Financial modeling techniques

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Information about Financial modeling techniques
Business & Mgmt

Published on February 25, 2014

Author: corporatebridge



For full text article go to : This Financial Modeling Technique will help you to understand some important techniques like color coding, circular reference, compilation of historical data, things needs to be considered before making an assumption etc in order to make a financial model easy to understand.

Financial Modeling Techniques By EduCBA

Financial Modeling • A financial model represents  The financial performance of a company  For both past and future. • Always advisable to build a financial model in excel. • Skill sets required by an individual to build a financial model are  Knowledge of excel  Knowledge of accounting  Knowledge of corporate finance  Understanding the company‟s operations

Historical Data • Gather right historical data from the right source • Remember – You are an “Analyst” not an “Auditor” • Don‟t sit to tally if the annual reports published by company do not tally

Assumption • Referred to as „drivers‟ or „inputs‟ • Financial models need to have clear and well defined assumptions • Should reflect business realities and expectations • Criteria one should consider while making an assumption are :-  No bias should get into the assumptions on the business  Understanding the company's financials  Clearly understand the expected changes in future performance  Understand Management expectations  Check out what other analysts think about the company

Color Coding Constant / Historical Input = BLUE Calculations = BLACK Linkages = GREEN

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

Circular reference A circular reference is a series of references where the last object references the first, resulting in a closed loop. Year 1 Income heet (Rs m) Lets understand this with the help of an example Net Sales • We need to calculate net income (-)Direct Costs • To calculate net income we need to calculate interest income • Interest income will be calculated as income rate Gross Profit (-)Selling, General & Admin Costs EBITDA (-)Depreciation/Amortisation EBIT percentage on the average cash and bank balances • Over here we are assuming that the entire cash balance in the bank (-)Interest Expense (+)Interest Income Pretax Income (-)Income Taxes Net Income

Circular reference Cash Flow Statement Operating Activities Year 1 • In order to calculate ending cash balance Net Income Depreciation/Amortization Change in Working Capital Cash Flow from Operating Activities we will require net income then we will be able to calculate interest income Investment Activities Capital Expenditures Additions to Intangibles Cash Flow from Investing Activities Financing Activities Issuance/ (Repayment) of Long Term Debt Issuance/ (Repurchase of) Equity Cash Flow from Financing Activities Net Change in Cash Beginning Cash Balance Ending Cash Balance Cash balances Average Cash Balance Interest Rate Interest Income Year 1

Circular reference How to do this ??? Step 1 - Calculate net income by considering interest income to be 0 Step 2 - Link this net income to the cash flow statement and find out the ending cash balance Step 3 - Link this ending cash balance to the average cash balances and find out the interest income Step 4 – Link this interest income to the income statement

Circular reference Wondering whether the new net income figure will get reflected in the cash flow statement Yes through circular reference this entire process will be done automatically and accordingly the other figures in the income statement , balance sheet and cash flow statement would also be changed

Circular reference Remember Excel cannot calculate automatically when the model contains a circular reference We need to Turn ON “Iterations” in order to resolve the situation How to turn on Iteration in excel Go to File >>> Options >>>> Formulas >>>>> Enable iterative calculation >>>> OK

Circular reference

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