forecast models in equity valuation
Explain how asset and financing models are built. Expect: financing needs from forecast balance sheet changes and retained earnings, FCFE computed two ways, the effect of dividends and borrowing on financing needs and FCFE, which balance sheet lines to grow, and why asset regressions are weaker than expense regressions.
How deeply to learn each part
- Know the idea
- Understand it in general. It frames other topics, but you will not calculate with it.
- Use it
- Understand it well enough to solve a question with it. Recognize when it applies.
- Memorize
- Learn it by heart. The exam will not give it to you.
You know this one. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still do.
You tested strong here. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still know it.
What does the asset model forecast?
The asset model decides how much working capital and how many fixed assets the revenue forecast needs, and so it sets net investment. The business model matters. Asset-light and asset-heavy business models need very different investment: a booking platform that owns no hotels earns revenue from a small asset base, while the hotel owner needs heavy investment. An asset-light model can be hard to keep as a company grows.
- The simplest assumption is assets growing with revenue , so that constant asset turnover (revenue divided by assets) holds. A quick test of history is to compare the compound growth of key assets with that of revenue. Assets growing faster than revenue mean growth has needed more investment.
- A regression of asset growth on revenue growth works like the expense regression of the last lesson. “Grow with revenue” means a = 0 and b = 1.
Asset regressions are usually weaker than expense regressions. Asset spending is less closely tied to revenue, and there is a timing mismatch : assets are bought before the revenue they produce.
Which balance sheet lines should grow?
An itemized asset forecast grows each line on its own. Apply two tests to every asset or liability: does it arise from operations, and does it involve cash payments or receipts? Lines that pass both are operating and cash-based line items , and they grow with the forecast. Receivables, inventory, payables, net long-term operating assets and intangibles bought for cash pass.
- Both tests yes: grow it Memorize receivables, inventory, payables, net long-term operating assets, intangibles bought for cash
- Not operating: do not grow it Memorize marketable securities and other non-operating assets; cash changes come from the financing model
- No cash involved: do not forecast it Memorize a value change such as a goodwill impairment
Non-operating assets such as marketable securities do not grow with the business, because cash changes come from the financing model. A value change with no cash, such as a goodwill impairment, is not forecast. Net investment, from lesson 1, is the change in working capital plus the change in net long-term assets.
How do you work out the financing needs?
The financing model asks who pays for the growth. Three steps give the financing needs .
- Forecast operating assets and take the change.
- Forecast non-debt liabilities and take the change.
- Forecast retained earnings: net income minus dividends, and take the change.
The first is the spending. The other two are internal funding.
A positive figure means the company must raise money or run down cash. A negative figure is a financing surplus . The sources and uses of financing follow the sign.
- Need above zero: money required Memorize
- Cash draw it down, but not below a safe level
- Debt check the debt ratio and the extra interest
- Equity avoid unless the company has issued before
-
- Need below zero: surplus Memorize
- Cash add to the balance
- Debt repay; check the debt ratio does not fall too low
- Equity buy back shares or pay extra dividends
-
Listed companies usually prefer cash and debt to new shares, because issuing is costly, dilutes holders and depends on market timing.
Dividends cut retained earnings, so with dividends and financing needs linked one for one, a higher dividend raises the financing needs by the same amount.
An analyst can also set a target debt ratio as a percentage of total assets and let debt follow it. The balancing figures then split each year’s financing need across cash, debt and equity in fixed proportions. A higher debt ratio can hurt the credit rating and raise the cost of debt. With a target of 35% of total assets of CAD 500 million, debt should be 175. If opening debt is 160, the company borrows 15.
How does financing change FCFE?
Free cash flow to equity (FCFE) can be computed from net income or from the uses of cash. The two must agree. The investment terms in the first equal the change in operating assets minus the change in non-debt liabilities, which is net investment.
An analyst forecasts that operating assets will rise by 42.00 and non-debt liabilities by 9.00. Net income is forecast at 30.00 and dividends at 9.00. The financing needs are closest to:
42.00 − 9.00 − (30.00 − 9.00) = 12.00
Financing needs12.00
- 42−9−30+9=12
- 42ENTER9−30−9+12
ENTER enter (on the HP, puts the number on the stack)
A company's forecast adds 4.50 to cash. It pays dividends of 9.00, buys back shares worth 0.00 and issues shares worth 0.00. Forecast free cash flow to equity (FCFE) is closest to:
4.50 + 9.00 + 0.00 − 0.00 = 13.50
FCFE13.50
- 4.5+9+0−0=13.5
- 4.5ENTER9+0+0−13.5
ENTER enter (on the HP, puts the number on the stack)
Try this 0 of 3
- Financing: raise the dividend and keep FCFE at 13.5
- Financing: make FCFE negative while net income stays positive
- Financing: turn the financing need into a surplus
Corvina Tools, CAD million. Free cash flow to equity (FCFE).
Cash is the balancing figure: it absorbs whatever borrowing does not cover.
- Δoperating assets42.0
- Δnon-debt liabilitiessuppliers and others fund it−9.0
- Retained earningsnet income 30 − dividends 9−21.0
- Financing needs12.0
| Net income | 30.0 |
|---|---|
| − Net investment | 33.0 |
| + Δdebt | +16.5 |
| = FCFE | 13.5 |
| Δcash | +4.5 |
|---|---|
| + Dividends | 9.0 |
| + Buybacks − new shares | 0.0 |
| = FCFE | 13.5 |
✓ The two routes agree: FCFE = 13.5. FCFF does not depend on these funding choices; FCFE does.
Show working
Net investment = 42.0 − 9.0 = 33.0. Retained earnings = 30.0 − 9.0 = 21.0.
Financing needs = Δoperating assets − Δnon-debt liabilities − retained earnings = 42.0 − 9.0 − 21.0 = 12.0.
Borrowing = 50% × 33.0 = 16.5; Δcash = 16.5 − 12.0 = +4.5.
FCFE = net income − net investment + Δdebt = 30.0 − 33.0 + 16.5 = 13.5. Uses of cash: +4.5 + 9.0 + 0.0 = 13.5.
- 42−9−30+9=financing needs 12
- 42ENTER9−30−9+financing needs 12
ENTER enter (on the HP, puts the number on the stack)
- 30−33+16.5=FCFE 13.5
- 30ENTER33−16.5+FCFE 13.5
ENTER enter (on the HP, puts the number on the stack)
- 4.5+9+0=FCFE 13.5
- 4.5ENTER9+0+FCFE 13.5
ENTER enter (on the HP, puts the number on the stack)
Exam tip Debt in, FCFE up; debt repaid, FCFE down. Dividends change the financing need, not FCFE, when cash absorbs them.
Free cash flow to the firm (FCFF) depends only on profitability and investment, so it is much less sensitive to financing assumptions than FCFE (only through the cost of financing). That is one reason analysts often value with FCFF, as lesson 7 shows.
Memorize this
MemorizeFinancing needs and FCFE
| Item | Formula |
|---|---|
| Financing needs | Δoperating assets − Δnon-debt liabilities − (net income − dividends) |
| FCFE (from net income) | net income − net investment + Δdebt |
| FCFE (uses of cash) | Δcash + dividends + buybacks − new shares |
| Net investment | Δoperating assets − Δnon-debt liabilities |
Memory hook Spend, minus what suppliers fund, minus what profits keep = what must be raised.
Know it cold Need above zero: cash, then debt, equity last. Need below zero: add to cash, repay debt or buy back shares. Higher dividends raise the need.
MemorizeAsset model rules
Memory hook Grow it only if it is operating and it is cash.
Know it cold Assets = revenue growth means constant turnover (a = 0, b = 1). Asset regressions are weak: looser link, and assets come before the revenue. Do not grow marketable securities or impairments.
- Both tests yes: grow it Memorize receivables, inventory, payables, net long-term operating assets, intangibles bought for cash
- Not operating: do not grow it Memorize marketable securities and other non-operating assets; cash changes come from the financing model
- No cash involved: do not forecast it Memorize a value change such as a goodwill impairment
- Need above zero: money required Memorize
- Cash draw it down, but not below a safe level
- Debt check the debt ratio and the extra interest
- Equity avoid unless the company has issued before
-
- Need below zero: surplus Memorize
- Cash add to the balance
- Debt repay; check the debt ratio does not fall too low
- Equity buy back shares or pay extra dividends
-
Quick example
Intercept a = 0.03, slope b = 0.40, revenue growth 5%: asset growth is 0.03 + 0.40 × 0.05 = 5.0%. "Assets grow with revenue" means a = 0 and b = 1.
- 0.4×0.05+0.03= 0.05
- 0.4ENTER0.05×0.03+ 0.05
ENTER enter (on the HP, puts the number on the stack)
Quick example
Operating assets rise 60 and non-debt liabilities 14. Net income is 35 and dividends 10, so retained earnings rise 25. Financing needs are 60 − 14 − 25 = 21: money is required.
- 60−14−35+10= 21
- 60ENTER14−35−10+ 21
ENTER enter (on the HP, puts the number on the stack)
Quick example
Net income 20, gross long-term assets +30, depreciation 10, working capital +5, debt +12. FCFE = 20 − (30 − 10) − 5 + 12 = 7.
- 20−30+10−5+12= 7
- 20ENTER30−10+5−12+ 7
ENTER enter (on the HP, puts the number on the stack)
Quick example
Cash rises 3, dividends are 6, buybacks 2 and new shares 4. FCFE = 3 + 6 + 2 − 4 = 7, the same company as the card above.
- 3+6+2−4= 7
- 3ENTER6+2+4− 7
ENTER enter (on the HP, puts the number on the stack)
How it is asked
-
Financing needs
Operating assets +55, non-debt liabilities +12, net income 38, dividends 15.
55 − 12 − 23 = 20 required. Forgetting the dividend (5) is the trap.
-
FCFE from the uses of cash
Surplus of 6 added to cash, dividends 14, no buybacks or issuance.
6 + 14 = 20.
-
Which line grows?
Inventory, marketable securities, goodwill after an impairment.
Inventory: operating and cash-based. The other two are not.
-
Surplus used to repay debt
What happens to FCFE if the surplus repays debt instead of adding to cash?
FCFE falls by the repayment: debt repaid is cash leaving the shareholders' side.
Exam traps
- Ignoring dividends in financing needs: retained earnings are net income minus dividends.
- Thinking a higher dividend raises FCFE: when cash funds it, FCFE is unchanged.
- Growing non-operating assets (marketable securities) or non-cash changes (impairments) with revenue.
- Expecting asset regressions to fit as well as expense regressions: assets come before revenue and track it loosely.
- Assuming new equity is the first source of funds: listed companies usually use cash and debt first.
Checkpoint
3 exam-style questions. About 90 seconds each.
1An analyst forecasts that a company's operating assets will rise by GBP 55 million and its non-debt liabilities by GBP 12 million next year. Net income is forecast at GBP 38 million, and dividends at GBP 15 million. The company's financing needs are closest to:
2A company's forecast shows a financing surplus of AUD 6 million, which the analyst adds to cash. The company pays dividends of AUD 14 million and neither buys back nor issues shares. Forecast FCFE is closest to:
3In an asset model, which balance sheet line should an analyst most likely forecast to grow with the company's operations?
Key takeaways
- The asset model grows operating, cash-based assets; it sets net investment.
- Financing needs = Δoperating assets − Δnon-debt liabilities − (net income − dividends).
- FCFE = net income − net investment + Δdebt = Δcash + dividends + buybacks − new shares.
- Borrowing raises FCFE; dividends raise the financing need; FCFF barely depends on financing.
Quick example
Intercept a = 0.03, slope b = 0.40, revenue growth 5%: asset growth is 0.03 + 0.40 × 0.05 = 5.0%. "Assets grow with revenue" means a = 0 and b = 1.
- 0.4×0.05+0.03= 0.05
- 0.4ENTER0.05×0.03+ 0.05
ENTER enter (on the HP, puts the number on the stack)
Quick example
Operating assets rise 60 and non-debt liabilities 14. Net income is 35 and dividends 10, so retained earnings rise 25. Financing needs are 60 − 14 − 25 = 21: money is required.
- 60−14−35+10= 21
- 60ENTER14−35−10+ 21
ENTER enter (on the HP, puts the number on the stack)
Quick example
Net income 20, gross long-term assets +30, depreciation 10, working capital +5, debt +12. FCFE = 20 − (30 − 10) − 5 + 12 = 7.
- 20−30+10−5+12= 7
- 20ENTER30−10+5−12+ 7
ENTER enter (on the HP, puts the number on the stack)
Quick example
Cash rises 3, dividends are 6, buybacks 2 and new shares 4. FCFE = 3 + 6 + 2 − 4 = 7, the same company as the card above.
- 3+6+2−4= 7
- 3ENTER6+2+4− 7
ENTER enter (on the HP, puts the number on the stack)
All Equities formulas, every lesson
Practice exam-style questions on Financial Statement Forecasting
Questions about this lesson?
Where this comes back
- Scenario analysis with probability weights Financial Statement Forecasting
Questions candidates ask
How do you calculate financing needs in a forecast model?
Change in operating assets minus change in non-debt liabilities minus the change in retained earnings (net income less dividends). A positive figure must be funded with cash, debt or equity; a negative figure is a surplus.
How do you calculate FCFE from forecast statements?
Net income − (change in gross long-term assets − depreciation) − change in working capital + change in debt. Or, from the uses of cash: change in cash + dividends + buybacks − new shares. Both give the same answer.
Why do analysts check asset growth against revenue growth?
Assets growing faster than revenue mean growth needs more investment, lowering free cash flow. Equal growth means constant asset turnover.
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