FINANCIAL MODELLING, SIMULATION, AND OPTIMISATION

Mihir Dash

Alliance Business School,

Bangalore, India

"Prediction is very difficult, especially if it's about the future."

--Niels Bohr, Nobel laureate in physics

ABSTRACT
A financial model is a model designed to represent in mathematical terms the relationships
among the variables of a financial problem so that it can be used to make projections and/or
answer „what if‟ questions. In particular, financial modeling can be combined with optimization
modeling to analyze corporate financial decisions and constraints in order to enhance firm value.
Further, uncertainty in key factors such as sales, interest rates, and foreign currency exchange
rates can be examined by optimizing over multiple scenarios.
This paper discusses a stochastic programming approach towards financial modeling,
combining it with simulation and optimization. As a case study, it applies this approach to
identify a financial recovery strategy for a MSE which had been badly affected by the global
recession. The stochastic programming model is used to determine the optimal ranges of
leverage (debt-equity ratio) and liquidity (current ratio) to target in order to optimize firm value.
The random input considered for the study is the rate of growth of sales. The case study
highlights a trade-off between leverage and liquidity, and suggests that liquidity considerations
may mediate optimal capital structure decisions.

Keywords: financial modeling, optimization modeling, simulation, stochastic programming,

trade-off between leverage and liquidity, optimal capital structure.

INTRODUCTION
Accurate forecasting is the key to business growth and success. It not only helps to plan for
the future, but also gives a powerful tool for managing the present. Business decisions, and
especially financially-related business decisions, depend heavily on forecasts of future events,
future cash flow, and future expected returns. Business success, whether for startups or more
established firms, depends in large part on the reliability of the financial forecasting. Often firms
fail not because of the business idea itself, but because of inadequate strategic financial planning.
A financial model is a model designed to represent in mathematical terms the relationships
among the variables of a financial problem so that it can be used to make projections and/or to
answer `what if' questions. Financial modeling involves forecasting the future financial
performance of the company by studying its past performance, and thereby suggesting the
optimal decisions to be taken.

Electronic copy available at: http://ssrn.com/abstract=1688891

 One of the major motivations for the increasing interest in financial modeling is the
increasing uncertainty about the balance between the cash flows, subject to financial and
operational risk. Financial models help in identifying this balance or stability. On the other hand,
financial models also help in understanding financial processes, in identifying opportunities.
Financial planning involves considering different investing and financing alternatives
available to a firm, projecting the consequences of these alternatives for the firm in the form of
financial plans, and comparing the alternatives in terms of these consequences, in order to
identify the optimal alternatives, and subsequently comparing future performance against the
plan. Financial planning is a critical activity for every business, irrespective of its age and size.
For new enterprises, the preparation of financial projections is integral to the business planning
process. For larger companies, financial planning forms a part of annual budgeting and plays an
important role in long-term planning, business appraisals, corporate development etc. The
purpose of financial projections for new or existing enterprises is to indicate the venture‟s
potential, present a timetable for financial viability, and lay a benchmark to measure the
effectiveness of management‟s performance along the financial axis.
In practice, financial planning models are quite complex as they must accommodate multiple
time periods (months, quarters and/or years) and handle hundreds of variables, including: sales
volumes, selling prices, tax rates for sales, material costs, direct manpower levels, wage rates,
other direct costs, tax rates for inputs, selling & distribution costs, management/ administration
costs, operating leases, finance leases, operational overheads, general overheads, research and
development expenditure, interest rates, changes in loans/debt, bad debt provisions, material and
work-in-process stocks, finished goods stocks, debtors, creditors, fixed assets, capital
expenditure, fixed asset disposals, intangible assets, depreciation rates, accumulated
depreciation, corporation tax, prepayments/accruals, dividends, share issues, and so on. A
comprehensive model can contain many thousands of formulae with functions ranging from
simple addition to complex conditional statements (e.g. if the projected operating profit is
positive, tax is deducted as a percentage of the projected operating profit to obtain the net profit).

TECHNIQUES OF FINANCIAL MODELLING

The outputs of financial forecasting are the pro forma income statement, the pro forma
balance sheet, and the cash flow statement.
The purpose of the pro forma income statement is to project the revenues and expenses of the
business over a given period of time, enabling profit-planning, and indicating the potential
financial feasibility and the timeframe of a new project/venture.
The purpose of the pro forma balance sheet is to detail the assets required to support the
projected level of operations and, through liabilities and capital, to show how these assets are to
be financed. Further, the projected balance sheet can indicate if debt-to-equity ratios, working
capital, current ratios, inventory turn over ratios, and other financial indicators are within
acceptable limits required to justify future financing that is projected for the venture.
The cash flow forecast is another very important financial tool. The purpose of the cash flow
forecast is to facilitate cash planning and cash management, particularly since the level of
earnings or profits during the start-up years of a venture would usually not be sufficient to
finance operating asset needs, and also since actual cash inflows do not always match the actual

Electronic copy available at: http://ssrn.com/abstract=1688891

cash outflows on a short-term basis. It provides a schedule of anticipated cash receipts and a
schedule of priorities for the payment of accounts, enabling estimation of external financing
requirements to finance day-to-day operations, therefore avoiding a cash shortage crisis. It also
facilitates in planning for the most effective use of cash, and it enables sensitivity analysis, to
measure the significance of unexpected changes in circumstances. It allows managers to take
action before problems occur and even to do “what if” calculations before taking on new
projects. Also, it provides an outline to show lenders that enough cash balance is maintained
towards loan payments on time. Investors can also make good use of cash flow information; to
some extent, fluctuations in a firm's stock prices reflect fluctuations in their cash flows.
The method most commonly used in financial forecasting is the percentage-of-sales method.
The starting point of the percentage-of-sales method is the sales forecast. All other variables are
projected either in terms of the sales forecast, or based on specific assumptions.
The sales forecast is a goal set for the business to proactively achieve. It is probably the most
difficult part of the business to forecast - especially for a starting business. Sometimes, the break-
even can provide a starting point for creating the sales forecast. If data on past performance is
available, statistical methods such as time series models, causal regression models, or more
general econometric models may appropriate for constructing the sales forecast.
The cost of goods sold forecast varies directly with the sales forecast, and is expressed as a
percentage of sales. The cost of goods sold forecast aids in estimating the amount that is to be
spent towards manufacturing. The operating and administrative expenses forecasts, both fixed
and variable, are to be ascertained in order to see that the expenses are met on time without
affecting the business. Generally, the variable components are expressed as a percentage of the
sales forecast. The overhead expenses forecast is an estimate of indirect expenses for the year.
The pro forma balance sheet is projected in terms of the sales forecast. The fixed assets required
to support sales is expressed as a percentage of sales (i.e. assuming a constant fixed assets
turnover ratio). A similar treatment applies for the working capital forecast. Receivables and
payables are expressed as a percentage of sales. Inventory is again related to the
distribution/supply chain strategy, and is usually expressed as a percentage of sales. The
inventory forecast should be carefully constructed to avoid unnecessary locking up of capital and
also shortage of supply of goods. Cash and equivalents are forecast based on periodic cash
requirements to cover regular/forecast expenses and any unexpected expenses; thus, the cash
forecast is expressed as a percentage of sales plus a safety level. The total assets (fixed assets
plus current assets) requirement is financed in terms of equity (owners‟ funds) and debt
(borrowed funds). The mix of equity and debt is usually determined by available sources of
funds and their terms. In principle, it is desirable to identify the optimal capital structure, i.e. the
mix of equity and debt which minimizes the weighted average cost of capital.
Also, financial forecasts should take into consideration qualitative factors such as investor‟s
perceived risk, industry and technology risk, venture upside potential and exit timing, anticipated
growth vis-à-vis the industry, stage of development, investor‟s return requirements, founder‟s
goals regarding growth, control, liquidity and harvesting, relative bargaining positions and
investor‟s required terms and covenants.

Electronic copy available at: http://ssrn.com/abstract=1688891

 APPLICATIONS
Financial models are used to compile forecasts and budgets; to assess possible funding
requirements; and to explore the likely financial consequences of alternative funding, marketing
or operational strategies. They can also be used for business planning, raising finance,
investment or funding appraisals, financial analysis, corporate planning etc. Used effectively, a
financial model can help prevent major planning errors; identify or evaluate opportunities; attract
external funding; provide strategic guidance; evaluate financial and development options;
monitor progress; and so on.
The explicit identification of assumptions in forecasts provides an opportunity to perform
sensitivity analysis. Sensitivity analysis is a process similar to what-if analysis, in which each
assumption is adjusted, and the impact of the adjustment on the forecast is examined. As all the
components of a financial model are linked by formulae, a change in any assumption in any
period results in appropriate adjustments to cash flows and profits throughout the model for the
remaining periods. Once initial assumptions have been entered, they can be readily altered to
evaluate a range of possible alternative scenarios. For example, a model could be used to explore
the extent to which future sales can be increased while holding borrowings within predetermined
limits; to assess the effects of varying selling prices and/or volumes on net profits; or to
determine the optimum level and mix of future funding for a business. Sensitivity analysis
provides a basis for considerable information about the firm, investigating into how projected
performance varies with changes in the key assumptions on which the projections are based.
Corporate financial planning is also amenable to analysis by optimization models.
Optimization models offer an appealing framework for analyzing corporate financial decisions
and constraints as well as for integrating them with decisions and constraints in other functional
areas. Typical financial decisions to be optimized include: allocating capital to the development
of new facilities, products or markets; creating capital budgets from net revenues or borrowing or
by issuing stock; managing short term cash flows to balance receivables against payables;
selecting capital depreciation schemes to exploit tax incentives; and so on. Further, uncertainties
in key factors such as demand, interest rates, foreign currency exchange rates and economic
conditions in countries where the company has plants and markets can be examined by
optimizing over multiple scenarios.
Financial plans may have several random inputs which are unpredictable before execution.
Simulation is a very useful technique which permits the evaluation of operating performance
prior to the execution of a plan. For example, when a company develops a new product, the
profitability of the product is highly uncertain. Simulation is an excellent tool to estimate the
average profitability and risk associated with new products. Another example would be that of
using simulation to model an acquisition. Suppose that a company is considering purchasing
another company whose cash flows are highly uncertain. Future cash flows depend on many
uncertain parameters such as future sales growth, gross margin, expenses, variations in working
capital, and the terminal value of firm. Simulation is thus well suited to model the uncertainty
involved in a potential acquisition. Similarly, simulation can be used with financial models. A
company's future profitability, borrowing, and many other quantities are all highly uncertain. It
seems natural to run a simulation to obtain a range of values on future profitability and
borrowing. Used in conjunction with optimization in financial models, simulation can help
companies become more aware of the potential risks in financial models.

4
 LIMITATIONS
Financial methods have significant limitations when applied to the early stages of
development, particularly in the case of "new product, new market" projects, where little is
known about the target market and potential sales. The accuracy of forecasts improves as
projects progress, but there may still be considerable uncertainty even at the time of
commercialization. The evaluation and selection of innovation projects is best tackled by using
more than just financial tools and techniques to assess the attractiveness of innovation projects,
and by applying an iterative approach to evaluating projects as they progress through
development. Iteration using different tools and techniques helps give a broader picture of the
attractiveness of projects. In the early stages of such projects, the potential of the idea is more
important, so the risks may be subordinated; in later stages, however, the risks, costs and
exploitation issues must be emphasized. When the new idea is first generated, the decision to
take it further cannot and should not be based on financial calculations alone; however, as the
project nears commercialization, the financial forecasts should become more and more
important, and eventually should dominate entirely. Recognizing that different approaches to
evaluation are needed over the product development cycle should help avoid problems.
It should be emphasized that financial forecasting is subordinate to, not a substitute for,
strategic and business planning. Strategic formulation and business planning must precede
financial forecasting. Failure to link and connect financial projections with strategic and business
planning necessarily yields forecasts that are inadequately justified. Financial forecasting is just a
tool to aid the process of strategic and business planning.
Another common limitation in financial forecasting is that of “realistic-ness.” On the one
hand, financial forecasts should not ignore company, industry, and macro-economic trends;
while on the other, they should be forward-looking and optimistic. However, they should not be
overly optimistic. It is very common for financial forecasts to overestimate market shares, sales
growth, and profit levels and to underestimate working capital requirements, costs (particularly
the cost of capital), delays likely to be encountered, and contingency funds for unexpected costs
(and for worst-case scenarios). One way to apply a “reality check” on the forecasts is to cross-
check against generally-accepted industry performance norms, financial guidelines and ratios;
for example, comparing the forecasted return-on-investment against the industry average.
Preparing a set of financial projections is only a means to an end. Once plans or projections
are in the process of being implemented, they should be continually updated, compared with the
results achieved, and revised to reflect the current business conditions at each stage: start-up,
growth, rapidly-growing, stagnating, or mature company. A plan is only useful if it is being
adhered to, if it serves as a benchmark for control purposes, and if the projected outcomes are
being realized.

MODEL DEVELOPMENT
The model proposed in the following is based on the FCFF model, with the value of the firm
expressed as the discounted value of free cash flows, extended to the stochastic optimization
setting. As with other standard valuation models, growth is assumed to be uncertain/variable for
a fixed period (n years), followed by steady-state growth at a growth rate g thereafter. The
financial planning is thus restricted to the immediate period of n years. The objective is to

5
maximize the long-run value of the firm. For simplicity, the model presented in the following is
expressed in terms of aggregates; more detailed models would involve disaggregated variables
and more detailed assumptions.
The income statement is modeled as follows:
S i (1 g i ) * S i 1
CGS i Si
OE i FC i Si
Depri .FAi
Int i r.Di
OPi (1 ).S i FC i .FAi r.Di
.OPi OPi 0
Ti
0 otherwise
NPi OPi Ti
d .NPi NPi 0
Divi
0 otherwise
RE i NPi Div i .
The model for the income statement is based on the percentage-of-sales method. The rate of
growth of sales gi is taken as a random input for the model. The cost of goods sold is assumed to
be a constant percentage λ of sales, while operating expenses have a fixed component FCi and a
variable component, which is also assumed to be a constant percentage μ of sales. Depreciation
is assumed to be at a constant rate δ of fixed assets, and interest is assumed to be at a constant
rate r of debt; these quantities are directly connected to the balance sheet. The tax rate is assumed
to be τ percent of the operating profit (if positive). Finally, the dividend payout rate is assumed to
be d percent of the net profit (if positive).
The free cash flow to firm (FCFF) is expressed as
FCFFi (1 ).S i FC i .FAi Ti CapExi WC i .

modeling the balance sheet:

The balance sheet is the focal point of strategic financial planning. For simplicity, the
strategic financial decisions can be modeled in terms of decisions related to capacity planning
(determining the level of fixed assets), decisions related to operational planning (determining the
level of working capital), and decisions related to financing (determining the equity-debt mix).
The balance sheet equation is expressed as FAi WC i Ei Di , or, expressed in terms of
changes: FAi WC i Ei Di . These equations inter-relate the capacity, operational, and
financing decisions. In particular, each of these play very important roles in enhancing the
profitability and the long-run value of the firm. This may be expressed through the following
constraints:
Si .FAi
Si .WC i
Si .CAi

6
 The first constraint bounds the fixed assets turnover ratio φ. An adequate level of fixed
assets, i.e. productive capacity, is required to support sales and long-run sales growth; though
expansion of fixed assets may not immediately be translated into sales growth. The change in
fixed assets is the capital expenditure CapExi. The second constraint bounds the working capital
turnover ratio ω. Working capital is operational in nature, maintaining a balance between
profitability and liquidity. More detailed working capital planning would involve disaggregation
of working capital into its major components, viz. cash and equivalents, investments,
receivables, inventory, and payables, and relating these with other strategic decisions. Changes in
cash/equivalents are subject to a cash flow equation, and may be further constrained by a
minimum cash balance requirement. Receivables are usually expressed as a percentage of sales,
or are based on an assumption of the number of days of credit provided by suppliers, or are based
on a payment policy of the firm. Similarly, payables are usually expressed as a percentage of
sales, or are based on an assumption of the number of days of credit provided to customers, i.e.
the credit policy of the firm. Inventory is also often modeled as a percentage of sales, but may
also depend to a great extent on the distribution/supply chain strategy of the firm. The third
constraint bounds the current asset turnover ratio κ.
The final element is the financing decision (the equity-debt mix). Theoretically, the optimal
capital structure is determined as the mix of equity and debt which minimizes the weighted
Ei .k e Di .k d
average cost of capital. The weighted average cost of capital, WACC i , is the
Ei D i
discount rate used in the FCFF valuation model. More generally, however, the debt-equity ratio
can also affect firm value through the free cash flow. Particularly, too high a debt-equity ratio
can be a sign of high risk, which in turn may affect sales. Similarly, too high a debt-equity ratio
would increase the cost of equity and the cost of debt.
The model thus looks for short-term adjustments to the balance sheet, subject to the different
constraints discussed above, and with uncertain growth rates of sales, in order to maximize the
n
FCFFi FCFFn (1 g )
firm value, given by: V i
.
i 1 (1 WACC i ) (WACC n g )(1 WACC n ) n

AN APPLICATION (CASE STUDY)

The model discussed above proposes a stochastic programming approach towards financial
modeling, combining it with simulation and optimization.
The model was applied to analyze different financial recovery strategies for a MSE textile
company. After the global financial crisis, the company had run into heavy losses due to a slump
in demand. Subsequently, the company has tried to reduce its risk exposure by entering new
markets, notably the rural market, which resulted in increased fixed costs, though not resulting in
immediate improvement in sales. The uncertainty in growth/profitability is expected to carry on
for another three years before stabilizing.
The analysis aims at controlling the debt-equity ratio and current ratio, in order to optimize
the firm value. The possibility of capacity expansion is also considered in conjunction with these
financial strategies.

7
 The initial financial position of the company at the beginning of the planning period was as
follows (all figures are in Rs. thousands):

BALANCE SHEET
Liabilities Assets
Equity Rs. 30,114.06 Fixed Assets Rs. 32,179.74
(+) Retained Earnings (Rs. 19,807.41) (-) Depreciation Rs. 6,435.95
Rs. 10,306.67 Rs. 25,743.79
Long Term Debt Rs. 74,350.47 Current Assets Rs. 81,572.31
Current Liabilities Rs. 22,658.98
Rs. 107,316.10 Rs. 107,316.10

PROFIT & LOSS ACCOUNT

Particulars Particulars
To Cost of Goods sold Rs. 27,190.77 Sales Rs. 45,317.95
To Operating Expenses Rs. 24,063.59
To Depreciation Rs. 6,435.95
To Interest Rs. 7,435.05
To Tax -
To Net Profit (Rs. 19,807.41)
Rs. 45,317.95 Rs. 45,317.95

The company had run into heavy losses, even though its sales growth has been quite
encouraging over the last ten years. The debt-equity ratio in particular had drastically shot up in
the recent past. The current ratio was also alarmingly high, suggesting inadequate control of
working capital. Thus, control of the debt-equity ratio and the current ratio were incorporated
into the model by specifying the constraints within which the ratios should lie. The objective is
to maintain the ratios within the ranges and optimize the equity and earnings per share. The
strategies analyzed were as follows:
strategy 1: debt-equity ratio and current ratio are both between 1.5 and 2.0.
strategy 2: debt-equity ratio is between 2.0 and 2.5; current ratio is between 1.5 and 2.0.
strategy 3: debt-equity ratio is between 1.5 and 2.0; current ratio is between 2.0 and 2.5.
strategy 4: debt-equity ratio and current ratio are both between 2.0 and 2.5.
These financial strategies are analyzed in the context of a possible capacity expansion.
The rate of growth of sales was considered as the random input in the financial forecasting
model. The rate of growth of sales was modeled as a normal random variable with mean
27.065% and standard deviation 4.9511%. One hundred samples were generated from this
distribution using Monte Carlo technique. The graph below shows the distribution of rate of
growth of sales generated for the study.

8
 rate of growth in sales
20

10
Frequency

Std. Dev = .04

Mean = .276
0 N = 100.00
.175 .200 .225 .250 .275 .300 .325 .350 .375 .400
.188 .213 .238 .263 .288 .313 .338 .363 .388 .413

rate of growth in sales

The sample mean of the rate of growth of sales was 27.56%, with standard deviation 4.39%.
Around 90% of the sample rates of growth of sales were in the range 22.5% - 32.5%.
The generated rates of growth of sales and costs were used as inputs in a financial
optimization model. The model generated forecasts of financial variables in a three-year
planning horizon which maximized the overall firm value. For each sample point, the
optimization was solved. The initial data was taken from the income statement and balance sheet
of the company, and the following simplifying assumptions were made: a fixed depreciation rate
of 20%, a fixed interest rate (cost of debt) of 10%, a fixed cost of equity of 20%, a fixed tax rate
of 33%, a fixed dividend rate of 10%, and a steady-state growth rate of 10%. The table below
shows the results of the financial optimization.

value of the firm (using FCFF model)

under the different strategic combinations
without expansion with expansion
of capacity of capacity
strategy 1 mean Rs. 56,144.14 Rs. 41,344.88
std.dev. Rs. 571.75 Rs. 1001.17
min. Rs. 55,000.64 Rs. 39,342.54
strategy 2 mean Rs. 51,808.19 Rs. 42,873.36
std.dev. Rs. 189.91 Rs. 282.43
min. Rs. 51,428.37 Rs. 42,308.50
strategy 3 mean Rs. 51,658.75 Rs. 26,790.55
std.dev. Rs. 415.61 Rs. 2,886.14
min. Rs. 50,827.53 Rs. 21,018.27
strategy 4 mean Rs. 47,631.21 Rs. 37,459.03
std.dev. Rs. 345.44 Rs. 389.20
min. Rs. 46,940.33 Rs. 36,680.63

The results show that the first strategy, without expansion of capacity, yields the highest
expected firm value, while the next-best strategy is the second strategy, without expansion in
capacity, yielding the next-highest expected firm value, with considerably lower variability.
Thus, capacity expansion does not yield benefits in terms of higher firm value at this juncture,

9
and may be more suitable later, once the company stabilizes. Further, the optimal financial
strategy suggested by the analysis would be to keep both the debt-equity ratio and the current
ratio within control between 1.5 and 2.0.

DISCUSSION
The paper proposes a stochastic programming model for financial planning. The model
combines financial modeling with simulation and optimization, facilitating financial strategic
planning under conditions of uncertainty. The proposed model suffers from the usual limitations
of using past data, trends, simplifications, and other assumptions to project future performance.
Further, the model focuses on certain variables only, though it can be expanded to widen its
scope. Also, other random inputs such as demand, prices, inflation, interest rates, exchange rates,
and other macroeconomic variables can be introduced into the model. Alternative objective
functions may also be considered. Thus, there is vast scope for further research in the field.
The application of the model to identify a financial recovery strategy provided some
interesting insights. The stochastic programming model was used to determine the optimal
ranges of leverage (debt-equity ratio) and liquidity (current ratio) to target in order to optimize
firm value, using the rate of growth of sales as a random input. The analysis highlights a trade-
off between leverage and liquidity, and suggests that liquidity considerations may mediate
optimal capital structure decisions. This finding also has scope for further investigation.

REFERENCES
Benninga, S. (2000), Financial Modeling, 2nd Ed., MIT Press
Bhalla, V.K. (2008), Working Capital Management, Anmol Publ. Pvt. Ltd., 4th Edition.
Brealey, R.A., and Myers, S. (1999), Principles of Corporate Finance, 6th Ed., McGraw-
Hill.
Chandra, P. (2004), Financial Management & Practice, 6th Ed., Tata McGraw-Hill Publ.
Co. Ltd.
Day, A.L. (2007), Mastering Financial Modeling in Microsoft Excel, 2nd Ed., Pearson
Education, Ltd.
Jakhotiya, G.P. (2007), Strategic Financial Management, Vikas Publ. House Pvt. Ltd.
Shapiro, J. F. (2002), Modeling the Supply Chain, Thomson Asia Pvt. Ltd, Singapore.
Winston, W.L. (2000), Financial Models Using Simulation and Optimization, 2nd Ed.,
Palisade Co.

10