Financial Modeling

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The Investment Banking Institute
 Table of Contents

I. Introduction

II. Spreading Historical Financial Statements

III. Deriving Historic Ratios, Trends and Variables

IV. Financial Statement Projections

Integration of Financial Statement Projections / Revolver
V.
Modeling

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 Introduction
Uses for Financial Models in Investment Banking and Private Equity
ƒ Investment bankers and Private Equity Professionals often must create
financial models that illustrate historic financial statements along with
integrated income statement, balance sheet and cash flow projections for
evaluating various types of transactions such as:
¾ Sale of the Company
¾ Merger of the Company
¾ Public or Private Placement of new capital (bank loans, high yield issue, IPO or
secondary equity offering, private equity or debt placement, etc.)
¾ Leveraged buyouts / Management buyouts
¾ Restructuring / Bankruptcy
ƒ In these cases, the associate or analyst is expected to construct the financial
model with guidance from the management team on assumptions and
projections.
ƒ Typically, the associate and analyst are responsible for “running the model”,
including the ability to run base-case, upside, downside and alternate capital
structure scenarios.
ƒ For pitches and other cases where there is no access to the management
team, projections from research reports (equity research reports, high yield
research reports, credit rating agency reports, etc) can be used.

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 Introduction
Tips for Setting Up the Financial Model
ƒ Keep historic and projected income statement, balance sheet and
cash flow on same worksheet
ƒ Have Historic Ratios / Assumptions for Projections on the same
worksheet but separate from the worksheet that has income
statement, balance sheet and cash flow
ƒ Formatting is very important in investment banking:
¾ same font and letter size throughout model
¾ clearly labeled pages
¾ blue text usually denotes an input that is a driver
¾ black text is usually output
¾ convention is one decimal point for $ amounts; 0 or 1 decimal points
¾ for percentages
¾ Set print ranges and preferences
¾ Footnote all sources and assumptions clearly
ƒ Keep it as simple as you can

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 Table of Contents

I. Introduction

II. Spreading Historical Financial Statements

III. Deriving Historic Ratios, Trends and Variables

IV. Financial Statement Projections

Integration of Financial Statement Projections / Revolver
V.
Modeling

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 Spreading Historical Financial Statements
ƒ Three to five year history for income statement, balance sheet
and cash flow usually sufficient
ƒ Source of historic financial statements:
¾ Publicly traded companies’ financial statements must be filed
with the SEC on a quarterly (10Q) and annual basis (10K) and are
publicly available
¾ Private companies: audited financial statements provided by
company
ƒ Adjust historical income statement for one-time,
extraordinary, non-recurring items such as restructuring
charges or sale of business division
ƒ When spreading the historic financial statements: keep it
simple!

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 Deriving Historic Ratios, Trends and Variables
ƒ Goal is to establish historic trends, margins, growth rates, etc. to use
for projections
ƒ Important variables to derive from historic income statement:
¾ Revenue Growth Rate
¾ Cost of Goods Sold (“COGS”) Margin (COGS / Sales)
¾ Gross Margin (Gross Profit / Sales)
¾ SG&A Margin (SG&A / Sales)
¾ Operating Margin (Operating Income / Sales) and Operating Income
¾ Growth Rate (aka Earnings before Interest and Taxes (“EBIT”))
¾ Depreciation / Gross PP&E*
¾ EBITDA Margin (EBITDA / Sales) and EBITDA growth rate
¾ Effective Tax Rate (income tax / pre-tax income)
¾ Interest expense and interest income will be discussed later
¾ Other income / expense items: need to read notes to financial
statements to determine what they are; if there is some discernable
trend, can use it to project; often there is not a trend.

* Depreciation schedules can also be used; for purposes of this model, we are using Depreciation as % of Gross PP&E; Depreciation
Schedule available for illustrative purposes.

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 Deriving Historic Ratios, Trends and Variables
ƒ Important variables to derive from Historic Balance Sheet and Cash
Flow:
¾ Accounts Receivable, Inventory, and Accounts Payable are calculated in
number of days:
– Accounts receivable: average number of days for collection calculated as
Accounts Receivable balance / Sales * 360 days
– Inventory: average number of days to turn raw purchases into finished goods
calculated as Inventory Balance / COGS * 360 days
– Accounts Payable: average number of days for company to pay its suppliers
calculated as Accounts Payable balance / COGs * 360 days
¾ Other assets and other liabilities (both current and long-term): need to
read notes to financial statements to determine what they are; can use
absolute values, percentage of sales / COGS, etc.
¾ Capital Expenditure (“Capex”) as % of sales (capital expenditure in cash
flow statement / sales for that period)
¾ Asset Disposition: read notes to financial statements to see if there is a
discernable trend; could be recurring asset sales, or one-time items like
the sale of a business division or subsidiary

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 Deriving Historic Ratios, Trends and Variables
ƒ Important variables to derive from Historic Balance Sheet and Cash
Flow:
¾ Accounts Receivable, Inventory, and Accounts Payable are calculated in
number of days:
– Accounts receivable: average number of days for collection calculated as
Accounts Receivable balance / Sales * 360 days
– Inventory: average number of days to turn raw purchases into finished goods
calculated as Inventory Balance / COGS * 360 days
– Accounts Payable: average number of days for company to pay its suppliers
calculated as Accounts Payable balance / COGs * 360 days
¾ Other assets and other liabilities (both current and long-term): need to
read notes to financial statements to determine what they are; can use
absolute values, percentage of sales / COGS, etc.
¾ Capital Expenditure (“Capex”) as % of sales (capital expenditure in cash
flow statement / sales for that period)
¾ Asset Disposition: read notes to financial statements to see if there is a
discernable trend; could be recurring asset sales, or one-time items like
the sale of a business division or subsidiary

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The Investment Banking Institute
 Table of Contents

I. Introduction

II. Spreading Historical Financial Statements

III. Deriving Historic Ratios, Trends and Variables

IV. Financial Statement Projections

Integration of Financial Statement Projections / Revolver
V.
Modeling

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 Income Statement Projections

ƒ Revenue projections are often based upon historic and expected growth
¾ Often, the revenue projections are built up based upon the products, pricing,
customers, etc.
¾ For example, revenues of a producer of steel coils would be calculated as the
number of tons sold * average price per ton; revenue growth would come from an
increase in tons sold and / or an increase in average price per ton
¾ For example, revenues for a restaurant chain could be calculated as average revenue
per store * number of restaurants; revenue growth would come from an increase
revenue per store and / or an increase in restaurants
ƒ COGS projections are often based upon the margin (COGS / Sales); however
COGS can also be determined by number of units and average cost per unit
¾ COGS is comprised of both variable and fixed costs; variable cost margins stay very
similar with increase / decrease in volume, while the absolute fixed costs remain the
same, but the margin would change
ƒ Depreciation can be calculated as a % of gross PP&E, or detailed depreciation
schedules can be used
¾ As detailed depreciation schedules require significant time, space and review by
management, depreciation as a % of gross PP&E is a good proxy

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 Income Statement Projections

ƒ SG&A expenses are typically projected as a % of sales;

however, some of the SG&A expenses are “fixed”, and
therefore do not necessarily increase along with sales
ƒ Interest expense and income are calculated based upon debt
and interest schedules, which will be discussed in detail later
ƒ Other income / expense items can be projected based upon
expected events (i.e. tax refund, sale of a subsidiary, etc),
or some discernable historic trend
¾ Often, the best projection for other income / expense items is $0
ƒ Effective taxes are typically projected as a % of pre-tax
income; however, any benefit from the use of a Net Operating
Loss (“NOL”) or other tax benefit should be taken into account

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 Balance Sheet Projections - Assets

ƒ Cash: related to revolver modeling and will be discussed in detail

later
ƒ Accounts Receivable: discern historical trend of days; use
number of days as assumption / driver
Accounts Receivable balance = number of days / 360 * Revenue
ƒ Inventory: discern historical trend of days; use number of days as
assumption / driver
Inventory balance = number of days / 360 * COGS
ƒ Other Assets: discern historical trend either absolute value or %
of revenue
ƒ Goodwill:
¾ Goodwill resulting from an acquisition can no longer be amortized
¾ One-time expenses incurred in the acquisition (legal fees,
investment banker fees, financing fees, etc.) can be amortized,
typically over 5 – 7 years.

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 Balance Sheet Projections – Assets (continued)

PP&E
ƒ Gross PP&E = beginning balance Gross PP&E + Capex – Asset sales
ƒ Capex projection: in cash flow statement; discern historical
capex as % of sales
ƒ Asset Sales projection: discern trend and read notes to financial
statements for expected upcoming events (i.e. sale of subsidiary,
acquisition closing, etc.); often best projection is $0.
ƒ Depreciation Expense (income statement) = % of gross PP&E
ƒ Depreciation Cumulative balance (balance sheet) = beginning
depreciation balance + depreciation expense for current period

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 Balance Sheet Projections – Liabilities and Shareholders Equity

Liabilities
ƒ Accounts Payable balance: discern historical trend of days; use
number of days as assumption / driver.
Accounts Payable balance = number of days / 360 * COGS
ƒ Accrued Liabilities and Other Liabilities balance: discern
historical trend; either absolute value or % of COGS
ƒ Debt: to be discussed in context of debt and interest expense
schedule

Shareholders Equity
ƒ Retained Earnings: Beginning balance + net income after any
dividend distributions
ƒ Other / (Plug / Balance): In the case of one-time transactions
(acquisition, divestiture, writedown of assets, etc), often you will
need this account as a plug to balance the balance sheet

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 Cash Flow Projections

ƒ All Changes in all Balance Sheet Accounts must be run through the cash
flow; otherwise the balance sheet totals will not balance
ƒ All Non-cash items in the income statement must be added back /
deducted from the operating cash flow
ƒ Operating Cash Flow = sum of:
¾ Net Income: take from income statement
¾ Depreciation and Amortization: take from income statement
¾ Add back / deduct any other non-cash expenses / income from the income
statement (examples are non-cash interest expense, any non-cash
restructuring charges, amortization of capitalized accounts, etc.)
¾ Changes in working capital
– Current Assets: Previous period balance – Current period balance
– Current Liabilities: Current period balance – Previous period balance
¾ Changes in other assets / other liabilities
– Other Assets: Previous period balance – Current period balance
– Other Liabilities: Current period balance – Previous period balance

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 Cash Flow Projections

ƒ Cash Flow from Investing Activities = sum of:

¾ Capital Expenditure
¾ Sale of Assets

ƒ Cash Flow from Financing Activities

¾ Driven by debt and interest schedule, which integrates the cash and
debt balance sheet accounts, interest expense and interest income
on income statement, and the cash flow statement

ƒ Ending Cash Balance = Beginning Cash Balance + Cash Flow from

Period

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 Debt and Interest Schedule Projections

ƒ Establish separate sections for each piece of debt

¾ Revolver
¾ Term Loan / Senior Credit Facilities
¾ Notes / Bonds
¾ Capital Leases
¾ Other Debt
ƒ The notes to the financial statements contain the required amortization payments
for each tranche of debt, as well as interest rates
¾ This information is also available in the credit agreements and note indentures
ƒ Ending debt balance = beginning debt balance + drawdowns – amortization
payments or paydowns
ƒ Interest Expense = average (beginning debt balance + ending debt balance) *
interest rate
ƒ Since the Revolver will be the account used to integrate the income statement,
balance sheet and cash flow, we will save this part of the modeling for last
ƒ Once you have modeled out the beginning debt balance, ending debt balance and
interest expense for all debt tranches (except for the revolver), link the results
back into the balance sheet and income statement:
¾ Ending debt balance: current period balance sheet item
¾ Interest expense: current period income statement item

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 Table of Contents

I. Introduction

II. Spreading Historical Financial Statements

III. Deriving Historic Ratios, Trends and Variables

IV. Financial Statement Projections

Integration of Financial Statement Projections / Revolver
V.
Modeling

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 Revolver Modeling

ƒ The Revolver will be the account used to integrate the income statement,
balance sheet and cash flow
ƒ Mechanically, the way the model works is as follows:
¾ If cash flow produced during the period (before any revolver paydown or drawdown) +
the beginning cash balance is greater than 0, than any excess cash is used to paydown
the revolver balance
– The amount of the paydown is the minimum of the beginning revolver balance or the cash flow +
the beginning cash balance
¾ If cash flow produced during the period (before any revolver paydown or drawdown) +
the beginning cash balance is less than 0, the cash deficit will be funded by a drawdown
on the revolver
– The amount of the drawdown is the amount of the cash flow deficit in this model
– In reality, there is a revolver availability based on a complicated borrowing base formula
calculated as a % of eligible accounts receivable + eligible inventory – reserves
¾ For the purposes of modeling the revolver, the cash flow produced during the period =
cash flow from operations + cash flow from investing activities + cash flow from all
financing activities except the revolver
ƒ As the calculation of the revolver drawdown / paydown, revolver ending balance,
and interest expense is a circular reference, you need to set your computer to
the proper setting
¾ On the “Tools” bar, go to “Options”, and “Calculation”, click “Manual”, “Iterations”,
and type 100 in the box next to “Maximum Iterations”

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 Revolver Modeling
PROJECTED FINANCIAL STATEMENTS
($ in millions) Fiscal Year Ending December 31,
2006P 2007P 2008P 2009P 2010P

Cash Flow
Net Income $23.6 $26.4 $29.3 $32.4 $35.7
Plus / (minus):
Depreciation and Amortization $7 $8 $8 $8 $8
Changes in Working Capital
Accounts Receivable ($0.5) ($0.5) ($0.5) ($0.6) ($0.6)
Inventory ($0.2) ($0.2) ($0.2) ($0.2) ($0.2)
Other Current Assets $0.0 $0.0 $0.0 $0.0 $0.0 Revolver (paydown) / drawdown =
Accounts Payable $0.2 $0.2 $0.2 $0.2 $0.2
Accrued Liabilities $0.1 $0.1 $0.1 $0.1 $0.1
If (Cash Flow from Operations +
Other Current Liabilities $1.0 $0.0 $0.0 $0.0 $0.0 Cash Flows from Investing +
Change in Other Liabilities $0 $0 $0 $0 $0 Cash Flows from Change in Term Loan +
Cash Flows from Operations $31.8 $33.7 $36.7 $40.0 $43.5
Changes in Unsecured Debt +
Cash Flows from Investing Beginning Cash Position) < 0,
Capital Expenditures ($8.8) ($9.3) ($9.7) ($10.2) ($10.7)
Asset Dispostions $0.0 $0.0 $0.0 $0.0 $0.0
-(Cash Flow from Operations +
Cash Flows from Investing ($8.8) ($9.3) ($9.7) ($10.2) ($10.7) Cash Flows from Investing +
Cash Flows from Change in Term Loan +
Cash Flows from Financing
Change in Revolver ($10.6) $0.0 $0.0 $0.0 $0.0 Changes in Unsecured Debt+
Change in Term Loan ($25.0) ($25.0) ($25.0) ($25.0) ($25.0) Beginning Cash Position),
Change in Unsecured Debt $0.0 $0.0 $0.0 $0.0 $0.0 -min (beginning revolver balance,
Total Cash Flows from Financing ($35.6) ($25.0) ($25.0) ($25.0) ($25.0)
(Cash Flow from Operations +
Total Cash Flow ($12.7) ($0.6) $2.0 $4.8 $7.8 Cash Flows from Investing +
Beginning Cash Position $58.1 $45.4 $44.8 $46.7 $51.5
Cash Flows from Change in Term Loan +
Change in Cash Position ($12.7) ($0.6) $2.0 $4.8 $7.8 Changes in Unsecured Debt+
Ending Cash Position $45.4 $44.8 $46.7 $51.5 $59.3 Beginning Cash Position))

Debt and Interest Schedule

Revolver
Beginning Revolver Balance $10.6 $0.0 $0.0 $0.0 $0.0
(Paydown) / Drawdown ($10.6) $0.0 $0.0 $0.0 $0.0
Ending Revolver Balance $0.0 $0.0 $0.0 $0.0 $0.0
Interest Rate 6.0% 6.3% 6.5% 6.8% 7.0%
Interest Expense $0.32 $0.00 $0.00 $0.00 $0.00

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 Revolver Modeling

ƒ Calculate the interest expense on the revolver as the interest

rate * average of beginning revolver balance and ending revolver
balance
ƒ Link the revolver balance back into the balance sheet, the
interest expense on the revolver back into the income statement,
and adjust the changes in revolver in the cash flow
ƒ Once the revolver has been properly modeled, the ending cash
balance should properly calculate in the cash flow, and this can
be linked into the cash balance in the balance sheet

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 Table of Contents

I. Introduction

II. Spreading Historical Financial Statements

III. Deriving Historic Ratios, Trends and Variables

IV. Financial Statement Projections

Integration of Financial Statement Projections / Revolver
V.
Modeling

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