3 - flow of a model (1)

Ben J. Sopranzetti, Ph.D.Ben J. Sopranzetti, Ph.D. 11

Flow of a ModelFlow of a Model

Chapter 3Chapter 3

Building your operating Building your operating assumptionsassumptions


The Core of the ModelThe Core of the Model

Three Financial StatementsThree Financial Statements


Income StatementIncome Statement

Revenue – Expenses = ProfitRevenue – Expenses = Profit


Balance SheetBalance Sheet

Assets = Liabilities + EquityAssets = Liabilities + Equity


Statement of Cash Statement of Cash FlowsFlows

Cash inflows – Cash outflows Cash inflows – Cash outflows ==

Cash BalanceCash Balance


The three statements are The three statements are interrelated… there is interrelated… there is

endogeneityendogeneity


Income statement links to Income statement links to balance sheet through balance sheet through retained retained

earningsearnings


Balance sheet links to income Balance sheet links to income statement through… statement through…

Interest expense Interest expense

Depreciation Depreciation

AmortizationAmortization


Cash flow statement delineates Cash flow statement delineates the amount of cash generatedthe amount of cash generated

This drives the amount of This drives the amount of debt debt required on the Balance required on the Balance SheetSheet


What does all this What does all this mean for you?mean for you?

You cannot forecast one of the You cannot forecast one of the financial statements, without financial statements, without

also doing the other two also doing the other two


Start your model with Start your model with the Income the Income StatementStatement

It is the most straightforward It is the most straightforward to modelto model


Revenue $118.0

Cost of Goods Sold - 87.5

Gross Profit 30.5

Selling, General & Administrative Expenses - 10.3

Operating Profit (EBIT)___________________ 20.2

Interest Expense (net) - 7.7

Pretax Income 12.5

Income Taxes - 5.4

Net Income 7.1

Sample Income Statement


Bifurcating the Income Bifurcating the Income StatementStatement

The Income Statement can be divided The Income Statement can be divided into two categoriesinto two categories

– Operating itemsOperating items– Non-operating items Non-operating items

““Operating” refers to Revenues, Operating” refers to Revenues, expenses, and expenditures that are expenses, and expenditures that are not impacted by Interest Expense.not impacted by Interest Expense.


Finance Jargon: Finance Jargon: Above the LineAbove the Line

Operating Profit is above the Operating Profit is above the Interest Expense line of an Interest Expense line of an

Income Statement Income Statement


Why is Operating Profit so Why is Operating Profit so important?important?

Below the Operating Profit line, the Below the Operating Profit line, the company’s results are impacted by its company’s results are impacted by its Capital Structure.Capital Structure.

Operating profits are not “directly” Operating profits are not “directly” affected by the choice of capital affected by the choice of capital structure.structure.

We’ll discuss the indirect impact in Advanced We’ll discuss the indirect impact in Advanced Corporate Finance.Corporate Finance.


For example,For example,

A company goes public and raises $75 A company goes public and raises $75 million of Equity to repay Debtmillion of Equity to repay Debt

Ceterus Paribus, Interest Expense will Ceterus Paribus, Interest Expense will decrease and its Net Income will increasedecrease and its Net Income will increase

But Operating Income will stay unchangedBut Operating Income will stay unchanged

Operating Income is also called Operating Operating Income is also called Operating Profit or Earnings Before Interest and Profit or Earnings Before Interest and Taxes (EBIT).Taxes (EBIT).


Operating Projects are Operating Projects are the most important the most important

projections in valuing a projections in valuing a businessbusiness

You can project the Operating You can project the Operating Assumptions of a business Assumptions of a business

independently of any independently of any transaction transaction


Below the LineBelow the Line

Nearly all transactions have an impact Nearly all transactions have an impact on non-operating line items because of on non-operating line items because of their effect on Interest Expense. their effect on Interest Expense.

With non-operating items, forecasts With non-operating items, forecasts depend on what kind of deal is depend on what kind of deal is analyzed, whereas operating items are analyzed, whereas operating items are independent of capital structure choices independent of capital structure choices


So what does that mean So what does that mean for forecasting the for forecasting the Income Statement?Income Statement?

Begin with the Operating Begin with the Operating Items that drive EBITItems that drive EBIT


Should we directly hard-wire Should we directly hard-wire the projections?the projections?

NO!NO!

Makes it impossible to analyze Makes it impossible to analyze multiple forecast scenarios and multiple forecast scenarios and makes it difficult to show key makes it difficult to show key summary data about the forecast summary data about the forecast

Create a separate Operating Create a separate Operating Assumptions PageAssumptions Page


Income Statement

Statement of Cash Flows

Balance Sheet

Operating Projections

→

Linked


Crucial assumptionsCrucial assumptions

Growth RatesGrowth Rates

Profit MarginsProfit Margins

Together these drive Operating Together these drive Operating ProfitsProfits


WAIT!WAIT!

What about Depreciation, What about Depreciation, Amortization, EBIT, EBITDA Amortization, EBIT, EBITDA and Capital Expenditures?and Capital Expenditures?


Depreciation and Depreciation and Capital Expenditures Capital Expenditures

Suppose Ajax spends $1,000 on a new Suppose Ajax spends $1,000 on a new machine. The machine is expected to machine. The machine is expected to last for 10 years. How do we handle last for 10 years. How do we handle

this?this?


The accountant The accountant does notdoes not show a show a gigantic $1,000 expense on the gigantic $1,000 expense on the

Income Statement Income Statement

Instead, the $1,000 is Instead, the $1,000 is capitalizedcapitalized

Increasing PP&E line item on the Increasing PP&E line item on the Balance Sheet. Balance Sheet.

$1,000 is recorded as a Capital $1,000 is recorded as a Capital Expenditure on the Cash Flow Expenditure on the Cash Flow Statement. Statement.


Money was spent on the machine, Money was spent on the machine, shouldn’t the Income Statement be shouldn’t the Income Statement be

impacted?impacted? The expense is recognized over the The expense is recognized over the

period of time that the benefits of period of time that the benefits of the machine are received. the machine are received.

A Depreciation expense of $100 per A Depreciation expense of $100 per year for the next 10 years would be a year for the next 10 years would be a very typical treatment. very typical treatment.


Meanwhile, Meanwhile,

The cash picture is different: The cash picture is different:

$1,000 is spent today for the $1,000 is spent today for the machine and $0 for the next 10 machine and $0 for the next 10 years.years.


What about Amortization?What about Amortization?

Very similar concept to depreciationVery similar concept to depreciation

Amortization is usually categorized Amortization is usually categorized as a SG&A expense instead of COGS. as a SG&A expense instead of COGS.

Collectively, Depreciation and Collectively, Depreciation and Amortization are often called D&A Amortization are often called D&A


Capitalizing an Expense

Line Item Now Years 1-10

Notes

Depreciation

$0 $100 •Categorized as a non-cash expense on the Income Statement (COGS) •Also appears on the Cash Flow Statement

Capital Expenditures

$1000

$0 •Impacts the Cash Flow Statement •Flows into Property, Plant and Equipment (PP&E) on the Balance Sheet •Has no direct impact on the Income Statement (until depreciated)


So what is a Capital So what is a Capital Expense?Expense?

CAPEX represent the CAPEX represent the amount actually amount actually spentspent on PP&E on PP&E

Depreciation and Amortization (D&A) Depreciation and Amortization (D&A) are merely accounting entries to are merely accounting entries to record a non-cash expenserecord a non-cash expense


We are focused on We are focused on cash flow cash flow

We want to separate out the non-We want to separate out the non-cash expenses from Operating cash expenses from Operating Profit and focus on a cash flow Profit and focus on a cash flow

measuremeasure


EBITDAEBITDA

Earnings Before Interest, Earnings Before Interest, Taxes, Depreciation and Taxes, Depreciation and

Amortization Amortization


EBITDAEBITDA

Equals EBIT plus D&A expenseEquals EBIT plus D&A expense

Take Operating Profit and add back Take Operating Profit and add back the non-cash Depreciation and the non-cash Depreciation and Amortization expenses that are Amortization expenses that are buried in the Operating Expenses buried in the Operating Expenses

Proxy for Operating Cash FlowProxy for Operating Cash Flow


I can’t find EBITDA!I can’t find EBITDA!

It doesn’t appear on the It doesn’t appear on the Income Statement. You will Income Statement. You will

need to calculate it.need to calculate it.


EBITDA can be calculated by EBITDA can be calculated by either: either:

Starting with Revenue and Starting with Revenue and subtracting only the "cash" expensessubtracting only the "cash" expenses

OrOr

Starting with EBIT and adding back Starting with EBIT and adding back the non-cash expensesthe non-cash expenses


Sample EBITDA Calculation

Revenue $118.0

"Cash" COGS - 86.0

Depreciation - 1.5

Gross Profit 30.5

"Cash" Selling, General & Administrative Expenses

- 9.3

Amortization - 1.0

Operating Profit (EBIT) 20.2

EBITDA $22.7


Get comfortable with Get comfortable with EBITDAEBITDA

You will be calculating it… A You will be calculating it… A LOT!LOT!


What about the cost of new What about the cost of new PP&E?PP&E?

The CAPEX line does not appear on the The CAPEX line does not appear on the P&L, but we need to focus on it. P&L, but we need to focus on it.

Why?Why?

If we just add back D&A, we're missing a If we just add back D&A, we're missing a large piece of the cost picture -- the cost of large piece of the cost picture -- the cost of investing in the infrastructure of the investing in the infrastructure of the company (PP&E).company (PP&E).


We will break out the Depreciation We will break out the Depreciation component of COGS and the component of COGS and the Amortization component of SG&A for Amortization component of SG&A for easy calculation of EBITDAeasy calculation of EBITDA

Also, CAPEX is a part of the Also, CAPEX is a part of the Operating Assumptions page. Operating Assumptions page.

This may seem odd, since this page This may seem odd, since this page primarily feeds the P&L, whereas CAPEX is a primarily feeds the P&L, whereas CAPEX is a Cash Flow Statement line item.Cash Flow Statement line item.

Concluding comments


Next up…Next up…

Excel BasicsExcel Basics

3 - flow of a model (1)

Documents

income statement ben

operating projects

operating assumptionsben

operating profits

operating projectionslinked

operating profit line

operating profit ebit

income taxes