Financial Statement Modeling & Spreadsheet Engineering

“Training in spreadsheet modeling improves both the efficiency and effectiveness with which analysts use spreadsheets” Steve Powell, Dartmouth College

Understand the Decision

What is the problem?What questions must be answered?What is the time horizon of the problem?What kind of output information is

needed?Who will use the information?What level of detail is necessary?

Structural Inputs of the Model

Define the equations and relationships that make up the model What are the decision variables and what are the

linkages between the decisions and the goal of the model?

What are the constraints?Definitions based on accounting rulesEconomic, industry, resource and technological

limits What happens at the end of the planning horizon?

Data Inputs

Internal data that describes the current state of the systemFirm’s financial statementsResources and capacities

External data that describes the firm’s operating environmentEconomic conditions such as interest rate,

costs, stock prices

Financial Analysis

Assess the strengths and weaknesses of the firm’s current conditionRatio analysisBreak-even analysisOperating and financial leverage analysis

Generate pro forma financial statements to identify strategies to improve the condition and assess future risks

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Growth and the Need for Financing

Growth frequently associated with cash Faster growth more profits more cash This is incorrect!

The problem Growth and profits do not equal cash flow

Growth is not an end in itself Needs to be managed Firms often fail because they do not plan for

growth

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Cash Flow is Needed to Support Sales Cash is the life blood of organizations

Funds receivables and inventory Buys productive assets Pays investors fair returns

BUT Cash needed to support growing sales can exceed

cash flow

Firms fail when Needs of expansion

Overwhelm Resources for expansion

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Flow of a Sales-Driven Model

Modeling Sales Forecasts

• Simple Method: Assume average or different growth rate for each period

• Develop detail forecast by product, business unit, customer or geographic market and aggregate forecasts

• Forecast the unit price and volume

• Forecast size of market and estimate market share

• Forecast costs and apply a margin assumption to derive sales

Financial Planning Model Assumptions

• Items that are functional relationships of sales– Percent of sales

• Operating expenses• Working capital and fixed assets

• Items that are functional relationships of other financial statement items– Interest, depreciation, dividends, marketable

securities, cash flows

• Items that involve policy decisions (e.g. long-term debt, equity, capital expenditures)

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Generating the Income Statement

Expenses in period t Related to asset and liability balances at the

end of period t – 1 Interest Expenset based on Debtt-1

Depreciationt based on Gross Fixed Assetst-1

Or Related to Sales in period t

COGSt = COGS/Sales * Salest

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Balance Sheet Sector

Track financial state of firm through time Balance sheet equations go a long way towards

ensuring this Results in one period (t – 1) become inputs to next

period (t) EXAMPLE

Debtt = Debtt-1 + Debt Issuedt – Debt Repaidt

Feed into income statement Interest Expenset = Debtt-1 * Interest Rate

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Investment ModuleCalculates Required New Investment

Compile changes in assets Left side of balance sheet Current Assets

Including Cash Balance Not including discretionary items (e.g. marketable

securities) Long-term assets

Net Fixed Assets Goodwill

Add cost of maintaining production Replacement of depreciated assets

Output information to Financing Module

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Three Sources for Financing New Investment

Spontaneous Increase in liabilities that increase naturally

with salesInternal equity

Current year's retained earningsExternal capital markets

New debt or equity

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Sustainable Growth in the Rapid Growth Phase

The "it takes money to make money" phase Increased sales require more assets of all

types Internal sources don’t generate enough cash

Retained earnings Increase in spontaneous liabilities

Need to raise capital externally New question: How fast can firm grow without

altering its current capital structure?

The “Plug”

The balance-sheet item which will “close” or balance the balance sheet model so that Total Assets will always equal Total Liabilities & Equity

Models the assumption of how the firm finances itself

Examples are cash & marketable securities, debt, debt & equity

See Plugs.xlsx

Plan Your Layout

On paper, map out the different sections of your model and their planned locations within the workbook

Consider how readable the model layout will be for the

usereasy it will be to modify the assumptionseasy it will be to extend the model to include

more time periods or new products.

Modules

Data InputsAssumptionsDecision Variables Internal Data and Data Structures

OutputsPro-forma statementsOther structural relationshipsDocumentation

Layout Strategies

Modules on different worksheets Stair-step format in same worksheet For each strategy,

Consider how difficult it will be to insert or delete a row or column

Consider how much linking needs to be done between different modules

Consider linking a data input to the computation area or output for later reference

Range Names

Use range names to create an overview of a worksheet in the model layout.Highlight the cell or range you want to

name, select Insert>Name>Define (2003) or Formulas>Define Name (2007)

Use View>Zoom where the Zoom factor is set to less than 40% to see overview

To apply name to all relevant formulas in spreadsheet, Insert>Name>Apply (2003) or Formulas>Define Name>Apply Name (2007)

Other Layout Considerations

Gaps between logical areas improve readability

Isolate blocks of similar formulas for safe and convenient copying

Use styles, fonts and colors with consistent meanings

Data Input Guidelines

Isolate constants into their own cellsDo not use constants in formulas unless it is

a number like 1 or 100 being used in percentage calculations

Don’t have multiple instances of a number that is used as a decision variable or assumption

Organize decision variables and model parameter/assumptions logically into separate physical areas

To Reduce Formula Errors

Use relative and absolute cell addressing where appropriate (Use [F4] to modify $ in formulas!) Set up common structures in different parts of the

model (e.g. same row labels for different worksheets)

Use formulae for a cell which are consistent in their relationship to adjacent cells

Minimize linking formulas across worksheets Split complex formulas into multiple

intermediary formulas

Circular References

• Created when expenses in period t refer to assets and liabilities in period t, resulting in modified values for the plug which then impact the income statement and the Addition to Retained Earnings

• Iterative process is required to produce a consistent and correct final set of financial statements

• To solve, use Tool Options Calculation Iteration (2003) or MS Office Button>Excel Options> Formulas> Iteration (2007)

• Not all circularities are convergent. Make sure to verify accuracy!

Verify Formula Reliability

Use Excel’s Auditing ToolbarTools>Auditing> (2003)Formulas>Formula Auditing (2007)

Use [Ctrl]+` to toggle between formulas and calculations

Use Conditional Formatting to flag suspicious resultsFormat>Conditional Formatting (2003)Home>Conditional Formatting (2007)

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Calculating a Plug with the Investment and Financing Modules Investment module

Required New Investment Financing module

Required External Financing Spontaneous Financing Internal Equity Financing

Required New InvestmentRequired External FinancingSpontaneous FinancingInternal Equity Finan

cing

• See Logic for Debt as Secondary Plug Excel file

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Testing the Model

Questions: Does it balance under extreme conditions? Does it make sense?

Extreme growth Set growth rate to -50% and 50% Does it still balance? Do debt or equity go negative? What happens to excess cash flow?

High Interest What happens when Net Income is negative?

Document the Spreadsheet

Use range names to make individual formulas more readable and module layouts clearer

Use comments to document assumptions and modifications in a formula’s logic as well as sources of data

Use textboxes to describe portions of the model’s logic and assumptions as well as instructions for use

Create a worksheet to describe the purpose of the model and document changes