Vladimir Baydin, Ph.D.

, MBA

Financial Modeling Guide

Part I

I remember the first model I built in 2005. It was awful: terrible design, bad
structure, calculations’ drawbacks, etc. Since that time I have made dozens of
different models. There were one-page high-level models, “normal,” and
complicated multi-scenario fully automated ones. They were used by large
corporations, start-ups, Private Equity Funds, and Investment companies. I have
learned something since 2005 and wish to share some insights into financial
modeling.

What is financial model about?

The financial model can be viewed as an attempt to forecast future business

dynamics. It serves the goal of evaluating investment project or the whole firm.
The most common approach to doing it is to forecast Free Cash Flow (FCF). Quick
remind - there are three different types of FCF: Free Cash Flow to Firm (Project),
Free Cash Flow to Equity, and Cash Flow to Lenders, which is simply principal
repayment.

What are the main parts of a financial model?

The structure of a financial model depends on a task, deadline, information

available, etc. A Financial model must include Assumptions, Income Statement
Pro-forma, Cash-Flow forecast, and Results. Also, Operational performance
forecast, Loan balance, and Fixed assets balance (or even the whole Balance
sheet), Scenarios, Sensitivity analysis, and any additional necessary calculations
could be included.

The rule of thumb is to use separate sheets for each part of your model!
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What is the process of Financial model construction?

The right answer – it depends on. J However, in the case of “normal” financial
model there are some tips:

1. Always start with Assumptions!

2. The next step is to forecast your operations: output/services and
supporting activities like labor force, office space, etc.
3. The third phase is to project your supporting calculations as Loan balance
and Fixed asset balance.
4. Then P&L (Profit & Losses) proforma.
5. The final step is to forecast Cash-Flow.

This following diagram demonstrates this simplified process:

If we go deeper than this process becomes a bit more complicated.

1. You start by making assumptions regarding

1. prospective output (capacity, growth rate, utilization, ),
2. legal environment (taxes),
3. operational activities (labor force for example),

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4. CAPEX projections (timeline, costs, structure, depreciation rate of

fixed assets, ),
5. Financial structure (Debt/Equity ratio, interest rate, loan terms, )
2. Then you project your output and predict Sales
3. Expenses go next. Some of them can be calculated as a % of Sales. A Clear
example of revenue-linked expense is COGS. Others should be projected in
a direct way. Interest expenses, taxes, and depreciation are most common
examples of such type of costs. Sometimes you can calculate wages, rents,
and some other expenses in that
4. Loan balance forecast gives you interest expenses for P&L proforma and
Principal Repayments for Cash-Flow.
5. Capital Expenditures (CAPEX) forms Fixed assets balance which provides
you Depreciation expenses.
6. Finally, you bring together Net Income from P&L, projected CAPEX,
Depreciation from Fixed assets balance, and Interests from Loan balance.
You get your FCFF (Free Cash Flow to Firm).

The following chart exemplifies this process:

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Also, you should include a change in Net Working Capital to get FCFF, but I did not
include it to simplify the process.

What are the main characteristics of a strong Financial model?

 All cells should be linked with assumptions. “Assumptions” is the wheel of

your model. No numbers are allowed within financial proforma; only links
to assumptions and other parts of the model. You should be able to change
any part of your model by changing relevant assumptions.
 Sufficiency principal: do not try to forecast everything. Instead, focus on
primary sources of revenue and principal expenditures
 The horizon of planning: five to ten years. The step of planning: quarterly or
annually. In rare situations – monthly basis.
 Clear structure and well design. I will write a little bit about it in the next
part.

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Part II

Structure and Design

There are no rigid rules to structure and create Financial model, except one: it
should be built in clear, unambiguous, and most efficient way. At the end of the
day, any external user of the Financial model should be able to easily understand
its structure, to find out underlying assumptions and all interconnections within a
model, and to adjust necessary input parameters. How can be this accomplished?
During my career, I have come up with several pillars of a good-designed model:

1) Units of measure. You can think this is a straightforward and obvious thing;
however, I observed situation when the promising project was rejected by
investor due to the absence of units of measure. Also, I recommend mentioning
all external sources used for Assumptions.

2) I wrote about it in the first part; still, it is worth to be repeated: no hard coded
cells within your Model. Each and every calculation should be linked through
Assumptions.

3) It is always good to use different colors to distinguish between various types of

tabs. I usually use blue for Results, orange for PL and CF, green for Assumptions,
and so on.

4) In case your model contains more than several sheets it is useful to implement
content tab and navigation bar. The most complex model I have ever created
included 35 sheets. You can imagine how hard it could be to navigate across all
these tabs. Therefore, I implemented a Content tab with hyperlinks to other
sheets within the model. Also, I added a hyperlink to the Content tab on each
sheet.

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5) Keep the structure simple. If your project involves Debt Financing to purchase
Fixed assets, then it makes sense to add "Debt Financing" and "Fixed Asset" tabs.

Scenarios and Sensitivity Analysis

Financial Model is the tool to forecast future. By nature, any forecast is an

estimation rather than precise meaning. Consequently, one of the most
important purposes of any Financial Model is to answer: what if...?

Scenarios refer to high-level of the Financial Model. It is common to link them to

the Revenue Forecast and, in particular, to the Growth Rate. On the other hand,
Sensitivity Analysis illustrates how one particular outcome, per example NPV or
Enterprise Value, changes in response to the change of one input parameter
holding others fixed.

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Scenarios Implementation

Common Scenarios are Basic, Optimistic, and Pessimistic. What I have learned
from investors is that they often don't pay much attention to the Optimistic one.
Their primary concern is potential losses in case of something goes wrong.
Therefore, I always pay maximum attention to the Basic and Pessimistic
Scenarios.

As I mentioned above, it is common to connect Scenarios with the Growth Rate. If

a model assumes steady growth rate, then you can input "If" formula to
automatically adjust Revenue Growth accordingly to the chosen Scenario.

In case Revenue Growth changes over time, you can bind Scenarios to the cell
containing percentage, and then multiply it by Revenue growth. For example,
your Basic Scenario implies 100% of predicted growth; alternatively, Pessimistic
one decreases this rate to 70%.

Besides self-explanatory "If" formula there is an alternate "fancy" way to add

Scenarios into your Model:

1) Step One: Insert "Combo Box" Form you can find under "Developer" Tab
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2) Step Two: Link your Scenarios to Input Range, then select a cell to show
numerical expression of chosen Scenario

3) Use "If" formula to tie Growth Rate to this cell

Sensitivity Analysis

The result of Sensitivity Analysis is a table demonstrating how a particular

outcome varies in response to an explicit assumption's change holding others
unchanged. For example, it shows what NPV would be if Growth Rate decreases
by 10% or Discount Rate increases by 10%.

There are several ways to do it. First of all, it can be done manually. Sometimes, it
is time-saving.

Another method is to process it through "Scenario Manager" under "What-if

Analysis" tab.

Unfortunately, the following process is annoying because you need to manually

add all values of altered parameters as separate "scenarios." The following

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example illustrates it. I added scenario named "Discount rate +10%" linked to the
Discount rate cell.

Then I manually input new value of a Discount rate which is 11% under this
scenario.

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After you add all scenarios, hit the Summary button.

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The final step is to choose Resulting parameter you want to evaluate. In my case,
it was NPV.

In the end, you should get new tab containing the following table demonstrating
NPV values under different scenarios.

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Having this data, you can calculate the impact of each factor. Increasing Discount
rate leads to decrease in NPV from 290.5 to 283.0 or by 2.6%. On the other hand,
Growth Rate lowering results in NPV reduction by less than 1% from 290.5 to
287.9. Consequently, Discount Rate influences NPV more then Growth Rate does.

Part III

It is the last part of Financial Modeling posts, and it is devoted to Cash Flow and
Enterprise Evaluation. There are a lot of papers, textbooks, and other materials
covering these Corporate Finance topics, so I am going to be brief. If you are
interested in exploring these issues, I would recommend this book.

At the end of the day, the purpose of Financial Model is getting some financial
results. The ultimate result of any business is cash. However, the thing is that this
stock belongs to different stakeholders. A part of it goes to suppliers and
employees, another part to debtees and shareholders. The last one is called Free-
Cash-Flow to Firm (FCFF). It is the base to calculate Enterprise Value.

Enterprise Value and Equity Value

What does determine Enterprise Value? The answer is simple - cash a firm will
generate. So, Enterprise Value is the sum of forecasted discounted cash flow
(FCFF) the company will produce in future. Debt can be presented as a discounted
sum of all future payments towards Lenders. Shareholders' part is the remainder
of cash a firm makes (which is called FCFE) adjusted to all payments made to
Creditors.

This concept can be shown in another way. Debt and Equity are the only sources
of a firm's capital. Consequently, company's value can be demonstrated as a sum
of market value of Debt and market value of Equity. Therefore, the formula is
EV=EqV+Debt. I remind that EV stands for the sum of discounted FCFF, EqV is the
sum of discounted FCFE, and Debt is the sum of discounted loan repayments.

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FCFF vs FCFE

Free-Cash-Flow to Firm (FCFF) reflects an amount of cash a firm generates after

Capital Expenditures (CAPEX), ignoring all payments to stakeholders
(Shareholders and Lenders). Consequently, FCFF equals to:

 Operating Profit after Taxes (NOPLAT) adjusted for all non-monetary

Expense (primarily, Depreciation). NOPLAT = (EBITDA-Depreciation)*(1-Tax
Rate)=EBIT*(1-Tax Rate)
 Minus change in Net Working Capital (NWC). NWC = Current Assets -
Current Liabilities. For simplicity, it could be represented as Accounts
Receivables minus Accounts Payable
 minus CAPEX

Free-Cash-Flow to Equity (FCFE) is simply FCFF adjusted for all payments made
towards Lenders. These payments include Interest Expense and Debt Repayment.
As Interest Expense decreases Tax Base, therefore FCFE includes Tax Shield. Tax
Shield equals Interest Expense multiplied by Tax Rate.

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It is necessary to keep in mind:

 do not include any non-operating expense/revenue for NOPLAT calculation;

 do not include Interest Expense or Debt Repayment for FCFF calculation;
 remember to add back Tax Shield on Interest Expense for FCFE calculation.

A Few Words About WACC

WACC is one of the most common ways to calculate discount rate. I am not going
to explain the whole concept, but there is one important issue related to the
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Capital Structure. WACC is based on market value of equity and market value of
debt. In a case of a public company market value of debt and market value of
equity would be equal to book values. In a case of a privately-held firm, we
cannot be sure that book value of equity/debt equals to the market one as there
is no market value. In this situation, it is better to use industry
average Debt/Equity Ratio. Hint: this ratio along with other important metrics like
betas, risk-free rate, and risk premiums can be found here.

Sample Model Description

First of all, this model is 100% fake. I imagined a hotel's owner considering to buy
another hotel. The final purpose of modeling is to compare Enterprise Value with
and without acquiring another hotel under two scenarios: Basic one and
Pessimistic.

Model Features:

1. Two scenarios tied to the prospective growth rate of business;

2. Growth rate reflects Occupancy rate of rooms;
3. Revenue is divided into three business segments: Rooms, Restaurant, and
Other Services;
4. Costs include COGS, SG&A, Interest, and Depreciation;
5. Debt Repayment is based on annuity;
6. Two types of CAPEX: rooms-related and management software purchase;
7. Option to calculate results with or without potential acquisition;
8. Interest rate increases in case of acquisition due to increased default risk;
9. Two WACC calculation: based on firm's data and industry average;
10.Target's EBITDA normalization is based on Target's owner salary. The
underlying assumption is that this expense will no longer exist after the
acquisition.

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