Financial Management Part 2

ZLK
Financial Management
Part 2
GSBM
Confidential — SyCip Gorres Velayo & Co. 2019 USSC Status Meeting
Agenda
1 Forecasting
a.Features
b. Definition
c. Sources
d. Process
e. Approaches
f. Methods
2 Budgeting
a.Definition
b.Goals
c.Types
d. Discount Rate
e. WACC
f. Budgeting vs. Forecasting
3
Financial Modelling
a. Definition
b. Steps in preparation
c. Sections
d. Uses
e. Types
Confidential — SyCip Gorres Velayo & Co. Philippine Christian University-Graduate School of Business Management 2019 USSC Status Meeting
Topic 1:Forecasting
Forecasting
Definition
► Forecasting refers to the practice of predicting what
will happen in the future by taking into consideration
events in the past and present. Basically, it is a
decision-making tool that helps businesses cope
with the impact of the future’s uncertainty by
examining historical data and trends. It is a planning
tool that enables businesses to chart their next
moves and create budgets that will hopefully cover
whatever uncertainties may occur.(CFI)
► Forecasting is a technique that uses historical data
as inputs to make informed estimates that are
predictive in determining the direction of future
trends. Businesses utilize forecasting to determine
how to allocate their budgets or plan for anticipated
expenses for an upcoming period of time.
(Investopedia)
► Forecasting is the process of making predictions of
the future based on past and present data and most
commonly by analysis of trends.(Wikipedia)
Forecasting
Features
1. Involves future events- Forecasts are created to predict the future, making them important for planning.
2. Based on past and present events-Forecasts are based on opinions, intuition, guesses, as well as on facts,
figures, and other relevant data. All of the factors that go into creating a forecast reflect to some extent what
happened with the business in the past and what is considered likely to occur in the future.
3. Uses forecasting techniques- Most businesses use the quantitative method, particularly in planning and
budgeting.
Sources
1.Primary sources- Information from primary sources takes time to gather because it is first-hand information,
also considered the most reliable and trustworthy sort of information. The forecaster himself does the
collection, and may do so through things such as interviews, questionnaires, and focus groups.
2. Secondary sources- Secondary sources supply information that has been collected and published by other
entities. An example of this type of information might be industry reports. As this information has already been
compiled and analyzed, it makes the process quicker.
Forecasting
Process
Forecasters need to follow a careful process in order to yield accurate results. Here are some steps in
the process:
1. Develop the basis of forecasting
The first step in the process is developing the basis of the investigation of the company’s condition
and identifying where the business is currently positioned in the market.
2. Estimate the future operations of the business
Based on the investigation conducted during the first step, the second part of forecasting involves
estimating the future conditions of the industry where the business operates and projecting and analyzing how
the company will fare.
3. Regulate the forecast
This involves looking at different forecasts in the past and comparing them with the actual things that
happened with the business. The differences in previous results and current forecasts are analyzed, and the
reasons for the deviations are considered.
4. Review the process
Every step is checked, and refinements and modifications are made.
Forecasting
Approaches in Forecasting
► Top-down Approach: Top-down forecasting is a method of estimating a company’s future performance by
starting with high-level market data and working “down” to revenue. This approach starts with the big picture
and then narrows in on a specific company.
Forecasting
Steps in Top-down Approach:
Step 1 Identify Total Addressable Market (TAM)
A financial analyst begins the analysis by outlining the Total Addressable Market (TAM) for each
business segments. TAM is the total addressable market that refers to the total market demand for a product or
service. It is the most amount of revenue an industry or business can generate by selling the product. This is a
common place for starting a top-down analysis. How to calculate TAM.
Top-down is based on industry data, market reports, research studies.You may also consider hiring a market
research consulting firm.
Bottom-up is when you calculate for the annual contract value(ACV) and multiply by the total number of
customers.
Forecasting
Steps in Top-down Approach:
Step 2 Estimate Market Share

The next step is to estimate how much market share you believe the company will capture in the future.
Market share is the percentage of an industry's sales that a particular company owns. In other words, it's a
company's total sales in relation to the industry.Market share gives a company an idea of its revenue compared
to the overall industry and its competitors.
Step 3 Calculate Revenue

With the market share figures in place, we can calculate the company’s estimated revenue by
multiplying the TAM by the percentage (%) of market share. Depending on the level of detail in your financial
model, you may also wish to add other assumptions, such as the volume of order and the average prices of
products or services being sold.
Forecasting
Bottoms-Up Approach: Bottom-up forecasting is a method of estimating a company’s future performance by

starting with low-level company data and working “up” to revenue. This approach starts with detailed customer
or product information and then broadens up to revenue.
Forecasting
Steps in Buttoms Up Approach:
Step 1 Number of Orders (Sales Volume)

A financial analyst begins the analysis by outlining the total orders that will be placed for each of the
company’s business channels.
Step 2 Product/Service Prices

The next step is to estimate how much the company will charge customers for its products and/or
services.
Step 3 Revenue
With the volume of orders and average net sales prices in place, we can calculate the company’s
estimated revenue by multiplying the number of orders and the average price. Depending on the level of detail
in your financial model, you may also wish to add other assumptions, such as returns, refunds, exchanges and
other items that may net out.
Forecasting
Methods
Businesses choose between two basic methods when they want to predict what can possibly happen in
the future, namely, qualitative and quantitative methods.
1. Qualitative method
Otherwise known as the judgmental method, qualitative forecasting offers subjective results, as it is
comprised of personal judgments by experts or forecasters. Forecasts are often biased because they are
based on the expert’s knowledge, intuition, and experience, and rarely on data, making the process non-
mathematical.Qualitative forecasting techniques are subjective, based on the opinion and judgment of
consumers and experts; they are appropriate when past or historical data are not available.
2. Quantitative method
The quantitative method of forecasting is a mathematical process, making it consistent and objective. It
steers away from basing the results on opinion and intuition, instead utilizing large amounts of data and figures
that are interpreted.Quantitative forecasting models are used to forecast future data as a function of past data.
They are appropriate to use when past numerical data is available and when it is reasonable to assume that
some of the patterns in the data are expected to continue into the future.
Forecasting
Qualitative Methods
Forecasting
Qualitative Methods
Delphi Method
The Delphi method uses a variation of the consensus approach where a group of experts convene in a
room to discuss their views on a specific event or issue. However, the Delphi method removes the cult of
personality that often results when an expert with a strong personality overrides the others’ opinions. Instead of
meeting face to face, the experts fill out questionnaires and surveys separately. The analysis team reviews all
the answers and makes applicable changes to the review material. The team repeats this process three or four
times until a consensus forecast emerges.
Jury of Executive Opinion

The jury of executive opinion qualitative forecasting model relies on the opinions of high level
managers. Companies may incorporate statistical models to help with the analysis. The resulting group
estimate becomes the forecast. Small businesses may find this model easier to use because of its simplicity.
For example, an owner can convene all of the department managers or her advisory board members, share
industry or company statistics with the group, then request everyone's opinion. After some discussion the group
will typically arrive at a consensus estimate the owner can use for forecasting.
Forecasting
Qualitative Methods
Grassroots Forecasting
The grassroots forecasting method requires a sophisticated, knowledgeable sales force. It works best
in non-retail environments where sales people or account managers have deep customer relationships and
thoroughly understand their customer base. The grassroots method asks those closest to the end user to
determine what they will sell in the next accounting period, then sums all the values together to obtain an
overall forecast. This forecasting method may work well with certain customer relationship management or
sales management software tools.
Market Research
The market research method involves consulting with current or potential customers. Companies
conduct market research to obtain information to use to make accurate predictions about the size, scope,
demographics and buying habits of a particular product and service market or niche. Market research ranges
from consumer surveys to interviews to panels which all provide subjective, qualitative information. Many
consumer product companies use market research as their primary forecasting tool.
Forecasting
Quantitative Methods-Forecasting Sales
Forecasting
Forecasting
Forecasting
Forecasting
Forecasting
Forecasting
Forecasting
► Expense Forecasting
Expense Forecasting Using Revenue

Expense forecasting using the revenue forecast simply involves establishing a percentage
relationship between the revenue and the expense, and applying that percentage to the forecast revenue
used in the financial projections to estimate the expense.
The best example of this type of expense is the cost of sales. The cost of sales, is the total of the
expenses associated with producing and manufacturing the products which have been sold during the year. If
there are no sales during the year, then there will be no cost of sales. By its nature, cost of sales includes
variable expenses which vary in direct proportion to the level of sales activity.
Cost of sales is best estimated by taking a percentage of the sales revenue, as there is a direct link
between the two. If you double the revenue, then the cost of sales will double.
Example
If the revenue is 100,000 and the cost of sales percentage is 40%, the the cost of sales is 100,000 x 40% =
40,000. If the revenue doubles to 200,000, then the cost of sales will also double to 200,000 x 40% = 80,000.
This relationship will hold true so long as the cost of sales percentage remains the same.
Forecasting
Expense Forecasting Using Headcount

Headcount refers to the number of people employed by the business. With the headcount forecast in
place, expense forecasting techniques can be used to estimate a large number of individual expenses.
A major expense for any business is the payroll expense, the cost of wages and salaries for
employees. Using the headcount forecast and the estimated average wage for the type of employee, the
wage expense can be forecast. For example, if the headcount forecast shows the requirement for four sales
employees, and the average wage of a sales employee is 25,000, then the estimate wage expense is 4 x
25,000 = 100,000.
Having established the total wage and salary expense using the headcount forecst, other payroll
related costs such as bonuses, recruitment fees and payroll benefits and taxes can be forecast by applying a
percentage to the wage and salary expense.
Example
If the headcount forecast shows five people with an average wage of 20,000, then the wage expense
estimate is 5 x 20,000 = 100,000. If bonuses are 5% of wages and payroll benefits are 15% of wages, then
the financial projections can use the wages expense estimate to calculate expense estimates of 5% x
100,000 = 5,000 for bonuses, and 15% x 100,000 = 15,000 for payroll benefits.
Forecasting
Expense Forecasting Using Other Cost Drivers

Of course not all variable costs can be linked to revenue or headcount. However, depending on the
type of business, there are other variables referred to as cost drivers which can be established to allow
expenses to be forecast.
A cost driver is the direct cause of a cost and its effect is on the total cost incurred. For example, if
you are to determine the amount of electricity consumed in a particular period, the number of units consumed
determines the total bill for electricity. In such a scenario, the number of units of electricity consumed is a cost
driver.
Fixed Expense Forecasting

Finally there is the category of fixed expenses. Fixed expenses are expenses which will happen
whether or not a business has any production or sales activity. Fixed expenses are a function of the passage
of time and are sometimes referred to as periodic expenses for this reason.
For example, rent on a building is normally a fixed expense, if the level of sales or production activity
changes, the rent for the building will remain the same. By looking at rental prices in the area and the size
and type of property required, a best estimate can be obtained.
Topic 2: Budgeting
Budgeting
Definition
Budgeting is the tactical implementation of a
business plan. To achieve the goals in a business’s
strategic plan, we need a detailed descriptive roadmap
of the business plan that sets measures and indicators
of performance. We can then make changes along the
way.
Budgeting is the process of designing,
implementing and operating budgets. It is the
managerial process of budget planning and preparation,
budgetary control and the related procedures.
Budgeting is the highest level of accounting in terms of
future which indicates a definite course of action and not
merely reporting. to ensure that we arrive at the desired
goals.
Budgeting
Goals
Budgeting is a critical process for any business in several ways.
1. Aids in the planning of actual operations

The process gets managers to consider how conditions may change and what steps they need to take,
while also allowing managers to understand how to address problems when they arise.
2. Coordinates the activities of the organization
Budgeting encourages managers to build relationships with the other parts of the operation and
understand how the various departments and teams interact with each other and how they all support the
overall organization.
3. Communicating plans to various managers
Communicating plans to managers is an important social aspect of the process, which ensures that
everyone gets a clear understanding of how they support the organization. It encourages communication of
individual goals, plans, and initiatives, which all roll up together to support the growth of the business. It also
ensures appropriate individuals are made accountable for implementing the budget.
4. Motivates managers to strive to achieve the budget goals
Budgeting gets managers to focus on participation in the budget process. It provides a challenge or
target for individuals and managers by linking their compensation and performance relative to the budget.
Budgeting
Goals
5. Control activities
Managers can compare actual spending with the budget to control financial activities.(Variance
Analysis)
6. Evaluate the performance of managers
Budgeting provides a means of informing managers of how well they are performing in meeting targets
they have set.Budgeting is the tactical implementation of a business plan. To achieve the goals in a business’s
strategic plan, we need a detailed descriptive roadmap of the business plan that sets measures and indicators
of performance. We can then make changes along the way.(flexible)
Budgeting
Types
A robust budget framework is built around a master budget consisting of operating budgets, capital
expenditure budgets, and cash budgets. The combined budgets generate a budgeted income statement,
balance sheet, and cash flow statement.
Budgeting
Operating budget
Revenues and associated expenses in day-to-day operations are budgeted in detail and are divided
into major categories such as revenues, cost of sales/services, salaries related expenses and other expenses.
The main components of an operations budget are outlined below. Each business is unique but these
items are general enough to apply to most industries.
1. Revenue
Revenue is usually broken down into its drivers and components. It’s possible to compute for revenue budget
on a year-over-year basis, but usually, more detail is required by breaking revenue down into its underlying
components.
Revenue drivers typically includes:
Volume (units, contracts, customers, products, etc.)

Price (average price, per unit price, segment price, etc.)
Budgeting
Operating budget
2. Variable costs
After revenue, variable costs are determined. These costs are called “variable” because they depend on
revenue, and are often calculated as a percentage of sales.
Variable costs often includes:
Cost of goods sold
Direct selling costs(Sales commissions)
Freight
Certain aspects marketing
Direct labor
Budgeting
Operating budget
3. Fixed costs
After variable costs are deducted, fixed costs are usually next. These expenses typically do not vary with
changes in revenue and are mostly constant, at least within the time frame of the operating budget.
Examples of fixed costs include:

Rent
Insurance
Telecommunication
Management salaries and benefits
4. Non-cash expenses
An operating budget often includes non-cash expenses, such as depreciation and amortization. Even though
these expenses don’t impact cash flow (other than taxes), they will impact financial reporting performance (i.e
the figures a company reports at the end of the year on their income statement).
Budgeting
Operating budget
5. Non-operating expenses
Non-operating expenses are those that fall below Earnings Before Interest and Taxes (EBIT) or Operating
Income.
Examples of expenses that may be included in a budget are:
Interest
Gains or Losses
Taxes
Budgeting
Cash budget
A cash budget is an estimation of the cash flows for a business over
a specific period of time. Cash budgets tie the other two budgets together and
take into account the timing of payments and the timing of receipt of cash
from revenues.
A cash budget is a budget or plan of expected cash receipts and
disbursements during the period. These cash inflows and outflows include
revenues collected, expenses paid, and loans receipts and payments. In other
words, a cash budget is an estimated projection of the company's cash
position in the future.
Cash budgets tie the other two budgets together and take into
account the timing of payments and the timing of receipt of cash from
revenues. Cash budgets help management track and manage the company’s
cash flow effectively by assessing whether additional capital is required,
whether the company needs to raise money, or if there is excess capital.
The cash budget allows management to forecast large amounts of
cash. Having large amounts of cash sitting idle in bank accounts is not ideal
for companies. At the very least, this money should be invested to earn a
reasonable amount of interest. In most cases, excess cash is better used to
expand and develop new operations than sit idle in company accounts. The
cash budget allows management to predict cash levels and adjust them as
needed.
Budgeting
Cash budget
Cash Budget Problem
ABC Clothing manufactures shoes, and it estimates $300,000 in sales for the months of June, July, and
August. At a retail price of $60 per pair, the company estimates sales of 5,000 pairs of shoes each month. ABC
forecasts that 80% of the cash from these sales will be collected in the month following the sale and the other
20% will be collected two months after the sale. The beginning cash balance for July is forecast to be $20,000,
and the cash budget assumes 80% of the June sales will be collected in July, which equals $240,000 (80% of
$300,000). ABC also projects $100,000 in cash inflows from sales made earlier in the year.
On the expense side, ABC also must calculate the production costs required to produce the shoes and
meet customer demand. The company expects 1,000 pairs of shoes to be in beginning inventory, which means
a minimum of 4,000 pairs must be produced in July. If the production cost is $50 per pair, ABC spends $200,000
($50 x 4,000) in the month of July on the cost of goods sold, which is the manufacturing cost. The company also
expects to pay $60,000 in costs not directly related to production, such as insurance.
How much is the ending cash balance for the month of July?
Budgeting
Answer: $100,000
Explanation:
ABC computes the cash inflows by adding the receivables collected during July to the beginning
balance, which is $360,000 ($20,000 July beginning balance + $240,000 in June sales collected in July +
$100,000 in cash inflows from earlier sales). The company then subtracts the cash needed to pay for production
and other expenses. That total is $260,000 ($200,000 in cost of goods sold + $60,000 in other costs). ABC’s
July ending cash balance is $100,000, or $360,000 in cash inflows minus $260,000 in cash outflows.
Budgeting
Capital budget
Capital budgets are typically requests for purchases
of large assets such as property, equipment, or IT systems
that create major demands on an organization’s cash flow.
The purposes of capital budgets are to allocate funds, control
risks in decision-making, and set priorities.
Capital budgeting is the process that a business uses
to determine which proposed fixed asset purchases it should
accept, and which should be declined. This process is used
to create a quantitative view of each proposed fixed asset
investment, thereby giving a rational basis for making a
judgment.
Capital budgeting involves choosing projects that add
value to a company. The capital budgeting process can
involve almost anything including acquiring land or
purchasing fixed assets like a new truck or machinery.
Budgeting
Methods in Capital Budgeting
Payback Period Method
The payback period calculates the length of time required to recoup the original investment. For
example, if a capital budgeting project requires an initial cash outlay of $1 million, the PB reveals how many
years are required for the cash inflows to equate to the one million dollar outflow. A short PB period is preferred
as it indicates that the project would "pay for itself" within a smaller time frame.Payback periods are typically
used when liquidity presents a major concern. If a company only has a limited amount of funds, they might be
able to only undertake one major project at a time. Therefore, management will heavily focus on recovering
their initial investment in order to undertake subsequent projects.Another major advantage of using the PB is
that it is easy to calculate once the cash flow forecasts have been established.
In the following example, the PB period would be three and one-third of a year, or three years and four
months.
Budgeting
Internal Rate of Return
The internal rate of return (or expected return on
a project) is the discount rate that would result in a net
present value of zero. Since the NPV of a project is
inversely correlated with the discount rate—if the
discount rate increases then future cash flows become
more uncertain and thus become worth less in value—
the benchmark for IRR calculations is the actual rate
used by the firm to discount after-tax cash flows.
An IRR which is higher than the weighted
average cost of capital suggests that the capital project is
a profitable endeavor and vice versa.
The IRR rule is as follows:
IRR > Cost of Capital = Accept Project
IRR < Cost of Capital = Reject Project
In the example below, the IRR is 15%. If the
firm's actual discount rate that they use for discounted
cash flow models is less than 15% the project should be
accepted.
Budgeting
Net Present Value
The net present value approach is the most intuitive and accurate valuation approach to capital
budgeting problems. Discounting the after-tax cash flows by the weighted average cost of capital allows
managers to determine whether a project will be profitable or not. And unlike the IRR method, NPVs reveal
exactly how profitable a project will be in comparison to alternatives.
The NPV rule states that all projects with a positive net present value should be accepted while those
that are negative should be rejected. If funds are limited and all positive NPV projects cannot be initiated, those
with the high discounted value should be accepted.
Some of the major advantages of the NPV approach include its overall usefulness and that the NPV
provides a direct measure of added profitability. It allows one to compare multiple mutually exclusive projects
simultaneously, and even though the discount rate is subject to change, a sensitivity analysis of the NPV can
typically signal any overwhelming potential future concerns.
Budgeting
Capital budget
In the two examples below, assuming a discount rate of 10%, project A and project B have respective
NPVs of $126,000 and $1,200,000. These results signal that both capital budgeting projects would increase the
value of the firm, but if the company only has $1 million to invest at the moment, project B is superior.
Budgeting
Discount Rate
In corporate finance, there are only a few types of discount rates that are used to discount future cash
flows back to the present. They include:
Weighted Average Cost of Capital (WACC) – for calculating the enterprise value of a firm
Cost of Equity – Cost of Equity is the rate of return a company pays out to equity investors. A firm uses cost of
equity to assess the relative attractiveness of investments, including both internal projects and external
acquisition opportunities. Companies typically use a combination of equity and debt financing, with equity
capital being more expensive.
Cost of Debt – The cost of debt is the return that a company provides to its debtholders and creditors. These
capital providers need to be compensated for any risk exposure that comes with lending to a company. Since
observable interest rates play a big role in quantifying the cost of debt, it is relatively more straightforward to
calculate the cost of debt than the cost of equity. Not only does the cost of debt reflect the default risk of a
company; it also reflects the level of interest rates in the market.
A pre-defined hurdle rate – for investing in internal corporate projects
Risk-Free Rate – risk-free rate of return is the interest rate an investor can expect to earn on an investment that
carries zero risk. In practice, the risk-free rate is commonly considered to equal to the interest paid on a 3-
month government Treasury bill, generally the safest investment an investor can make.
Budgeting
Weigthed Average Cost of Capital(WACC)
A firm’s Weighted Average Cost of Capital (WACC) represents its blended cost of capital across all
sources, including common shares, preferred shares, and debt. The cost of each type of capital is weighted by
its percentage of total capital and they are added together.
The weighted average cost of capital (WACC) is a financial ratio that calculates a company’s cost of
financing and acquiring assets by comparing the debt and equity structure of the business. In other words, it
measures the weight of debt and the true cost of borrowing money or raising funds through equity to finance
new capital purchases and expansions based on the company’s current level of debt and equity structure.
A firm’s Weighted Average Cost of Capital (WACC) represents the required rate of return expected by
its investors.
Formula:
Budgeting
Weigthed Average Cost of Capital(WACC)
WACC Problem
Budgeting
Answer
A Corporation B Corporation
► Using the formula, the WACC for A Corporation is 12.99% while the WACC for B Corporation is 12.36% Based
on these numbers, both companies are nearly equal to one another, but because B Corporation has a higher
market capitalization, their WACC is lower (presenting a potentially better investment opportunity than A
Corporation).
Budgeting vs Forecasting
Budgeting vs. Forecasting
One thing that is definitely true is that budgeting and forecasting are both tools that help businesses plan for
their future. However, the two are distinctly different in many ways. Let’s consider the following points:
Budgeting involves creating a statement that consists of numerous financial activities of a company for a
specific period, such as projected revenue, expenses, cash flow, and investments. It is usually not conducted
solely by one department, say, the finance department, because it requires input from other departments in
order to come up with a holistic and detailed report. Therefore, the budgeting process takes time to complete.
The company uses the budget to guide it in its financial activities.
While budgets are usually made for an entire year, forecasts are usually updated monthly or quarterly. Through
forecasting, a company is able to adjust its budget and allocate more funds to a department, as needed,
depending on what is foreseen. In summary, budgets depend on the forecast.
In essence, a budget is a quantified expectation for what a business wants to achieve. Conversely, a forecast is
an estimate of what will actually be achieved
Topic 3: Financial Modelling
Financial Modelling
Definition
► the word financial modelling refers to complex mathematical calculations.
► Financial models, therefore, refer to the creation of abstract representations of a company’s financial
statements. The idea behind the creation of these models is that decision-makers can simulate their
decisions and finally see the impact on the company’s finances.
► A financial model allows a company to simulate their revenues and expenses under various situations. This is
the reason why financial models are extensively used when companies are about to make big decisions like
launching a new product line, entering a new market, or acquiring a competitor.
► financial modeling refers to a wide variety of tasks and methods which are used for planning by companies
depending upon their own capabilities and financial position. It would also be fair to say that financial
modeling is the cornerstone of diligent decision making and hence, is extensively used by businesses today.
► A financial model is simply a tool that’s built in spreadsheet software such as MS Excel to forecast a
business’ financial performance into the future. The forecast is typically based on the company’s historical
performance, assumptions about the future, and requires preparing an income statement, balance sheet,
cash flow statement, and supporting schedules (known as a 3 statement model).
Financial Modelling
Steps in preparing financial model

1. Historical results and assumptions
Every financial model starts with a company’s historical results. You begin building the financial model
by pulling three years of financial statements and inputting them into Excel. Next, you reverse engineer the
assumptions for the historical period by calculating things like revenue growth rate, gross margins, variable
costs, fixed costs, to name a few. From there you can fill in the assumptions for the forecast period as hard-
codes.
2. Start the income statement
With the forecast assumptions in place, you can calculate the top of the income statement with
revenue, COGS, gross profit, and operating expenses down to EBITDA. You will have to wait to calculate
depreciation, amortization, interest, and taxes.
3. Start the balance sheet
With the top of the income statement in place, you can start to fill in the balance sheet. Begin by
calculating accounts receivable and inventory, which are both functions of revenue and COGS, as well as the
AR and inventory assumptions. Next, fill in accounts payable, which is a function of COGS and AP
assumptions.
Financial Modelling
4. Build the supporting schedules
Before completing the income statement and balance sheet, you have to create a schedule for capital
assets like Property, Plant & Equipment (PP&E), as well as for debt and interest. The PP&E schedule will pull
from the historical period and add capital expenditures and subtract depreciation. The debt schedule will also
pull from the historical period and add increases in debt and subtract repayments. Interest will be based on the
average debt balance.
5. Complete the income statement and balance sheet
The information from the supporting schedules completes the income statement and balance sheet. On
the income statement, link depreciation to the PP&E schedule and interest to the debt schedule. From there,
you can calculate earnings before tax, taxes, and net income. On the balance sheet, link the closing PP&E
balance and closing debt balance from the schedules. Shareholder’s equity can be completed by pulling
forward last year’s closing balance, adding net income and capital raised, and subtracting dividends or shares
repurchased.
6. Build the cash flow statement
With the income statement and balance sheet complete, you can build the cash flow statement with the
reconciliation method. Start with net income, add back depreciation, and adjust for changes in non-cash
working capital, which results in cash from operations. Cash used in investing is a function of capital
expenditures in the PP&E schedule, and cash from financing is a function of the assumptions that were laid out
about raising debt and equity.
Financial Modelling
7. Perform the DCF analysis
When the 3 statement model is completed, it’s time to calculate free cash flow and perform the business valuation.
The free cash flow of the business is discounted back to today at the firm’s cost of capital (its opportunity cost or required
rate of return). We offer a full suite of courses that teach all of the above steps with examples, templates, and step-by-step
instruction. Read more about how to build a DCF model.
8. Add sensitivity analysis and scenarios
Once the DCF analysis and valuation sections are complete, it’s time to incorporate sensitivity analysis and
scenarios into the model. The point of this analysis is to determine how much the value of the company (or some other
metric) will be impacted by changes in underlying assumptions. This is very useful for assessing the risk of an investment or
for business planning purposes (e.g., does the company need to raise money if sales volume drops by x percent?).
9. Build charts and graphs
Clear communication of results is something that really separates great from merely good financial analysts. The
most effective way to show the results of a financial model is through charts and graphs, which we cover in detail in our
advanced Excel course, as well as many of the individual financial modeling courses. Most executives don’t have the time or
patience to look at the inner workings of the model, so charts are much more effective.
10. Stress test and audit the model
When the model is done, your work is not over. Next, it’s time to start stress-testing extreme scenarios to see if the
model behaves as expected. It’s also important to use the auditing tools covered in our financial modeling fundamentals
course to make sure it’s accurate and the Excel formulas are all working properly
Financial Modelling
Sections of a Financial Model
The main sections to include in a financial model (from top to bottom) are:
1. Assumptions and drivers

2. Income statement
3. Balance sheet
4. Cash flow statement
5. Supporting schedules
6. Valuation
7. Sensitivity analysis
8. Charts and graphs
Financial Modelling
Uses of Financial Model
The output of a financial model is used for decision making and performing financial analysis, whether
inside or outside of the company. Inside a company, executives will use financial models to make decisions
about:
1. Raising capital (debt and/or equity)

2. Making acquisitions (businesses and/or assets)
3. Growing the business organically (e.g., opening new stores, entering new markets, etc.)
4. Selling or divesting assets and business units
5. Budgeting and forecasting (planning for the years ahead)
6. Capital allocation (priority of which projects to invest in)
7. Valuing a business
8. Financial statement analysis/ratio analysis
9. Management accounting
Financial Modelling
Types of Financial Model
1.Three Statement Model

The 3 statement model is the most basic setup for financial modeling. As the name implies, in this
model the three statements (income statement, balance sheet, and cash flow) are all dynamically linked with
formulas in Excel. The objective is to set it up so all the accounts are connected and a set of assumptions can
drive changes in the entire model. It’s important to know how to link the 3 financial statements, which requires a
solid foundation of accounting, finance, and excel skills.
2. Discounted Cash Flow (DCF) Model

The DCF model builds on the 3 statement model to value a company based on the Net Present Value
(NPV) of the business’ future cash flow. The DCF model takes the cash flows from the 3 statement model,
makes some adjustments where necessary, and then uses the XNPV function in Excel to discount them back to
today at the company’s Weighted Average Cost of Capital (WACC).
These types of financial models are used in equity research and other areas of the capital markets.
Financial Modelling
Steps to build Three Statement Model
There are several steps required to build a three statement model, including:
1. Input historical financial information into Excel

2. Determine the assumptions that will drive the forecast
3. Forecast the income statement
4. Forecast capital assets
5. Forecast financing activity
6. Forecast the balance sheet
7. Complete the cash flow statement
Financial Modelling
Three Statement Model
Financial Modelling
Advantages of Financial Modelling
Some of the major advantages of using financial models are as follows:
Better Understanding of the Business: Developing a financial model requires an intricate understanding of the business.
The process of model creation forces the business to think about and list down the drivers which impact the various aspects
of the business. The process also forces the business to think about the various changes that may happen internally as well
as in the external environment. Hence, it would be fair to say that companies which create financial models are somehow
forced to do more due diligence as compared to their counterparts. This creates a better understanding of the business.
Creation of financial models, therefore, has a spillover effect which leads to a better understanding of the underlying
business.
Helps Decide on a Funding Strategy: When companies develop financial models, they are able to clearly understand what
their cash flow situation will be. The cash flow requirements that the company would face as well as the ability to borrow and
make interest payments can be easily ascertained. This helps the company choose an appropriate funding strategy. For
instance, start-up firms have uncertain revenues. However, their expenses are more or less fixed. Using financial modeling,
they can decide on the amount of money that they need to have on hand in order to ensure that they survive till the revenues
start flowing in. Therefore, start companies are able to ascertain the amount of equity stake they should sell so as to reach
the next milestone.
Helps Reach the Correct Valuation: Financial modeling allows companies to understand their true worth. In the absence of
modeling, the worth of a company is decided by using discounted cash flow models. Some of these models assume linear
relationships between revenues and expenses, which are just not true. Financial models make it possible to ascertain the
exact amount of free cash flow that will accrue to the firm at different points in time. This helps companies to know their exact
worth when they are selling out their stakes to third party investors such as investment bankers and private equity funds.
Financial Modelling
Disadvantages of Financial Modelling
The process of financial modeling is riddled with disadvantages as well. Some of the important ones have been
listed below.
Time-Consuming: Firstly, it is important to understand that financial modeling is a time-consuming exercise. This is because
creating a financial model is a project which requires several tasks to be done. The data needs to collected, the underlying
factors have to be identified, and the model needs to be tested for financial as well as technical irregularities. This model
then needs to be made intuitive and user-friendly. Needless to say, all this costs a lot of time and money. Many companies,
particularly smaller ones, may not have the resources to spare for this exercise. Hence, in many cases, financial models
have very limited applicability.
Inaccurate: In many cases, financial models have proven to be woefully inadequate. The subprime mortgage crisis of 2008
is widely quoted while trying to explain this point. However, it needs to be understood that inaccuracy is built into the model
itself. Nobody has the knowledge required to predict factors such as interest rates, tax rates, and market shares with utmost
precision. If a person did have such an ability, they would make a killing by trading in the stocks and derivatives market and
would not need to create financial models! Therefore, the numbers provided by the financial model need to be taken with a
pinch of salt. If numbers are being projected far into the future, then one can be almost certain that these numbers will not be
met.
Soft Factors Not Considered: Lastly, many mergers have failed because of soft factors such as difficulties integrating the
culture of the two acquired companies. It is impossible to build such factors into financial models. On the one hand, models
take into account synergies which will be created by reducing expenses as a result of the merger. However, on the other
hand, they do not take into account the expenses which will arise due to lack of cultural compatibility. This leads to an
overvaluation of assets in the long run. Many mergers have failed in the past even though the financial models had predicted
that these models would be successful.
Financial Modelling
Understanding the Discounted Cash Flow Model(DCF Model)
A DCF model is a specific type of financial model used to value a business. DCF stands for Discounted
Cash Flow, so a DCF model is simply a forecast of a company’s unlevered free cash flow discounted back to
today’s value, which is called the Net Present Value (NPV).
Unlevered Free Cash Flow (also called Free Cash Flow to the Firm) – is cash that’s available to both
debt and equity investors.
The terminal value is a very important part of a DCF model. It often makes up more than 50% of the net
present value of the business, especially if the forecast period is five years or less. There are two ways to
calculate the terminal value: the perpetual growth rate approach and the exit multiple approach.
When building a DCF model using unlevered free cash flow, the NPV that you arrive at is always the
enterprise value (EV) of the business. This is what you need if you’re looking to value the entire business or
compare it with other companies without taking into account their capital structures (i.e., an apples-to-apples
comparison)
Financial Modelling
Exit Multiple Method (Explained)
► If investors assume a finite window of operations, there is no need to use the perpetuity growth model.
Instead, the terminal value must reflect the net realizable value of a company's assets at that time. This often
implies that the equity will be acquired by a larger firm, and the value of acquisitions are often calculated with
exit multiples.
► Exit multiples estimate a fair price by multiplying financial statistics, such as sales, profits, or earnings before
interest, taxes, depreciation, and amortization (EBITDA) by a factor that is common for similar firms that were
recently acquired. The terminal value formula using the exit multiple method is the most recent metric (i.e.
sales, EBITDA, etc.) multiplied by the decided upon multiple (usually an average of recent exit multiples for
other transactions). Investment banks often employ this valuation method, but some detractors hesitate to
use intrinsic and relative valuation techniques simultaneously.
► The exit multiple model for calculating terminal value of a company's cash flows estimates cash flows by
using a multiple of earnings. Sometimes equity multiples such as the price-to-earnings (P/E) ratio are used to
calculate terminal value. A commonly used approach is to use a multiple of earnings before interest and
taxes (EBIT) or earnings before interest, taxes, depreciation and amortization (EBITDA). For example, if
companies in the same sector as the company being analyzed are trading at, on average, 5 times EBIT/EV,
then the terminal value is calculated as 5 times the company's average EBIT over the initial forecast period.
Financial Modelling
DCF Model Illustration
Additional Information:
EBITDA is 6,258,560 in 2022 and assumes an EV/EBITDA of 8.0X
Financial Modelling
Financial Model-Sensitivity Analysis
A sensitivity analysis determines how different values of an independent variable affect a particular
dependent variable under a given set of assumptions. In other words, sensitivity analyses study how various
sources of uncertainty in a mathematical model contribute to the model's overall uncertainty. This technique is
used within specific boundaries that depend on one or more input variables.
Sensitivity analysis is used in the business world and in the field of economics. It is commonly used by
financial analysts and economists, and is also known as a what-if analysis.
Example of Sensitivity Analysis

Assume Sue is a sales manager who wants to understand the impact of customer traffic on total sales. She
determines that sales are a function of price and transaction volume. The price of a widget is $1,000, and Sue
sold 100 last year for total sales of $100,000. Sue also determines that a 10% increase in customer traffic
increases transaction volume by 5%. This allows her to build a financial model and sensitivity analysis around
this equation based on what-if statements.
It can tell her what happens to sales if customer traffic increases by 10%, 50%, or 100%. Based on 100
transactions today, a 10%, 50%, or 100% increase in customer traffic equates to an increase in transactions by
5%, 25%, or 50% respectively. The sensitivity analysis demonstrates that sales are highly sensitive to changes
in customer traffic.
THANK YOU
Confidential — SyCip Gorres Velayo & Co. 2019 USSC Status Meeting

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ZLK

Step 2 Estimate Market Share

Step 3 Calculate Revenue

Bottoms-Up Approach: Bottom-up forecasting is a method of estimating a company’s future performance by

Step 1 Number of Orders (Sales Volume)

Step 2 Product/Service Prices

Jury of Executive Opinion

Quantitative Methods-Forecasting Sales

Expense Forecasting Using Revenue

Expense Forecasting Using Headcount

Expense Forecasting Using Other Cost Drivers

Fixed Expense Forecasting

1. Aids in the planning of actual operations

Volume (units, contracts, customers, products, etc.)

Examples of fixed costs include:

Budgeting vs. Forecasting

Steps in preparing financial model

1. Assumptions and drivers

1. Raising capital (debt and/or equity)

1.Three Statement Model

2. Discounted Cash Flow (DCF) Model

1. Input historical financial information into Excel

Understanding the Discounted Cash Flow Model(DCF Model)

DCF Model Illustration

Example of Sensitivity Analysis

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