7 Financial Models for Analysts, Investors and Finance Professionals: Theory and practical tools to help investors analyse businesses using Excel

7 Financial Models for Analysts, Investors and Finance Professionals

Theory and practical tools to help investors analyse businesses using Excel

By Paul Lower

Contents

About the Author

Acknowledgements

Preface

Chapter 1 – Financial Modelling and Excel Basics

The need for financial models

Financial models – what they are and how they are used most effectively

Using Excel spreadsheet software for financial modelling

Best practice in building financial models

Ten steps to create good financial models

Tips on how to get the best results using Excel for financial modelling

Chapter 2 – Understanding and Using Financial Statements

Understanding financial statements

The purpose of financial statements

Financial position

Financial performance

Some key accounting concepts

Accruals concept

Prudence concept

Going concern concept

Consistency concept

The structure of financial statements

1. Balance sheet – statement of financial position

2. The income statement or profit statement

3. Cash flow statement

Comparing financials for different companies

Chapter 3 – Model 1: Key Financial Indicators

The Financial Indicator Model

Topic refresher – the financial analysis toolkit

Five-year summary overview

Income statement analysis

Balance sheet analysis

Ratio analysis

Return on investment (ROI)

Profitability ratios

Return on net assets (RONA)

Profit margin

Net asset turnover

Efficiency and working capital ratios

Fixed asset turnover

Working capital turnover

Working capital efficiency

Days' sales in inventory (DSI)

Days' sales outstanding (DSO)

Days' purchases outstanding (DPO)

The working capital cycle

How financial indicators guide improvements in ROI

Liquidity ratios

Current ratio

Acid test ratio

Financing structure and risk ratios

Gearing ratio or debt ratio

Interest cover

Shareholder return ratios

Return on equity (ROE)

Three-Step DuPont analysis

Using Three-Step DuPont analysis

Earnings per share (EPS)

Price/earnings ratio (P/E ratio)

Dividend yield

Cash flow ratios

Operating cash flow ratio

Price/cash flow ratio

Cash flow margin ratio

Cash flow to debt ratio

Comparing financial indicators for different companies

Chapter 4 – Model 2A: Sales Forecasting

Identifying trends and other variations in time series data

Using an Excel chart to identify a trend

The Sales Forecasting Model

Using Excel functions to isolate a trend from time series data

Calculating seasonal and random variations

Calculating a seasonal index

Extending the trend for the sales forecast

Adjusting the trend for seasonal variations

Chapter 5 – Model 2B: Cost Forecasting

Causal analysis

Adding a line of best fit through the data

Using correlation to test the strength of the relationship

Measuring correlation

Using the Excel CORREL function

The Cost Forecasting Model

Using Excel functions to identify variable and fixed costs

Correlation and causation

Making a maintenance cost forecast

Interpolation and extrapolation

Chapter 6 – Model 3: Cash Flow Forecasting

The Cash Flow Forecasting Model

Topic refresher – understanding business cash flow

Calculating cash flow for a period

Cash generated from operating activities (operating cash flow)

Direct method of calculating operating cash flow

Indirect method of calculating operating cash flow

Understanding working capital

Direct versus indirect method of calculating operating cash flow

Investing activities

Financing activities

Forecasting cash flow

Direct method of cash flow forecasting

Direct cash flow forecast example

Indirect method of cash flow forecasting

Input assumptions for the Cash Flow Forecasting Model

The operating cash flow section of the forecast

EBITDA (earnings before interest, taxation, depreciation and amortisation)

The output from the operating cash flow section of the forecast

Forecasting with strong seasonal sales patterns

Investing activities and financing activities

The output from the investing and financing sections

Using the Cash Flow Forecasting Model to test the impact of risk on cash flow

The complete output section of the cash flow forecasting app

Chapter 7 – Model 4: Pricing and Profit

The Pricing and Profit Model

Topic refresher – understanding pricing and profit

Acme Widget Company

Interpreting the Cost-Volume-Profit (CVP) chart

Gross margin and break-even point

Gross margin and pricing

Pricing and sales volume decisions

The limitations of this approach

The Pricing and Profit Model workbook

Input worksheet for the Pricing and Profit Model

The Price Check Analysis Model

The Cost-Volume-Profit Analysis Model

CVP calculations

The CVP chart

Chapter 8 – Model 5: Investment Decision

The Investment Decision Model

Topic refresher – discounted cash flow and capital investment decisions

Net Present Value

Example

Internal rate of return (IRR)

The Excel NPV function

Example

The Excel IRR function

Relevant costs and benefits for investment decisions

Which discount rate to use

DCF and inflation

DCF investment analysis – practical methodology

Calculating terminal value

Example

The Investment Decision Model workbook

Input worksheet for the Investment Decision Model

The DCF analysis

Chapter 9 – Model 6: Financial Statement Forecasting

The Financial Statement Forecasting Model

Topic refresher – the impact of risk on financial performance

Expected values

Example

Simulation modelling

Monte Carlo simulation modelling

Scenario analysis

Sensitivity analysis

Forecasting financial statements for sensitivity analysis

Conventional approach to forecasting financial statements

Key business drivers

The Financial Statement Forecasting Model workbook

Input sheet for the Financial Statement Forecasting Model

Income statement forecast

The balance sheet forecast

The cash flow statement forecast

The executive summary

Chapter 10 – Model 7: Business Valuation

The Business Valuation Model

Topic refresher – business valuation

The Shareholder Value Added (SVA) method of business valuation

The key shareholder value drivers

Valuation of the operational assets

Calculating the residual value of the operational assets

The Business Valuation Model

DMT2Z product margin assumptions

Other input assumptions

EBITDA analysis

SVA model

Publishing details

About the Author

Paul Lower is a trainer, lecturer and author, specialising in financial planning and analysis, and financial modelling and forecasting. He has worked for major clients in the UK (including Associated British Foods, Reckitt Benckiser and Angel Trains) and the Middle East (including SABIC and Saudi Aramco) and has also lectured on the MBA programme at one of the UK’s leading business schools.

Before moving into training he enjoyed a successful business career spanning more than 30 years. After gaining experience in blue chip companies, including Asda, H. J. Heinz and Pfizer, he held a number of Finance Director roles with major international companies in the media and publishing sector. Working for more than 20 years at board level, he gained extensive experience in financial planning and analysis, business valuations and acquisitions.

Paul is a Fellow of the Chartered Institute of Management Accountants, a Chartered Global Management Accountant and is also a Fellow of the Institute of Leadership and Management.

Acknowledgements

The job of the technical author is to write in such a way that allows readers without the same level of knowledge or experience to get a clear understanding of the topic and develop practical skills. I would like to thank Craig Pearce and his editorial team at Harriman House for their expert guidance in helping to bring clarity to my writing and offering numerous suggestions for how to improve the book.

The challenge for the financial modeller is to design an application that is user-friendly, unbreakable and bug free. This involves a time-consuming testing process and I am very grateful to my long-standing friend and business colleague, Stan Dwight, for generously giving his time to this task, as well as offering invaluable help to improve the text.

Preface

The 1970s was a decade of profound change. The oil price increase that resulted from regional conflicts in the Middle East and the formation of the Organisation of Petroleum Exporting Countries (OPEC) ushered in a period of stagnating economic growth and high levels of price inflation (stagflation), breaking what had been a sustained period of post-war prosperity in the developed economies. Another significant change in the closing years of that decade was the early-stage development of personal computers that would eventually kill off the expensive mainframe and mini computers then in use in the largest companies.

In 1978, I was working as a Management Accountant for a company that used computing technology spun-off from the US space programme to produce high-quality analysis of the seismic data coming out of the geophysical exploration for oil. I arrived at the office reception area one day to find a dozen large boxes each emblazoned with a large graphic of an apple. The finance department was allocated one of the Apple II computers that had been shipped in these boxes. The Regional CEO had ordered the machines and when we asked him what he wanted us to do with ours, he told us that he had no idea, but he expected that we would think of something. Some of the more adventurous finance team members clubbed together and bought a book on programming in BASIC (one of the earliest programming languages) and we took our first fumbling steps in using computers to do the basic numerical grunt work that was still been done by thousands of highly-trained finance professionals using rudimentary electronic calculators.

The decades that followed brought not just further extraordinary global change but also a striking increase in the rate of change. This was nowhere more obvious than in the field of personal computers and the software they used. Microsoft Excel was launched in 1985 and subsequently established itself as the de facto spreadsheet software. It had been preceded by a number of other successful products including Lotus 123 and Supercalc. From the start these spreadsheet applications revolutionised the way in which finance professionals worked and how they spent their time at the office.

Most importantly they facilitated a number of significant changes in the way that financial models could be used for business forecasting and decision-making. For example, in the 1960s Nobel Prize winning economists Modigliani and Miller had posited that the real value of a business was a function of the present value of all of the future cash flows that could be generated in perpetuity from its assets, taking into consideration the underlying risk in those assets. This principle is the basis for the business valuation model in Chapter 10. When you have had an opportunity to study the structure and functionality of this model you will have some idea of how this kind of financial modelling was all but impossible for most investment analysts and finance professionals in the age of the mainframe computer and the simple calculator. The emergence and dominance of the Shareholder Value Added (SVA) approach to business valuation during the last 25 years is due in large part to the ability to build this type of SVA financial model on a PC.

I was a working finance professional during this period and I was able to exploit much of the increasing power and functionality in these spreadsheet products to develop different financial models with which I could improve my own productivity and, more crucially, provide more meaningful insights for colleagues into the probable effects of their own business decisions and the potential impact of various kinds of risk events on company performance. This book is a guide on how to design, build and use some of the most useful of these financial models.

The book is intended primarily for investment analysts and finance professionals, who I hope will find useful practical applications for these models in their own businesses. Having had some experience as a visiting lecturer on an MBA programme, I would also