Course Notes

Building a Financial Model in Excel

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© 2017, all rights reserved. https://www.corporatefinanceinstitute.com

A structured approach
to financial modeling
Session Objectives

• Practice building a financial model

• Learn best practices of a good financial model
• Create an income statement from scratch
Key structure for model building

• Inputs
• Processes
• Outputs
Key structure for model building

• Inputs should be easy to identify

• Should not be redundant

Key structure for model building

• Processes should be broken down

• They should be transparent

• By breaking processes into small chunks, it makes the model easier to

follow
Key structure for model building

• Lastly, outputs should be accessible

• Outputs should be designed in such a way as to deliver its message as

easily and quickly as possible

Modeling best practice

• Clarify

• Simplify

• Plan

• Integrity

• Stress test
Inherent tensions in model building

• Realistic vs robust

• How do we make it large enough it needs to be but not so large as to be

overly complicated?

• Will the model be too simple to aid proper decision making?

Model inputs

• Inputs should be easy to use and understand

• Guide the user with color coding and data validation

Use data validation

• Data validation ensures that the proper data is put in

• For example, data validation can prevent dollar values from being put into

a date cell

• The data validation tool in Excel can also be used to set certain accepted

ranges for number values

Model processing

• Should we cram a long process into one formula?

• Should we hide the formulas in hidden worksheets to make the model

cleaner?

• Again, modeling is about balancing the needs and complexity of the

model
Locking / unlocking cells

• Locking cells prevents it from being modified

• Output cells should be locked

• Input cells should be unlocked so assumptions can be changed

Grouping cells

• Grouped cells can be quickly hidden and unhidden

• This helps group together related data, such as all the line items in an income statement
The four step approach

1. Forecast revenues  EBIT

2. Forecast operating assets

3. Forecast finance

4. Forecast cash flows

The four step approach

1. Income Statement

2. Balance Sheet

3. Income Statement + Balance Sheet

4. Cash Flow Statement

Forecasting operating revenues and profits

• The operating profit section can be forecasted on its own

• Everything after operating profit involves financing costs, which require certain parts of

the balance sheet before forecasting

Forecasting revenues

• Modeling revenues should reflect the underlying economics of the business

• Figure out what drives revenues and use this as an input

• Drivers can be unit sales, market size, expansion rate, square footage, and even

macroeconomic trends
Forecasting revenues

• Modeling revenues should reflect the underlying economics of the business

• Figure out what drives revenues and use this as an input

• Drivers can be unit sales, market size, expansion rate, square footage, and even

macroeconomic trends

• Alternatively, use historic figures to forecast future trends

Forecasting gross margins and SG&A expenses

• Forecasting gross margins involves forecasting the percentage of cost of goods sold

• SG&A margins can be left as balancing figures

Forecasting income statement and
balance sheet items
Forecasting financial statements

• For the balance sheet, we first want to forecast the main line items tied to operations

• These are: AR, Inventory and AP

• This also helps us figure out the days outstanding for each of these metrics

• The important part about these line items are that they help generate the gross margin

as they are part of the operating cycle

Forecasting property, plant and equipment (PP&E)

• First principles approach: try to forecast the realistic CapEx and depreciation policies

• Quick and dirty: use trends from historic sales

Capital asset (PP&E) turnover ratio

• Capital Asset Turnover = Sales / Capital Assets

• This helps forecast future capital assets

• Forecasted Capital Assets = Sales / Capital Asset Turnover

Forecast PP&E acquisitions and disposal

• A proper depreciation schedule will allow us to see historic acquisitions and disposals

• This schedule allows us to see how often and how large the company makes

acquisitions

• This, in turn, helps forecasting

Forecasting working capital

• As stated before, we can figure out the turnover ratios for each current asset

• The first principle approach uses turnover ratios to figure out days outstanding, then

reverse engineers these to forecast future working capital

• The quick and dirty approach uses historic trends and figures as forecasts
Working capital equations

• Accounts receivable days = AR / Sales x 365

• Thus, future AR = Receivable Days / 365 x Sales

Working capital equations

• This technique is the same for Inventory and Accounts Payable days

• Each of their “Days” formulas must be reverse engineered

Working capital equations

• Payable Days = Accounts Payable / Cost of Sales (or Purchases) x 365

• Inventory Days = Inventory / COGS x 365

• If neither COGS nor purchases is available, sales revenue can be substituted

Debt and Financing Schedules
Forecasting financial statements

• The third step of the four step approach is to forecast finances

• This means forecasting debt and equity financing

Forecasting the financing structure

• This is also known as the capital structure

• The optimal structure varies between companies

• Use leverage ratios and coverage ratios

The practicalities of forecasting finance

• “Is it necessary to use a target leverage ratio” (D/E)

• In other words, is debt independent of equity?

• If it is, the model is simpler and debt can be forecasted as constant

The practicalities of forecasting finance

• However, if target leverage ratios are needed, we need to forecast future debt

• We also need to calculate interest

• This may entail generating a debt schedule

Circular references

• Circular references occur when a formula references another formula that references

the first formula

• In effect, the formula references each other in a chain

• Because the formulas are based off of predecessor answers, it cannot calculate properly
Understanding the problem

• Why does using average debt lead to circular references?

• Average debt is calculated from opening debt and closing debt

• Closing debt is calculated from opening debt and accrued interest

• Accrued interest is calculated from average debt and the interest rate

• All formulas are tied in a chain

Solving circular references with iteration

• Iteration is a tool that helps cancel out circular references

• It aims to find a solution to the equations tied in the chain

• Iteration must be turned on manually

An analytical approach

• It’s recommended to avoid turning off iteration as it does not alert us to the addition of

any new circular references

• As such, it’s better to solve the circular reference by cutting the chain
Building a free cash flow forecast
Cash flow from operating activities

• The indirect method of finding CFO adds back non-cash expenses to net income

• Then, changes in working capital are added to this adjusted net income to find the cash

flow from operating activities

Cash flows from investing activities

• Investing activities come from PP&E

• Thus, we can use our forecasts from acquisitions and disposals to find the inflow or

outflow of CFI
Cash flows from financing activities

• Cash flows from financing activities involve any inflows or outflows tied to debt or equity

financing

• Debt financing involves repayments of debt, proceeds from new debt, or interest

payments

• Equity financing involves issuance of new shares, repurchases or payments of dividends

Forecasting free cash flows to the firm

• FCFfirm is the amount of cash left over after money is spent to grow the business and

fund daily operations

• This is found by adding back depreciation to after-tax operating profits, and deducting

any capital acquisitions and funds to working capital

Forecasting free cash flow to equity

• Free cash to the firm is preferred for equity valuation

• FCFe = cash flows from operations – capital expenditures

Reconciling free cash flows

• Free cash flow to equity differs only slightly from free cash flow to the firm

• To reconcile, simply add back the after-tax interest expense to find FCFfirm
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