The ValueModel checks whether your cash-to-sales-ratio forecast deviates substantially from the past.
Forecasting cash levels for a certain company can be difficult, especially if we don’t have detailed information regarding the companies plan for the future. In general, we can say that cash levels are necessary for a firm to cover for unexpected events and economic downturns. Many firms increase their cash levels as they grow while some increase it to a certain level they feel comfortable with and leave it at that particular threshold. Forecasting cash is important as its function is not only to be a safety net but also a source of funding. If a firm cannot generate enough profit to finance their upcoming investments, they might want to decrease their cash level (temporarily) instead of taking a loan (especially if their debt level is high).
In most cases, it is very unrealistic that a company would grow their cash level faster than their revenue. One reason for this is that it is uneconomically in the sense that firms would rather pay out dividends or reinvest it to further enhance growth. Increasing cash level can be a sign that the company has limited investment opportunities.
Please note that your cash forecast will be overwritten in case there is excess cash that you did not use as cash and short-term debt are plugs in the model to balance out the balance sheet.
Related “Common valuation mistakes” articles
Imbalance between assets and source of funding
Building up too much cash and not growing fixed assets fast enough: If a company is building up cash it is usually a good sign. Liquidity ratios improve and the company has fewer difficulties covering their short-term liabilities. However, when using financial models, this can also happen by accident. Let’s say you are valuing a high growth company: the company had a rough patch in the recent past but the completion of a very profitable plant is imminent and you expect the earnings to increase massively. Some analysts would accelerate the revenue growth rapidly but wouldn’t increase the asset growth in an appropriate intensity. These receipts are then booked as cash. The result is that your forecast is suggesting that the company is building up huge amounts of cash when in fact it might be an unrealistic assumption as a strongly growing company would probably invest more heavily to generate further growth. Another consequence of this mistake would be that in some cases net fixed assets will be decreasing in your forecast, which is rarely the case in reality (we suggest at least 3% in net fixed asset growth).
If you have grown your assets fast enough and there is still too much cash, it would be reasonable to assume the company is going to pay them out as dividends rather than holding the cash if they haven’t done so in the past. Therefore, it is of importance to always keep an eye on the “Cash & short-term investment/sales” ratio.
Override cash forecast when no ST-debt: By using the ValueModel you might be curious why in some cases the “Cash & short-term investment/sales”-ratio does not influence the actual number for “Cash & short-term investments”. The reason for this is that your input is causing short-term debt to be negative which is not possible. As a result of that, the model will build up cash and overwrite your suggested input. “Cash & short-term investments” and “Overdrafts & short-term debt” are used to balance out assets and liabilities, so in that way you can think of them as a plug.
Too much ST-debt when growing assets too fast: “Cash & short-term investments” and “Overdrafts & short term debt” are used to balance out assets and liabilities, so in that way you can think of them as a plug. Whenever “Overdrafts & short-term debt” gets unrealistically high, the problem is the discrepancy between assets and the source of funding. It can be avoided by growing liabilities faster (Long-term borrowing growth, Other long-term liability growth, Other current liabilities/sales). Once you finance your capital spending properly with those items, short-term debt will be reduced automatically.