Financial Modeling

Copyright Investment Banking Institute

www.ibtraining.com

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Table of Contents

I. Introduction

II. Spreading Historical Financial Statements

III. Deriving Historic Ratios, Trends and Variables

IV. Financial Statement Projections

V. Integration of Financial Statement Projections / Revolver Modeling

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Introduction

Uses for Financial Models in Investment Banking and Private Equity:

Models begin with inputting historical results, and then making projections for future years, linking the income statement, balance sheet, and cash flow statement

Examples of a model’s use: – Acquisition or sale of an entire company or division – Merger of equals – Leveraged buyouts / Management buyouts – Public or private placement of new equity or debt capital – Restructuring / Bankruptcy

The associate or analyst will construct and maintain the model, and set the model up so that any changes in financial projections or the deal terms can be quickly entered, and the result seen immediately. Creating a robust model is imperative.

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Introduction Tips for Setting Up the Financial Model:

Keep historic and projected income statement, balance sheet and cash flow on same worksheet

Have Historic Ratios / Assumptions for Projections on the same worksheet but separate from the worksheet that has income statement, balance sheet and cash flow

Formatting is very important in investment banking: – same font and letter size throughout model – clearly labeled pages – blue text usually denotes an input that is a driver – black text is usually output – convention is one decimal point for $ amounts; 0 or 1 decimal points for

percentages – Set print ranges and preferences – Footnote all sources and assumptions clearly

Keep it as simple as you can

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Table of Contents

I. Introduction

II. Spreading Historical Financial Statements

III. Deriving Historic Ratios, Trends and Variables

IV. Financial Statement Projections

V. Integration of Financial Statement Projections / Revolver Modeling

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Spreading Historical Financial Statements

3 to 5 year history for income statement, balance sheet and cash flow

usually sufficient

Source of historic financial statements:

Publicly traded companies’ financial statements must be filed with the SEC on a quarterly (10-Q) and annual basis (10-K) and are publicly available

Private companies: audited financial statements provided by company

Adjust historical income statement for one-time, extraordinary, non-recurring items such as restructuring charges or sale of business division

When spreading the historic financial statements: keep it simple!

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Deriving Historic Ratios, Trends and Variables

Goal is to intuit historical trends, margins, growth rates for making projections. Remember that the past is not always a guide to the future, but sometimes it is.

Important ratios needed for historical results in the income statement:

Revenue growth

Gross margin: (revenue – cost of goods sold) / revenue

SG&A margin: SG&A / revenue

Operating margin: operating income / revenue

EBITDA margin: (operating income + D&A) / revenue

Operating income growth (AKA EBIT) and EBITDA growth

Depreciation as a percentage of gross P,P&E

Effective tax rate: income tax / pre-tax income

Other income/expense: read the notes to statements to see if there is a trend

– Depreciation schedules can also be used; for purposes of this model, we are using Depreciation as % of Gross PP&E; Depreciation Schedule available for illustrative purposes.

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Deriving Historic Ratios, Trends and Variables

Important ratios needed for historical results in the balance sheet:

Accounts receivable, Inventory, and Accounts Payable are expressed in terms of number of days (e.g. DSOs are 30 days):

Days in Accounts Receivable: Average A/R Balance / Revenue * 360 days

Days in Inventory: Average Inventory Balance / COGS * 360 days

Days in Payables: Average A/P Balance / COGS * 360 days

• Days in accounts receivable is also called “days in receivables” or “days sales outstanding” (DSOs)

• Other assets and liabilities can be expressed either as a percent of revenue or COGS, it all depends on what they are most correlated with

• Capital Expenditures (CAPEX) is expressed as a % of revenue

• Asset Dispositions should be explored in notes to statements, to see if there is a trend or if they are one-time (non-recurring) items.

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Table of Contents

I. Introduction

II. Spreading Historical Financial Statements

III. Deriving Historic Ratios, Trends and Variables

IV. Financial Statement Projections

V. Integration of Financial Statement Projections / Revolver Modeling

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Income Statement Projections

Revenue projections are based sometimes on historical growth if a mature or cyclical company, or more on market intelligence and judgment if a fast growing company

Revenue = price x quantity. Break them out, maybe you have a good handle on future unit sales, or price. Does the company have power to pass through future cost increases? Is the sector expanding capacity, which may pressure prices?

For a restaurant chain, if average revenue per store were stable, and we knew the number of new stores they planned to open, we can project revenue.

COGS projections - what percent of COGS is fixed v. variable? Variable costs go up in line with their % of unit volume, but fixed costs stay the same unless capacity is expanded. What are Capex plans? D&A is a component of COGS.

Break out COGS as detailed as possible. 2/3 of a chemical manufacturer’s COGS is energy, what is our outlook for natural gas prices? An aircraft engine maker sources metals, are miners expanding or shrinking capacity (impacts prices).

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Income Statement Projections

S,G&A expenses are projected as a % of revenue (e.g. hard key 15%,

then make the expense projection = 15% x projected revenue), however a portion is a fixed cost and will not increase in line with revenue.

Interest income and expense are projected based on debt and cash balance projections. Is there debt coming due, and if/when rolled over, will rates be higher or lower?

Other income / expense is hard to project unless there is a recurring trend. If not, project zero.

Income tax expense is projected as a % of pre-tax income, based on past rates as long as constant. Be mindful of future use of “net operating loss” (NOL), which reduces tax rates.

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Balance Sheet Projections - Assets

Cash: this is the one item on the balance sheet that will be linked FROM

the cash flow statement (beg of yr cash + net cash flow = end of yr cash)

Accounts Receivable: in an assumptions sheet, you will hard key DSOs based on trends, if 30 days, then AR balance will = 30 / 360 * revenue projection

Same methodology for Inventory and Accounts Payable, except multiply by COGS projection instead of revenue

Other Assets: discern if there are trends or not, could be hard keyed or tied as a % of revenue

Goodwill: is not amortized, it sits there unless there is an impairment, which one cannot project.

Amortization: Financing fees from acquisitions can be amortized, but not investment banking fees (to be discussed in the LBO section). You can project this for past expenses, but rarely do you project future acquisitions, unless maybe if you work in corporate development as an in-house banker.

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Balance Sheet Projections – Assets

Property, Plant & Equipment (P,P&E)

Gross P,P&E = beg balance + capex – asset sales

Capex projection: discern historical capex (from cash flow statement) as % of revenue

Asset sales projection: discern trends, read notes. Often you will project $0.

Then project depreciation expense (from historical cash flow statement) as % of gross P,P&E historically.

Add each year’s projected depreciation to the accumulated depreciation balance.

Net P,P&E = gross – accumulated depreciation.

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Balance Sheet Projections

Liabilities:

Accounts payable projection, if 40 days in payables = 40 / 360 * COGS projection

Accrued liabilities and other: discern trends, express either as absolute hard keyed value, or as % of COGS

Debt: read the debt schedule in the filings, is there debt coming due?

Shareholders’ Equity:

Retained earnings projection = beg balance + net income (after dividends)

Liabilities and Shareholders Equity

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Cash Flow Projections

All Changes in all Balance Sheet Accounts must be run through the cash flow; otherwise the balance sheet totals will not balance

All Non-cash items in the income statement must be added back / deducted from the operating cash flow

Operating Cash Flow = sum of….

Net Income: take from income statement

Depreciation and Amortization: take from income statement

Add back / deduct any other non-cash expenses / income from the income statement (examples are non-cash interest expense, any non-cash restructuring charges, amortization of capitalized accounts, etc.)

Changes in working capital – Current Assets: previous period balance – current period balance – Current Liabilities: current period balance – previous period balance

Changes in other assets / other liabilities – Other Assets: previous period balance – current period balance – Other Liabilities: current period balance – previous period balance

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Cash Flow Projections

Cash Flow from Investing Activities = sum of….

Capital Expenditures are outflows

Acquisitions are outflows

Sale of Assets are inflows

Cash Flow from Financing Activities

Driven by debt and interest schedule, which integrates the cash and debt balance sheet accounts, interest expense and interest income on income statement, and the cash flow statement

An increase in debt or equity is a cash inflow

Ending Cash Balance = Beginning Cash Balance + Cash Flow during Period

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Debt and Interest Schedule Projections

Create a section just for debt and interest, all tranches

The notes to financial statements contain info on amortization, maturity, and rates.

Ending debt balance = beg balance + drawdowns – amortization, paydowns, or maturing debt that is not rolled over

Interest expense projection = average debt balance x interest rate

After projecting each debt tranche in the separate table, link the beginning and ending balances to the balance sheet

Link the interest expense to the income statement’s interest expense

Link projected interest income to the income statement’s interest income, because a cash balance earns interest.

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Table of Contents

I. Introduction

II. Spreading Historical Financial Statements

III. Deriving Historic Ratios, Trends and Variables

IV. Financial Statement Projections

V. Integration of Financial Statement Projections / Revolver Modeling

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Revolver Modeling

The revolver is a short-term bank line that can be drawn on or

paid down daily.

We will learn how to write a formula so that any excess cash flow will automatically be used to pay down as much of the revolver as possible, or so that any cash flow deficits will use the revolver to maintain sufficient working capital for operations.

The following slide is a snapshot of how that will appear in the model we will create……

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Revolver Modeling Cash Flow Before Revolver = Operating CF + Investing CF + CF from Change in Term Loan + CF from Change in Unsecured Debt + Beg Cash Position

(Paydown)/Drawdown= -MIN (Cash Flow before Revolver, Beginning Revolver Balance)

1. If negative cash flow before revolver, company borrows up to the amount of its cash flow deficit. Balance sheet cash is zero after borrowing.

2. If positive cash flow AND a revolver balance, company can pay back the revolver, but ONLY up to the amount of positive cash flow it generated.

3. If company has positive cash flows but NO revolver balance, then the positive cash flow goes to balance sheet cash.

Cash FlowNet Income $23.4 $26.4 $29.4 $32.7 $36.2Plus / (minus): Depreciation and Amortization $7 $7 $7 $8 $8 Changes in Working Capital Accounts Receivable ($0.6) ($0.5) ($0.6) ($0.6) ($0.6) Inventory ($0.2) ($0.2) ($0.2) ($0.2) ($0.2) Other Current Assets $0.0 $0.0 $0.0 $0.0 $0.0 Accounts Payable $0.2 $0.2 $0.2 $0.2 $0.2 Accrued Liabilities $0.1 $0.1 $0.1 $0.1 $0.1 Other Current Liabilities $1.3 $0.1 $0.1 $0.1 $0.1 Change in Other Liabilities $0 $0 $0 $0 $0Cash Flows from Operations $31.3 $33.3 $36.5 $40.0 $43.7

Cash Flows from InvestingCapital Expenditures ($8.8) ($9.3) ($9.7) ($10.2) ($10.7)Asset Dispositions $0.0 $0.0 $0.0 $0.0 $0.0Cash Flows from Investing ($8.8) ($9.3) ($9.7) ($10.2) ($10.7)

Cash Flows from FinancingChange in Revolver ($10.6) $0.0 $0.0 $0.0 $0.0Change in Term Loan ($25.0) ($25.0) ($25.0) ($25.0) ($25.0)Change in Unsecured Debt $0.0 $0.0 $0.0 $0.0 $0.0 Total Cash Flows from Financing ($35.6) ($25.0) ($25.0) ($25.0) ($25.0)

Total Cash Flow ($13.1) ($0.9) $1.8 $4.8 $8.0

Beginning Cash Position $86.9 $73.7 $72.8 $74.6 $79.4Change in Cash Position ($13.1) ($0.9) $1.8 $4.8 $8.0Ending Cash Position $73.7 $72.8 $74.6 $79.4 $87.3

Cash Flow Before Revolver $84.4 $72.8 $74.6 $79.4 $87.3Debt and Interest ScheduleRevolver Beginning Revolver Balance $10.6 $0.0 $0.0 $0.0 $0.0(Paydown) / Drawdown ($10.6) $0.0 $0.0 $0.0 $0.0Ending Revolver Balance $0.0 $0.0 $0.0 $0.0 $0.0Interest Rate 6.25% 6.50% 6.75% 7.00% 7.25%Interest Expense $0.3 $0.0 $0.0 $0.0 $0.0

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Revolver Modeling

Calculate the interest expense on the revolver as: interest rate x avg of beginning and ending revolver balance

Link the revolver balance back into the balance sheet, the interest expense on the revolver back into the income statement, and adjust the changes in revolver in the cash flow

Once the revolver has been properly modeled, the ending cash balance should properly calculate in the cash flow, and this can be linked into the cash balance in the balance sheet