Rift Valley University

Abichu Campus
College of Business & Economics,
Department of Accounting & Finance
Course: Title: Financial Modelling
Credit Hour: 2
Inst. Megersa H.(MSc)
Email: magarsahirpha4@gmail.com
Phone: +251910484555/+251925766659
 Chapters Outlines
Chapter One: Introduction to Financial
Modelling
Chapter Two:
Excel Fundamentals: Formulas for
Models in Finance
Chapter Three: Financial Statement
Modelling
Chapter-Four:
Valuation Fundamentals
 Chapter One:
Introduction to Financial
Modelling
 1.1. What is a Financial Model?
• A Financial Model is a representation in
numbers of some or all aspects of a
company's operations.
• A financial model is a tool used to forecast
a business’s financial performance into the future
based on historical data and assumptions.
• Financial Modelling is the process of
representing in numbers of a company's
operations in the past, present, and the
forecasted future.
 1.2. Uses of Financial Models
• Financial modelling is used to estimate the value
of a business, viability of projects, sensitivity
analysis, Cash Flow Analysis, Financial Statement
preparation.
• Financial Models are decision making tools
• Financial modelling is the process of creating a
summary of a company's expenses and earnings
in the form of a spread sheet that can be used to
calculate the impact of a future event or decision.
 1.3. Why do we build financial models?
• For anyone pursuing a career in
– Finance and investment
– corporate development,
– investment banking,
– equity research,
– commercial banking, or other areas of
corporate finance
 1.3. Types of Financial Models
Financial Statement Models
DCF Model
Merger Model
Initial Public Offering (IPO) Model
Consolidation Model
Budget Model
Forecasting Model
Option Pricing Model
 1.5. Key Structure for Model
Building
Good Models clearly separate inputs,
processing and outputs.
Inputs -Clearly identified Should only
ever be entered once.
Processing- Transparent Broken down in
to simple steps Easy to follow
Outputs- Quickly Accessible
 1.6. Modelling Best Practices
What are modelling best practices ?
1. Clarify
2. Simplify
3. Plan
4. Integrity
5. Model Testing
 …con’t
1) Clarify
• What problem is the model meant to solve?
• Who is the end user?
• What are users supposed to do with the model?
2) Simplify
• What is the minimum number of inputs
and outputs to build a useful model?
3) Plan
• Plan how inputs and outputs will be
laid out
4) Integrity
• Keep all inputs in one place Consider using Excel tools such as:
“Data validation” and “Conditional formatting”
5) Model Testing
• Use test data to ensure the model works as expected
 1.7. Financial Model Elements

1)Inputs
2)Processes
3) Outputs
 Model Inputs
Achieving objectives Objectives
• Enter each data once • Accurate
• Use colour to
differentiate • Reasonable data
inputs and outputs ranges
• Use data validation & • Easy to use
conditional formatting • Easy to understand
• Use comments • Easy to update data
 Model Processing
Achieving objectives Objectives
Break down complex
calculations • Easy to maintain
Use comments and • Accurate processing
annotations • Transparency
Use formatting
Calculate final figures
which will go onto the
output reports
 Model Outputs
Achieving objectives Objectives
• Make outputs • Provide key results
modular to aid decision-
• Consider creating a making
summary section with • Easy to understand
only the most • Unambiguous
important key model
outputs
 Chapter Two
Excel Fundamentals: Formulas for
Models in Finance
 2.1 Overview of Microsoft Excel
Excel is a powerful tool that is extensively used in
the finance industry for various models and
calculations. In this article, we will discuss some of
the fundamental formulas used in finance models in
Excel.
2.2. Understanding Workbooks
In Microsoft Excel the data you enter, whether it
consists of numbers, text, or formulas, is stored in a
file known as a workbook.
Screen Elements of Microsoft Excel
 …Con’t
• Workbooks are just like huge electronic books with
pages (or sheets) that have been ruled into columns
and rows.
• Before using Excel it is helpful to know what the
various parts and elements that make up a workbook
are:
2.2.1. Worksheet
• A worksheet (or page) in a workbook contains 16,384
columns that are labelled using letters of the
alphabet. The first column in a worksheet is labelled
column A, while the last is labelled XFD.
• A worksheet (or page) in a workbook contains
1,048,576 rows that are labelled using numbers from
1 to 1,048,576.
 …Con’t
• Where a column and row intersect we get what is
known as a cell. You enter your data into these
cells. Each cell in a worksheet can hold up to
32,767 characters.
• A workbook is made up of pages known as
worksheets. You can have as many sheets in a
workbook as your computer resources can
accommodate. As a default, a new blank
workbook normally has 3 worksheets labelled
Sheet1, Sheet2, and Sheet3.
2.3. Navigating In a File
 2.4. Typing Text or Numbers into a Worksheet
• To type anything into a worksheet you need to
make the cell into which you wish to enter the
data active. This can be done in a number of
ways but the most common is to click in it first
before typing.

2.5. Typing Simple Formulas in a Worksheet

The whole idea behind Excel is to get it to perform
calculations. In order for it to do this you need to
type formulas in the worksheet.
 …Con’t
• Usually these formulas reference existing
numbers, or even other formulas, already in the
worksheet using the cell addresses of these
numbers rather than the actual value in them.
Formulas must be typed beginning with an equal
sign (=).
 2.6. Filling A Series
• A series refers to a sequence of ordered entries in
adjacent cells, such as the days of the week or
months of the year. The fill technique can be used
to create these in a worksheet for you, reducing
the amount of time taken for data entry, and
ensuring that the spelling is correct.
 2.7. Inserting and Deleting Worksheets
• Once you’ve decided on a structure for
your workbook, you may find that there
are some worksheets that can be deleted.
Alternatively, you may find that you need
additional blank worksheets inserted.
• However, remember that deletion of
worksheets is permanent and can’t be
done using Undo, so always save your
workbook before making these changes.
 2.8. Copying A Worksheet
• Just as you can copy the contents of cells and ranges
within a worksheet, you can duplicate worksheets
within a workbook. This technique is ideal for
replicating layouts.
2.9. Renaming a Worksheet
• By default, Excel names worksheets as Sheet1,
Sheet2, Sheet3, etc. These names are fine if you are
not planning to share the workbook, but changing
these to something more relevant makes it much
easier to understand the purpose of a worksheet. You
can also adjust the horizontal scroll bar to make
room for longer, more meaningful worksheet
names.
 2.9. Overview of Excel Functions For
Modelling.
• Microsoft Excel offers a wide range of functions
that can be used to create and manipulate models.
Here is an overview of some of the key functions:
A) SUM and SUMIF: These functions add up a
range of numbers or a subset of numbers that
meet a specific criterion, respectively.
B) AVERAGE and AVERAGEIF: These functions
calculate the average of a range of numbers or a
subset of numbers that meet a specific criterion,
respectively.
 …Con’t
C) MAX and MIN: These functions find the highest and
lowest value in a range of numbers, respectively.
D) COUNT and COUNTIF: These functions count the
number of cells in a range or a subset of cells that meet a
specific criterion, respectively.
E) IF: This function allows you to test a condition and
return one value if the condition is true and another value if
the condition is false.
F) VLOOKUP formula: is used to search for a value in a
table and return a corresponding value from another column
in that table. This formula is frequently used in financial
models for tasks such as retrieving historical market data or
comparing values from different sources.
 …Con’t
G) NPV formula: is used to calculate the present
value of a series of future cash flows. It helps in
assessing the profitability of an investment by
discounting future cash flows to their present value.
H) IRR formula: is used to determine the discount
rate that makes the net present value of a series of
cash flows equal to zero. This formula is commonly
used in finance models to evaluate investment
opportunities.
I) PMT formula: is used to calculate the periodic
payment for a loan or an annuity. It is useful in
finance models to calculate loan or bond payments.
 …Con’t
J) RATE formula: The RATE formula in Excel is
used to calculate the interest rate for an
investment or loan. It helps in determining the rate
of return or cost of borrowing in finance models.
• These are just a few of the many formulas
available in Excel that are used extensively in
finance models. Mastering these formulas allows
finance professionals to build robust and accurate
models that help in analysing and making
informed financial decisions.
 1.3. Basic Financial Calculations Using Excel
• Basic financial calculations can be easily performed
using Excel. Here are a few commonly used formulas:
A) Simple Interest: To calculate simple interest, use the
formula =PRT, where P is the principal, R is the
interest rate, and T is the time.
For example, if the principal is $1000, the interest rate is
5%, and the time period is 3 years, the formula would be
=1000*5%*3, which gives a result of $150.
 …Con’t, Basic Financial Cal..
B) Compound Interest: To calculate compound interest, use
the formula =P*(1+R)^T, where P is the principal, R is the
interest rate, and T is the time period.
 For example, if the principal is $1000, the interest rate is 5%,
and the time period is 3 years, the formula would be
=1000*(1+5%)^3, which gives a result of $1157.63.
C) Present Value: To calculate present value, use the formula
=PV(R,T,N,PMT,FV), where R is the interest rate, T is the
time period, N is the number of payments, PMT is the
payment amount, and FV is the future value.
 For example, if the interest rate is 5%, the time period is 3
years, the number of 5 payments is 12, the payment amount
is $100, and the future value is $0, the formula would be
=PV(5%,3*12,-100,0), which gives a result of $ $1,654.69.
 …Con’t, Basic Financial Cal..
• Future Value: To calculate future value, use the formula
=FV(R,T,PV,PMT), where R is the interest rate, T is
the time period, PV is the present value, and PMT is
the payment amount.
• For example, if the interest rate is 5%, the time period is
3 years, the present value is $1000, and the payment
amount is $100, the formula would be =FV(5%,3,-
1000,-100), which gives a result of $ $3,268.26.
 Chapter Three:
Financial Statement Modelling
 3.1. Financial Statement Forecasting
Framework
• Assumption & drivers- Historical ratios and
figures which drive the forecast.
• Income Statements- Summarizes the company’s
profit and Loss.
• Balance sheet-displays company’s assets,
liabilities and shareholders equity
• Cash Flow Statements-Report the cash
generated and spent by the company
• Supporting Schedules- Breakdown longer
calculation such as PP&E and debt schedule
 3.2. Financial Modelling Steps
1) Copy and Paste raw data into the blank model
2) Format and link the historical subtotals
3) Calculate the historical cost ratios
4) Make assumptions based on the guidance
provided
5) Start the income statement
6) Start the balance sheet
7) Build supporting schedules
8) Build the cash flow statements
9) Create charts, graphs and outputs
 3.2. Forecasting Methods
• Forecasting Operating Revenues and Profits
•
Forecasting Gross Margin And SG&A
Expenses
Forecasting Working Capital
…con’t
…con’t
…con’t
…con’t
 Chapter-Four:
Valuation Fundamentals
4.1. Introduction to valuation and valuation standards
• Valuation is the process of determining the current worth
of an asset or a company. Financial market participants to
determine the price they are willing to pay or receive to
affect a sale of a business use it.
• Valuation standards are the set of rules and principles
used to determine the value of an asset or a company.
• These standards are important for ensuring that valuations
are accurate and consistent. Valuation standards provide
guidance on the methods and approaches used to value an
asset or company and help to ensure that all valuations are
conducted in a fair and consistent manner.
 4.1. Methods to Compute Enterprise
Value (EV)
• Enterprise Value (EV) is a measure of a company's total
value, including its debt, equity, and other liabilities. There
are various methods to calculate EV, some of which are:
• Market Capitalization + Debt – Cash: This is the most
commonly used method to calculate EV, where you add the
company's market capitalization (the total value of its
outstanding shares) to its debt and subtract any cash and
cash equivalents.
• Net Asset Value (NAV) + Debt – Cash: This method
involves calculating the net asset value of the company (the
total value of its assets minus its liabilities) and then adding
its debt and subtracting any cash and cash equivalents.
 …Con’t
• Discounted Cash Flow (DCF): This method
involves projecting the company's future cash
flows and discounting them back to their present
value using a discount rate that takes into account
the risk of the investment.
• Price-to-Earnings (P/E) Ratio: This method
involves multiplying the company's earnings per
share by its price-to-earnings ratio to get its
market capitalization.
• Price-to-Sales (P/S) Ratio: This method involves
multiplying the company's sales per share by its
price-to-sales ratio to get its market capitalization.
 4.2. Using Accounting Book Values to Value a
Company: The Firm’s Accounting Enterprise Value
• While accounting numbers are rarely used to value a
company, the balance sheet is a useful starting point
for the valuation process. This section demonstrates
how financial statements can assist in defining the
concept of enterprise value (EV).
2.3. Efficient Markets Approach to Corporate
Valuation
The Efficient Markets Approach to Corporate Valuation
is an analytical method used to assess the value of a
company. It is based on the idea that the market price of
a company’s stock reflects all available information
about the company, and that the stock price is the best
indicator of its true value.
 …Con’t
• This approach relies on the efficient market
hypothesis, which states that market prices reflect
all available information, and that it is impossible
to consistently outperform the market by trading
on such information.
• This approach is used to evaluate a company’s
performance and prospects, and to determine a
fair market value for the company’s stock. The
Efficient Markets Approach to Corporate
Valuation is a useful tool for investors, as it helps
them to make informed decisions about their
investments.
 4.4. Enterprise Value (EV) as the Present
Value of the Free Cash Flows: DCF “Top
Down” Valuation
• Enterprise Value (EV) is an important financial
metric that measures the total value of a company,
including both its equity and debt.
• The most common method for calculating EV is
by using the discounted cash flow (DCF)
analysis, which is a "top-down" approach to
valuation. In this lecture note, we will discuss the
concept of EV and how it is calculated using DCF
analysis.
 4.4.1. What is Enterprise Value?
• Enterprise Value (EV) represents the total value of a
company and is calculated by adding its market
capitalization (market value of equity) to its outstanding
debt and subtracting its cash and cash equivalents. In
other words, EV is the value that would be required to
purchase a company outright, including both equity and
debt.
• Investors to compare the value of one company to
another, as it provides a more complete picture of a
company’s value than just looking at its stock price, can
use EV.
 4.4.2. Calculating EV using DCF analysis
• DCF analysis is a popular method for valuing
companies and involves estimating the future cash
flows a company will generate and discounting them
back to their present value using a discount rate that
reflects the risk associated with the investment. In the
case of EV, the present value of a company's free cash
flows (FCF) is used to determine its total value.
• FCF is the cash flow generated by a company after
accounting for capital expenditures needed to
maintain its operations. It is a measure of the cash a
company can use to pay down debt, pay dividends, or
invest in growth opportunities. FCF can be calculated
by subtracting a company's capital expenditures
(CAPEX) from its operating cash flow (OCF).
 …Con’t
• The formula for calculating EV using DCF analysis is as follows:
EV = Present value of FCF + Present value of terminal value
- Net debt.
Where:
Present value of FCF is the sum of the discounted
future cash flows a company is expected to
generate. This is typically calculated using a 5- or
10-year forecast period.
Present value of terminal value is the value of a
company beyond the forecast period, assuming a
steady-state growth rate. This is often calculated
using the perpetuity growth method.
Net debt is a company's total debt minus its cash
and cash equivalents.
 …Con’t
• To calculate the present value of FCF and terminal
value, a discount rate is used that reflects the risk
associated with the investment. This rate is typically
based on the company's weighted average cost of
capital (WACC), which takes into
account the cost of debt and equity financing.
• The discounted cash flow (DCF) method emphasizes
two key ideas:
1) Free cash flows (FCFs) of a company are defined as the cash
generated by its operating activities. The weighted average cost
of capital (WACC) of a company is the risk-adjusted discount
rate proportionate to the risk of the FCFs.
2) The enterprise value (EV) of a company is the present value
of future FCFs discounted at the WACC:
 4.5. Definition of Free Cash Flow (FCF)
• Free Cash Flow (FCF) is a financial metric that is
used to measure the amount of cash generated by a
business after accounting for capital expenditures.
• It represents the amount of cash that a company has
available for distribution to its investors or for
reinvestment in the business.
• In other words, FCF is the cash flow that is available
to a company's investors, including its shareholders
and debt holders, after all capital expenditures have
been accounted for. Capital expenditures refer to the
amount of money a company has spent on long-term
assets such as property, plant, and equipment,
and other long-term investments.
 …Con’t
• FCF is important because it is a measure of a
company's ability to generate cash, which is
essential for its growth and financial health.
• A positive FCF indicates that a company is
generating more cash than it is spending, while a
negative FCF indicates that a company is spending
more cash than it is generating.
The formula for calculating FCF is as follows:
FCF = Operating Cash Flow - Capital Expenditures
Where:
Operating Cash Flow is the amount of cash a company
generates from its day-today operations, including sales,
expenses, and other income.
 …Con’t
• Capital Expenditures refer to the amount of money a
company has spent on long-term assets such as
property, plant, and equipment, and other long-term
investments.
• In general, investors prefer a higher FCF, as it indicates
that a company has more cash available to pay
dividends, buy back stock, or invest in new projects.
• However, it is important to note that FCF can vary from
year to year, depending on a company's business model,
capital expenditures, and other factors.
• Overall, Free Cash Flow is a crucial financial metric
that can help investors evaluate a company's financial
performance and potential for growth.