financial statement modeling & spreadsheet engineering
DESCRIPTION
Financial Statement Modeling & Spreadsheet Engineering. “Training in spreadsheet modeling improves both the efficiency and effectiveness with which analysts use spreadsheets” Steve Powell, Dartmouth College. Understand the Decision. What is the problem? What questions must be answered? - PowerPoint PPT PresentationTRANSCRIPT
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Financial Statement Modeling & Spreadsheet Engineering
“Training in spreadsheet modeling improves both the efficiency and effectiveness with which analysts use spreadsheets” Steve Powell, Dartmouth College
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Understand the Decision
What is the problem?What questions must be answered?What is the time horizon of the problem?What kind of output information is
needed?Who will use the information?What level of detail is necessary?
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Structural Inputs of the Model
Define the equations and relationships that make up the model What are the decision variables and what are the
linkages between the decisions and the goal of the model?
What are the constraints?Definitions based on accounting rulesEconomic, industry, resource and technological
limits What happens at the end of the planning horizon?
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Data Inputs
Internal data that describes the current state of the systemFirm’s financial statementsResources and capacities
External data that describes the firm’s operating environmentEconomic conditions such as interest rate,
costs, stock prices
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Financial Analysis
Assess the strengths and weaknesses of the firm’s current conditionRatio analysisBreak-even analysisOperating and financial leverage analysis
Generate pro forma financial statements to identify strategies to improve the condition and assess future risks
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Growth and the Need for Financing
Growth frequently associated with cash Faster growth more profits more cash This is incorrect!
The problem Growth and profits do not equal cash flow
Growth is not an end in itself Needs to be managed Firms often fail because they do not plan for
growth
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Cash Flow is Needed to Support Sales Cash is the life blood of organizations
Funds receivables and inventory Buys productive assets Pays investors fair returns
BUT Cash needed to support growing sales can exceed
cash flow
Firms fail when Needs of expansion
Overwhelm Resources for expansion
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Flow of a Sales-Driven Model
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Modeling Sales Forecasts
• Simple Method: Assume average or different growth rate for each period
• Develop detail forecast by product, business unit, customer or geographic market and aggregate forecasts
• Forecast the unit price and volume
• Forecast size of market and estimate market share
• Forecast costs and apply a margin assumption to derive sales
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Financial Planning Model Assumptions
• Items that are functional relationships of sales– Percent of sales
• Operating expenses• Working capital and fixed assets
• Items that are functional relationships of other financial statement items– Interest, depreciation, dividends, marketable
securities, cash flows
• Items that involve policy decisions (e.g. long-term debt, equity, capital expenditures)
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Generating the Income Statement
Expenses in period t Related to asset and liability balances at the
end of period t – 1 Interest Expenset based on Debtt-1
Depreciationt based on Gross Fixed Assetst-1
Or Related to Sales in period t
COGSt = COGS/Sales * Salest
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Balance Sheet Sector
Track financial state of firm through time Balance sheet equations go a long way towards
ensuring this Results in one period (t – 1) become inputs to next
period (t) EXAMPLE
Debtt = Debtt-1 + Debt Issuedt – Debt Repaidt
Feed into income statement Interest Expenset = Debtt-1 * Interest Rate
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Investment ModuleCalculates Required New Investment
Compile changes in assets Left side of balance sheet Current Assets
Including Cash Balance Not including discretionary items (e.g. marketable
securities) Long-term assets
Net Fixed Assets Goodwill
Add cost of maintaining production Replacement of depreciated assets
Output information to Financing Module
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Three Sources for Financing New Investment
Spontaneous Increase in liabilities that increase naturally
with salesInternal equity
Current year's retained earningsExternal capital markets
New debt or equity
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Sustainable Growth in the Rapid Growth Phase
The "it takes money to make money" phase Increased sales require more assets of all
types Internal sources don’t generate enough cash
Retained earnings Increase in spontaneous liabilities
Need to raise capital externally New question: How fast can firm grow without
altering its current capital structure?
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The “Plug”
The balance-sheet item which will “close” or balance the balance sheet model so that Total Assets will always equal Total Liabilities & Equity
Models the assumption of how the firm finances itself
Examples are cash & marketable securities, debt, debt & equity
See Plugs.xlsx
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Plan Your Layout
On paper, map out the different sections of your model and their planned locations within the workbook
Consider how readable the model layout will be for the
usereasy it will be to modify the assumptionseasy it will be to extend the model to include
more time periods or new products.
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Modules
Data InputsAssumptionsDecision Variables Internal Data and Data Structures
OutputsPro-forma statementsOther structural relationshipsDocumentation
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Layout Strategies
Modules on different worksheets Stair-step format in same worksheet For each strategy,
Consider how difficult it will be to insert or delete a row or column
Consider how much linking needs to be done between different modules
Consider linking a data input to the computation area or output for later reference
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Range Names
Use range names to create an overview of a worksheet in the model layout.Highlight the cell or range you want to
name, select Insert>Name>Define (2003) or Formulas>Define Name (2007)
Use View>Zoom where the Zoom factor is set to less than 40% to see overview
To apply name to all relevant formulas in spreadsheet, Insert>Name>Apply (2003) or Formulas>Define Name>Apply Name (2007)
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Other Layout Considerations
Gaps between logical areas improve readability
Isolate blocks of similar formulas for safe and convenient copying
Use styles, fonts and colors with consistent meanings
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Data Input Guidelines
Isolate constants into their own cellsDo not use constants in formulas unless it is
a number like 1 or 100 being used in percentage calculations
Don’t have multiple instances of a number that is used as a decision variable or assumption
Organize decision variables and model parameter/assumptions logically into separate physical areas
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To Reduce Formula Errors
Use relative and absolute cell addressing where appropriate (Use [F4] to modify $ in formulas!) Set up common structures in different parts of the
model (e.g. same row labels for different worksheets)
Use formulae for a cell which are consistent in their relationship to adjacent cells
Minimize linking formulas across worksheets Split complex formulas into multiple
intermediary formulas
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Circular References
• Created when expenses in period t refer to assets and liabilities in period t, resulting in modified values for the plug which then impact the income statement and the Addition to Retained Earnings
• Iterative process is required to produce a consistent and correct final set of financial statements
• To solve, use Tool Options Calculation Iteration (2003) or MS Office Button>Excel Options> Formulas> Iteration (2007)
• Not all circularities are convergent. Make sure to verify accuracy!
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Verify Formula Reliability
Use Excel’s Auditing ToolbarTools>Auditing> (2003)Formulas>Formula Auditing (2007)
Use [Ctrl]+` to toggle between formulas and calculations
Use Conditional Formatting to flag suspicious resultsFormat>Conditional Formatting (2003)Home>Conditional Formatting (2007)
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Calculating a Plug with the Investment and Financing Modules Investment module
Required New Investment Financing module
Required External Financing Spontaneous Financing Internal Equity Financing
Required New InvestmentRequired External FinancingSpontaneous FinancingInternal Equity Finan
cing
• See Logic for Debt as Secondary Plug Excel file
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Testing the Model
Questions: Does it balance under extreme conditions? Does it make sense?
Extreme growth Set growth rate to -50% and 50% Does it still balance? Do debt or equity go negative? What happens to excess cash flow?
High Interest What happens when Net Income is negative?
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Document the Spreadsheet
Use range names to make individual formulas more readable and module layouts clearer
Use comments to document assumptions and modifications in a formula’s logic as well as sources of data
Use textboxes to describe portions of the model’s logic and assumptions as well as instructions for use
Create a worksheet to describe the purpose of the model and document changes