Financial Modeling Ebook 1 of 4

Financial Modeling E-book

Part 1 of 4

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Discussion topics
Overview of Financial Modeling Excel Best Practices Modeling Warm Up

Financial Modeling Ebook 1 of 4

Key Financial Statements

Working Capital Schedule Depreciation Schedule Amortization Schedule Long Term Items (Others) Schedule

Building Income Statement

Shareholders Equity Schedule Shares Outstanding Schedule Preparing for Debt & Interest Trouble Shooting Completing the Financial Model

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Introduction to Financial Modeling

Simplified representation of performance
Both past and future

Financial Modeling Ebook 1 of 4

Blend of skills is required

Understanding of the companys (projects) operations Accounting Knowledge Corporate Finance principles Excel (spreadsheet) techniques

Different Types of Models

Earnings model with projected earnings/ profits Debt/ Recapitalization/ Financing Model Merger Consequences model (Mergers/ Acquisitions/ Divestitures) Discounted Cash Flow models

Utility of Financial modeling

Virtual recreation of the actual business (need to understand the business logic) Ability to test assumptions to analyze impact on future performance
Growth Rates Operating Margins Product lines/ business segments Refinancing/ recapitalization

Understanding the purpose of the modeling in order to create the right design and functionality

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Assumptions Importance in Financial modeling

Need to have clear and well defined assumptions
Referred to as drivers or inputs these are based on a thorough understanding of the business

Financial Modeling Ebook 1 of 4

Assumptions should reflect business realities and expectations

No bias should get into the assumptions on the business Always remember GIGO Garbage In Garbage Out Use the past performance and a guide for future expectations Clearly understand the expected changes in future performance Understand Management expectations Check out what other analysts think about the company

How to make Assumptions

Past as an indicator of future performance, except in case of
Start up situations Significant acquisitions or divesture activities Volatile industry structure

Key tests a financial model should withstand

Is it a reasonable model Can the assumptions/ model be defended

Features of an effective model

Should be realistic based on reasonable and defensible assumptions and projections Should be flexible and adaptable with dynamic working schedules (or modules) Should be easy to follow, should not intimidate the reader
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Excel Best Practices

Maintain Consistency

Financial Modeling Ebook 1 of 4

Makes understanding and constructing easier

Consistent Color scheme makes life easy for self and others using the model
BLUE for inputs (historical data, assumptions, drivers) BLACK for calculations and references on same schedule/ asset GREEN reference from another schedule/ sheet RED warnings to another user/ links to another model

Clarity of presentation
You should be able to understand the model when you revisit after some time lapse! More Important Others should be able to understand!

Be efficient
Utilize excel to improve productivity Do Not hard code in formulae cells

X
Separate line items are always useful

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Excel Best Practices

Be efficient
Do not input same numbers twice. Also, Excel takes care of formatting!

Financial Modeling Ebook 1 of 4

Never Hide rows or columns its useful to group them instead (Data -> Group)

Set up the first sheet as a template for a complete worksheet using Page Set Up
Use Edit -> Move/ Copy Sheet to create as many sheets as required in the model Take care as named cells will be duplicated in the new sheet

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Modeling Warm Up!

Use a Modular Approach

Financial Modeling Ebook 1 of 4

Core Statements Income Statement, Balance Sheet, Cash Flow Statements

Focus on Others Do all the dirty work Use them as a conduit between core schedules Export the supporting schedules to the core statements on completion All projections need to be referenced from Schedules

Prepare supporting schedules

Balance Sheet and Cash Flow Statements

Working Capital

Income Statement

Debt & Interest

Plant & Machinery, Depreciation

Cash Flow Statement

Shareholders Equity

Intangibles, Amortization

Balance Sheet

Other LT Items

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Things to Remember
Historical data as a guide for projections
Aim at projecting future performance Remember you are an Analyst and not an Auditor! Do not get worked up if historicals do not reconcile (its quite common!)

Financial Modeling Ebook 1 of 4

Reasonable and Defensible set of Assumptions and Projections

Models need to be efficient and clear

A bad model is difficult to follow and audit

A good model should be easy to follow and focus on key drivers

Use Beta testing

Test the logic after inputting right or down check for flow

Challenge each assumption with the following

How does the model behave if you increase the assumption? What is a impact if the assumption is decreased? Try making the assumption equal to Zero What if the sign of the assumption changes?

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Key Financial Statements - Overview

Create the line items
Income Statement Balance Sheet Cash Flow Statement

Financial Modeling Ebook 1 of 4

Income Statement
Historical information

Project Revenue and Operating expenses (Sales to EBITDA)

Balance Sheet
Historical data only

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Income Statement - Sample

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Setting up the Income Statement

Sources for appropriate line items financial statements, management guidance and research Incorporate detailed line items to suit the business under analysis Ensure the income statement represents the company/ industry

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Balance Sheet - Sample

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Setting up the Balance Sheet

Sources for appropriate line items financial statements, management guidance and research Simplify or expand line items to sit the analytical objective Modify as required to represent the company/ industry

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Cash Flow Statement - Sample

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Setting up the Cash Flow Statement

Past allowances are usually not made historical cash flow statements are often difficult to reconcile Ensure the columns are consistent with the Income Statement and the Balance Sheet Standard layouts are useful for references from other schedules

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Income Statement - Sample

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Calculations in Black
Inputs are in Blue

Input past information in the Income Statement

Normalize for any non-recurring items Ensure to make notes as necessary Calculate historical ratios & growth rates Do not forget formatting!

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Income Statement - Sample

Financial Modeling Ebook 1 of 4

Forecasted figures

Forecast net sales for future years

Drivers: forecasted annual sales growth Sources: management guidance, research, past trends Challenge assumptions for being reasonable Footnote all sources for assumptions

Drivers based on input assumptions

Only one blue input cell if constant growth is assumed

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Income Statement - Sample

Financial Modeling Ebook 1 of 4

Inputs from research/ past trends

Forecast future operating expenses

Drivers: margin assumptions for future operations Sources: management guidance, research, past trends Challenge assumptions for being reasonable Other Expense/ (Income) is usually a number based on research/ past trends (but not in % terms like other specific line items) Calculate till EBITDA. Depreciation & Amortization will be referenced from schedules to be built in model Drivers

Calculations

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Balance Sheet - Sample

Financial Modeling Ebook 1 of 4

Calculations in Black
Inputs are in Blue

Its practical to show 2 condensed debt items

Input past information for the Balance Sheet

Check if past Balance Sheets are balancing If combining line items into one item, make sure not to miss out any items

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Illustrative Flow of Funds

Financial Modeling Ebook 1 of 4

Income Statement

Cash Flow Statement

Balance Sheet

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Working Capital Schedule

Working Capital Overview
Create the working capital line items Reference the historical balances Calculate past ratios related to working capital items Project future working capital by each line item Calculate projected cash flows generated out of working capital items Link with balance sheet & cash flow statement work sheets

Financial Modeling Ebook 1 of 4

Referenced from Income Statement

Setting up the Working Capital Schedule

Ensure clarity by using the same working capital line items in the same order in the balance sheet Reference Net Sales & Cost of Goods Sold from the Income Statement these are the drivers for working capital line items

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Working Capital Schedule - Sample

Financial Modeling Ebook 1 of 4

Referenced from BS

Calculations

Reference the past data from the balance sheet

Calculate net working capital Arrive at increase/ decrease in working capital

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Working Capital Schedule - Sample

Financial Modeling Ebook 1 of 4

Calculations

Calculate historical ratios and percentages

Use the ending or average balance Both are acceptable as long consistency is maintained

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Working Capital Schedule - Sample

Financial Modeling Ebook 1 of 4

Assumptions

References, if constant

Assumptions for future working capital items

Certain items without an obvious driver are usually assumed at constant amounts Ensure assumptions are reasonable and in line with the business

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Working Capital Schedule - Sample

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Drivers

Projections

Drivers

Use the future ratios and assumptions to project the forecasted working capital balances

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Working Capital Schedule - Sample

Financial Modeling Ebook 1 of 4

Check and make sure the signs match!

Calculations

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Arrive at Cash Flows based on individual line items Ensure signs are accurate!
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Balance Sheet - Sample

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Referenced from Working Capital Schedule

Link up the forecasted Working Capital to the Balance Sheet

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Cash Flow Statement - Sample

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Referenced from Working Capital Schedule

Link up the forecasted Working Capital cash flows with the Cash Flow Statement

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Illustrative Flow of Funds

Working Capital Schedule

Financial Modeling Ebook 1 of 4

Sales COGS

Income Statement

Working Capital

Change in WC Working Capital

Cash Flow Statement

Balance Sheet

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