4.4 The Need for a Dynamic Adjustment Mechanism
Whilst the last example shows how an integrated forecast can be created using arithmetic only (and no functions), this forecast is valid for the base case, but may not be valid if input assumptions are changed. For example, let us assume the same operating assumptions for the business (i.e. so that the Income Statement and Cash Flow Statement are unchanged, and are therefore as shown above), but where the owner initially invests only $100 (instead of $150). The calculations for the Cash and Equity balances, and the Balance Sheet would be:
Note that the Balance Sheet still balances. However, the lower initial investment is now insufficient to cover the cumulated losses during the first three periods. As a result, in period 3, the Assets (Cash) and Liabilities (Equity) become negative. Whilst this is correct from a pure calculatory perspective, it does not reflect the behaviour of the real-life situation: In practice, the business could not function with a negative cash balance, and may not be allowed to exist legally if equity were negative.
In real-life, the business would have to adapt, either operationally or financially. For example:
- By ceasing operations and closing down completely.
- By increasing the prices charged, so that the profit becomes higher.
- By reducing the costs (Product Costs or Fixed Operations Cost).
- … and so on.
Any such changes also need to be captured within the logic of the integrated financial model (change which we refer to as making “dynamic adjustments”). Such adjustments are sometimes called “dynamic balancing”, however, the need for the adjustments is to capture the real-life situation more precisely: The two sides of the Balance Sheet in any case always balance, even in the case where the figures are unrealistic or invalid.
In most forecasting models one implicitly assumes the continuity of the business. That is, there is an assumption that the business operations continue as originally forecast, and that any adjustments are made to the financing side of the business (and thus there is an assumption that financing would be available). Of course, one could build different models that reflect the restructuring or partial closure of the business (or many other actions) if one desired to do so.
In other words, the common assumption is that if additional financing is required, then this is available and will be used. Its source could be the original owner, or additional owners who purchase new equity through a cash injection, or the taking on of debt or loans.
Similarly, if the business is sufficiently profitable over an extended period of time, then one may wish to adapt the model to reflect that dividends are paid, and so on