For full text article go to : https://www.educorporatebridge.com/financial-modeling/financial-modeling-technique/ This Financial Modeling Technique will help you to understand some important techniques like color coding, circular reference, compilation of historical data, things needs to be considered before making an assumption etc in order to make a financial model easy to understand.
2. Financial Modeling
• A financial model represents
The financial performance of a company
For both past and future.
• Always advisable to build a financial model in excel.
• Skill sets required by an individual to build a financial model are
Knowledge of excel
Knowledge of accounting
Knowledge of corporate finance
Understanding the company‟s operations
3. Historical Data
• Gather right historical data from the right source
• Remember – You are an “Analyst” not an “Auditor”
• Don‟t sit to tally if the annual reports published by
company do not tally
4. Assumption
• Referred to as „drivers‟ or „inputs‟
• Financial models need to have clear and well defined assumptions
• Should reflect business realities and expectations
• Criteria one should consider while making an assumption are :-
No bias should get into the assumptions on the business
Understanding the company's financials
Clearly understand the expected changes in future performance
Understand Management expectations
Check out what other analysts think about the company
6. Features of an effective model
Should be realistic based on reasonable
and defensible assumptions and
projections
Should be flexible and adaptable with
dynamic working schedules (or modules)
Should be easy to follow, should not
intimidate the reader
7. Circular reference
A circular reference is a series of references where the last object references the first,
resulting in a closed loop.
Year 1
Income heet (Rs m)
Lets understand this with the help of an example
Net Sales
• We need to calculate net income
(-)Direct Costs
• To calculate net income we need to calculate interest
income
• Interest income will be calculated as income rate
Gross Profit
(-)Selling, General & Admin
Costs
EBITDA
(-)Depreciation/Amortisation
EBIT
percentage on the average cash and bank balances
• Over here we are assuming that the entire cash
balance in the bank
(-)Interest Expense
(+)Interest Income
Pretax Income
(-)Income Taxes
Net Income
8. Circular reference
Cash Flow Statement
Operating Activities
Year 1
• In order to calculate ending cash balance
Net Income
Depreciation/Amortization
Change in Working Capital
Cash Flow from Operating Activities
we will require net income then we will
be able to calculate interest income
Investment Activities
Capital Expenditures
Additions to Intangibles
Cash Flow from Investing Activities
Financing Activities
Issuance/ (Repayment) of Long Term Debt
Issuance/ (Repurchase of) Equity
Cash Flow from Financing Activities
Net Change in Cash
Beginning Cash Balance
Ending Cash Balance
Cash balances
Average Cash Balance
Interest Rate
Interest Income
Year 1
9. Circular reference
How to do this ???
Step 1 - Calculate net income by considering interest income to be 0
Step 2 - Link this net income to the cash flow statement and find out the ending
cash balance
Step 3 - Link this ending cash balance to the average cash balances and find out the
interest income
Step 4 – Link this interest income to the income statement
10. Circular reference
Wondering whether the new net income figure will get reflected
in the cash flow statement
Yes through circular reference this entire process will be done
automatically and accordingly the other figures in the income
statement , balance sheet and cash flow statement would also be
changed
11. Circular reference
Remember
Excel cannot calculate automatically when the model contains a
circular reference
We need to Turn ON “Iterations” in order to resolve the situation
How to turn on Iteration in excel
Go to
File >>> Options >>>> Formulas >>>>> Enable iterative
calculation >>>> OK
13. For more information:Knowledge is like a line with no ends
so
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