INTRODUCTION

This book will teach you how to bring together what you know
of fi nance, accounting, and the spreadsheet to give you a new
skillbuilding fi nancial models. The ability to create and understand
models is one of the most valued skills in business and fi nance today. It is an expertise that will stand you in good stead in
any arenaWall Street or Main Streetwhere numbers are important.
Whether you are a veteran, just starting out on your career,
or still in school, having this expertise can give you a competitive
advantage in what you want to do.
By the time you have completed the steps laid out in this
book, you will have created a working, dynamic spreadsheet fi nancial model that you can use to make projections for industrial/
manufacturing companies. (Banks and insurance companies
have different fl ows in their businesses and are not covered in
this book.)
This second edition is an extensive rewrite of the fi rst edition
and includes an additional chapter on discounted cash fl ow
valuation modeling. This edition uses screen illustrations from
Excel 2007, the latest version from Microsoft Offi ce available as
of this writing. Although the instructions still apply to earlier
versions, the illustrations are oriented more toward this latest incarnation
of the worlds most popular spreadsheet application.

FIRST, SOME DEFINITIONS

A spreadsheet can be used to tabulate and organize numbers, but

it does not become a model until it contains data, equations, and
specifi c relationships among the numbers that organize them into
informational output.
The model becomes a fi nancial model when it incorporates the
relationships of operating, investing, and/or fi nancing variables
based on general accounting principles.
It can be called a fi nancial projection model when it uses assumptions
about future performance to give a view of what a
companys future fi nancial condition might be like. By changing
the input variables, such a projection model becomes useful for
showing the impact of different assumptions and/or strategies
for the future.

TWO REQUIREMENTS FOR MAGIC

The task of developing a good spreadsheet model is a combination

of many things, but primarily it is about good thinking and
a sound knowledge of the tools at hand. These two attributes will
put you on the right track for producing a model structure and layout
that are robust yet easy and, yes, delightful to use. Arthur C.
Clarke, the late renowned science writer, once said, Any suffi ciently advanced technology is indistinguishable from magic. I
hope that after using the approaches and techniques for building
models in this book, you too can look at your work and feel the
magic you have created. And I certainly hope that your colleagues,
managers, and clients will have the same reaction.

THIS IS A HANDS-ON BOOK

This book will lead you through the development process for a
projection model. It is laid out in a step-by-step format in which
each chapter describes a step. Each chapter covers a specifi c phase

of building a model. This is a hands-on book. You will get the most
out of this book if you perform the steps outlined in each chapter
on your computer screen. By the end of the book, you will have
viii Introduction

the satisfaction of having built your own model. To this model you
can then add you own changes and modifi cations.

BUILD MODELS WITH YOUR OWN STYLE

Building models is a fl uid, creative activity, and there are as many

ways to build a model as, say, to write a book. Most of them will
result in working models, but not necessarily very good ones;
there are, after all, bad books. But there are also excellent books
with very different styles. The intent of this book is to show you
the toolsthe vocabulary and the syntax of model building, if you
willfor developing a model that works properly, and so provide
you with the foundation for developing other models. Just as you
develop your own style of writing once you have learned the basics
of language, you can then develop your own style of model
building.

THE MODEL WE WILL BE BUILDING

The projection model we will be developing is one that you might

fi nd as the starting point in many forms of analysis. The model
will have these key features:
It will have historical and forecast numbers for
modeling an industrial type of company or business.
Forecast numbers can be entered as hard-coded
numbers (e.g., sales will be 1,053 this year and 1,106
next year, etc.) or as assumptions (e.g., sales growth next
year will be 5%, etc.).
The income statement, balance sheet, and a cash fl ow
statement are interlinked following general accounting
principles.
The balance sheet balances: the total assets must equal
the total liabilities and net worth.
Two mechanisms are introduced for balancing the
balance sheet: the balance sheet method and the cash
fl ow method.
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Introduction ix

With the accounting interrelationships correctly in place,

the cash fl ow numbers will also foot, i.e., the change
in cash from the total cash fl ow in any one year equals
the change in the cash on the balance sheet from the
prior year to the current year.
There will be a cash sweep mechanism to
automatically prepay outstanding debt with any excess
cash on the balance sheet in the forecast years.
The model drives a discounted cash fl ow valuation
module. This module includes the standard methodology
approaches for valuing a company.
Additional outputs include common-size statements that
show the income statement and balance sheet values as
percentages of revenue and assets, respectively.
Once you have this model functioning, you can use it as

the engine to drive other calculations such as your own ratios.

I have posted some of the models used in this book in the
companion website www.buildingfi nancialmodels.com.

MICROSOFT EXCEL

This book describes model building in Microsoft Excel 2007, but

its core model-building concepts can be realized in earlier versions
of Excel as well as any other model development language. Excel
2007 commands are organized in a menu ribbon at the top of
the screen that reorganizes the placement of the commands seen in
earlier Excel versions. For this reason, I give directions for operating
the menus in both versions of Excel. Where I cover the menu
commands from earlier versions of Excel, I refer to these earlier
versions as Excel 2003 for convenience. This reference should
also be taken to mean versions of Excel from earlier years.

COMMANDS

Commands in Excel are described in this book using the > notation
to indicate the menu selection process. Thus, the sequence for
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x Introduction

saving a fi le in Excel 2007 would be shown as Offi ce button> Save,

for example. (The Offi ce button is the round icon at the far left
in the Excel 2007 menu ribbon.) In Excel 2003, the same sequence
would be File>Save.

ACKNOWLEDGMENTS FOR THE SECOND EDITION

My thanks to those who helped me as readers of the draft of this

edition:
Students in the fi nance class of Dr. Ben Sopranzetti at
Rutgers University, including Ben Schmid, Saad Siddiqui,
David Skibinski, Arthur King, Jorge Barreiro, and James
McGrath.
Readers of my fi rst book who contacted me with valuable
feedback include Peter McAniff and William H. Jarnagin.

ACKNOWLEDGMENTS FOR THE FIRST EDITION

This book is just a part of what I have learned in my career as a fi nancial modeler in investment banking; so in thanking those who
have helped me in the writing of this book, I must give thanks
to all with whom I have worked, including the many hundreds
of colleagues in J.P. Morgan (past) and JPMorgan Chase (present),
who gave me encouragement and constructive feedback through
all of the many generations of fi nancial models I developed for
that fi rm.
In looking back at my career and how I started to build
fi nancial models, I must return to the fi rst time I saw a newfangled
white box sitting on somebodys desk some time in the
early 1980s. I remember asking, What do you do with this?
And my then-colleague Lillian Waterbury said, Type Lotus at
the C prompt sign. I did, and at this fi rst PC I caught my earliest
glimpse of the spreadsheet (it was Lotus 1-2-3 Release 1A).
This would be a new direction for me. Thanks, Lillian.
Thanks to my friends and colleagues from the Financial
Advisory Group. Sue McCain and Carol Brunner gave me my
fi rst chance to work as a modeler, and it made all the difference.
Introduction xi

Juan Mesa taught me what clear thinking was about when we

built a Latin American model with infl ation fi nancial accounting.
Christopher Wasden was my guide in the arcane accounting for
banks when we built a model for banks.
I worked together with Jim Morris and Humphrey Wu in
New York and Mike Koster in London, and consider them as
cohorts and comrades-in-arms in the arcane alchemy of fi nance,
accounting, Excel, and Visual Basic for Applications that is the
art of fi nancial modeling. We all gave our best to produce modeling
packages that were often more than the sum of their parts.
Thanks, Jim, Humphrey, and Mike.
In the new JPMorgan Chase, Pat Sparacio, Marguerita Courtney,
and Leng Lao were enthusiastic supporters of my work,
and I thank them. Jay Chapin, an independent credit training
consultant, read the manuscripts and cheered me on from his
home base in Houston. Thanks, Jay. Fern Jones, a colleague and
friend from my earliest days in fi nance so many years ago, also
read the manuscript and encouraged me through the dark hours
that probably every author experiences. Thanks also to Sumner
Gerard, who took the time late into the night to look over the
manuscript.
Finally, thanks to Susan Cabral, now of Cabral Associates,
who in 1967 built in the mainframe computer the fi rst fi nancial
projection model for J.P. Morgan, and quite possibly for Wall
Street. Susans model design was still in use 15 years later, and
it was the starting point for me when I began modeling for the
PC. Her design is present in almost all the models I have developed
in my career. Thank you, Susan, for being the pioneer and
for showing me the way.