Financial Statement Modeling

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Table of contents
SECTION 1: PREPARING FOR MODELING Welcome letter Introduction Gathering historical documents/information Understanding projections Modeling techniques in Excel Debt schedule Interest expense SECTION 3: ENHANCEMENTS TO A COMPLETE MODEL Balancing the model and circularity Ratio analysis Form toggles, sensitivity and scenario analysis

SECTION 2: BUILDING A FINANCIAL STATEMENT MODEL Income statement historicals Income statement projections Balance sheet historicals Balance sheet projections Working capital schedule Deferred taxes Intangible assets Property, plant, & equipment Treasury stock and shares outstanding Minority interests and equity in affiliates Goodwill and other balance sheet items Retained earnings ***************************** Cash flow statement projections

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Understanding projections
Example of a driver (simple sales driver)
Take the last reported years sales growth rate, and project that growth rate to future years (called straight-lining projections)

Calculation (black cells) Formula in Excel =E3*(1+F4)

Historical inputs (blue cells)

Calculations (black cells)

Simple driver (blue cells)

Well discuss formatting rules extensively in the next section.

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Modeling techniques in Excel

Formatting (contd)
Maintain standard formatting of numbers throughout your model Maintain standard formatting of worksheets throughout your model Maintain standard column and row headings across multiple sheets

$ sign only shown on first row of worksheet and highlighted financial results

Negative numbers shown in parenthesis

EPS and share price data: always carry to 2 decimals ($25.43)

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Modeling techniques in Excel

Modeling best practices
Structure your model as clearly and simply as possible so it can be easily checked (audited) by others, and usable in your absence.

Golden Rule
Understand what you are modeling

Assumptions should be placed together on one page and be explicit and driven off clearly identified drivers when possible. Save often and keep many versions of your model. Believe us Excel does crash sometimes! When appropriate, explain your work via footnotes or comments Footnotes Written in the bottom of the model Shows up when model is printed Clients will see these Comments Embedded within a specific cell (Shift F2)

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Modeling techniques in Excel

Modeling habits to avoid
Never re-enter the same input in different places: Your model should flow dynamically so that if one assumption (input) changes, the whole model changes. Do not embed numbers within formulas When updating model inputs, you are more likely to forget an input buried within a formula.

When inputting historical financial statements, calculate where appropriate Total assets although disclosed should be calculated in the financial model as the summation of all assets. *****************************

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Modeling techniques in Excel

Modeling habits to avoid
Avoid hiding information by hiding rows, moving information on to the side of the model, or below the model. It is easy to forget that you hid the rows

Rows 5-8 are hidden

If you must hide information, group the rows or columns so the hidden information shows up on the margin. Shortcut in Excel to group / ungroup rows: Shift + Alt + Right arrow key / Left arrow key

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Income statement historicals

Inserting rows in Excel Highlight row: Shift Spacebar Add row: Shift Ctrl = Insert a dynamic header formula in Excel Using the & sign, you can combine text and formulas, so that whatever you type in the company name input area should automatically change the header. Formatting inputs As in all models, inputs are blue and calculations are black. In addition, inputs are designated by the light yellow background color for easier navigation.

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Income statement historicals

Adjust historical IS for nonrecurring items Insert lines below reported COGS, SG&A and Other, Non-operating Income, and Taxes that will reference the nonrecurring items input area to calculate pro forma (normalized) historical results.

Also remember to change EBIT, EBT, and net income calculations to reflect ***************************** pro forma (vs. reported) FROM TUTORIAL GUIDE SAMPLE PAGES results.
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Income statement historicals

Remember minority expense and equity income! Recall that we just excluded minority interest expense and equity income from the Other expense category. As such, we will explicitly identify them (on an after-tax basis) by ***************************** multiplying the pre-tax figures by CLs effective tax rate.

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Income statement historicals

Confirm models historical EPS matches consensus EPS Since our EPS matches the consensus EPS, we can be fairly certain that we have caught all the nonrecurring items and made all the adjustments that The Street has made.

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Working capital schedule

See next page for explanation of the formula

Accounts receivable 3 ways to project: 1. By default, the model grows accounts receivable balances at the revenue growth rate. Assumption is that sales that generate accounts receivable will grow at the same rate as cash sales. ***************************** 1. User can override this projection by projecting days sales outstanding 2. User can override both the default and theFROM TUTORIAL GUIDE SAMPLE PAGES DSO projection by inputting an absolute projection for accounts receivable. 12 For illustrative Purposes Only

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Property, plant, & equipment

We will calculate PP&E by projecting capital expenditures, depreciation, and asset sales during the year as follows:
PP&E: Beginning-of-year balance Capital expenditures: During the year Disposition of assets/asset sales: During the year Depreciation: During the year PP&E: End-of-year balance

Modeling asset dispositions/sales Only model these if the company continually sells assets and the practice is expected to continue. Sale leasebacks Some companies continually sell assets and lease them right back as a financing tool or to alter their capital structure. If the company you are analyzing does this consistently, you should also project a reduction in PP&E as a result of the sale-leaseback.

+ -

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Modeling write-downs Similarly to intangible assets, unless we have specific information to the contrary, we do not typically have a basis for expecting any asset write-downs, and do *****************************not incorporate any projections for this in our model.
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Property, plant, & equipment

Reference historical PP&E balance from balance sheet Input historical capital expenditures from cash flow statement (p.41) Determine whether historical asset sales reported on the cash flow statement (p.41) will be recurring, and if so, input them as well. Calculate historical depreciation: D&A minus amortization expense.

Set up the row headers

Project PP&E Reference 2004 actual PP&E balance from balance sheet

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Property, plant, & equipment

CL management disclosed that capital expenditures in 2007 are expected to increase to a rate of 5% of revenues (10-K p.21). We will hold this ratio constant throughout our projection period. Remember to format the cell blue because there is a constant inside the formula.

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Property, plant, & equipment

Straight-line recurring asset sales

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Cash flow statement projections

Reference net income and depreciation & amortization from the income statement

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Cash flow statement projections

Working capital assets Increases / (decreases) in yearover-year balances represent cash outflows / (inflows)

Calculate cash impact of all working capital assets

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Cash flow statement projections

Working capital liabilities Increases / (decreases) in yearover-year balances represent cash inflows / (outflows)

Calculate cash impact of all working capital liabilities

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Cash flow statement projections

Deferred tax liabilities Increases / (decreases) in yearover-year balances represent cash inflows / (outflows)

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Debt schedule

10. Reference from balance sheet

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Debt schedule
11. Reference cash from prior years balance sheet balance

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Balancing the model and circularity

Circularity
Debt levels increase because of lower free cash flows Higher interest expense because of higher debt

Debt levels

Interest expense

levels

Cash surplus/ deficit

Net Income

Reduced net income because of higher Reduced free cash flows ***************************** interest expense because of lower net income SAMPLE PAGES FROM TUTORIAL GUIDE
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Balancing the model and circularity

Due to this circularity, your model may sometimes become unstable and lines may show REF!, Div/0! or #Value errors. The model blows up These errors happen for no good reason!

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Balancing the model and circularity

What to do when the model blows up Step 1: Do not panic ensure the Iteration box is checked for 100 iterations as illustrated. If the error persists, turn to the next page for guidance.

Excel 2007 Office Button > Excel Options > Formulas tab

Excel 2003 Tools > Option > Calculation tab

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Balancing the model and circularity

What to do when the model blows up Option 1: Manually break the circularity 1. Copy the interest expense reference from the income statement off to the right beyond the last projection column. 2. Replace the income statement interest expense projections with zeros. This effectively breaks the circularity the errors should now disappear. 3. Copy and paste the interest expense formulas (that you pasted to the right of your model) back into the income statement. Option 2: Insert a circularity breaker toggle (preferred option) 1. Create an input cell somewhere in the model where the user can either type in 1 or 0. 2. When the user inputs 0 in that cell, it tells Excel to automatically place zeros instead of interest expense projections on the income statement. This will break the circularity and the errors are flushed out. 3. Then, the user can input 1 again in that cell, which will replace the zeros with the proper interest expense reference on the income statement.

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Balancing the model and circularity

Naming Cells: Ctrl F3

Name the cell circref

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Balancing the model and circularity

Inserting a circularity breaker toggle Insert an IF statement to modify the interest expense formula to incorporate the circularity breaker, such that if it is turned on, the interest expense becomes zero, breaking the circularity in the model.

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Balancing the model and circularity

Once user selects 0, Excel automatically places zeros instead of interest expense projections, breaking the circularity and flushing out any errors.

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Balancing the model and circularity

Model completed We have now completed building an integrated, fully dynamic financial statement model Scroll down to the balance sheet and ensure that projected assets = projected liabilities + shareholders equity

Balance-check should read 0 for every projected year. If not, you will need to locate the source of the error. Turn to the next page for guidance.

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Sensitivity & scenario analysis

Incorporating data tables, the OFFSET function, form toggles, and scenarios into the model.

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Form toggles, sensitivity and scenario analysis

Decide what assumptions to sensitize

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Form toggles, sensitivity and scenario analysis

Close the Properties window In Excel 2003: Click on the top left icon in the Control Toolbox Exit design mode. Close the Control Toolbox In Excel 2007: Click on Design Mode in the Developer Tab. Excel 2007 Click design mode Excel 2003 Exit design mode

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Form toggles, sensitivity and scenario analysis

Cleanup: move the Select a case input Since this area is no longer the user input area (now users seelct the desired scenario from a toggle), be sure to remove this from the face of the model. Some modelers paint this white to hide it altogether. If you do this, be careful, because once you paint it white, you may forget it is there and inadvertantly delete it by accident.

Cut and paste to the right off the model as illustrated:

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Form toggles, sensitivity and scenario analysis

We will now create a data table that will calculate 2007 EPS based on a range of 2007 revenue growth and gross profit margin assumptions Input a range of revenue growth rates in a column Input a range of gross profit margins in a row Reference 2007 EPS (the output variable) from model above into the cell between the input row and input column as illustrated below

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Form toggles, sensitivity and scenario analysis

Highlight the matrix Excel 2003: Type Alt d t (Data>Table...) Excel 2007: Type Alt a w t (Data>What-if analysis>Data Table) Reference the row input variable from the model above (2007 gross profit margin is the row input variable) Reference the column input variable from the model above (2007 revenue growth is the column input variable) Hit Enter

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