FINANCIAL MODELING

BA 584

January 30, 2017

Mustafa N. Gltekin
Agenda
Q&A
Survival Accounting for Financial Modeling
Income Statement
Balance Sheet
Cash Flow Statements
Regulatory Filings
Introduction to Financial Statement Analysis
Next:
Financial Statement Analysis Wrap-up
Complete the Analysis and Answer the Questions in Assessing a Firms Future Financial
Health Before Class

Case discussion - O.M. Scott & Sons Company

Assignment 1 Due

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Steps in Building A Financial Model
Accounting: Language of Business
Financial Statement Analysis

SURVIVAL ACCOUNTING FOR

FINANCIAL MODELING

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Steps in Building the Financial Model: Overview
Projections is the most important feature of a
financial model
Its a blend of skills
Economy
Industry
Firm
Management
Environment

Historical financial performance of the company is a
starting point
Must know how to read Financial Statements

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Accounting: The Language of Business
It is a standard set of rules for
measuring firms financial
performance
Generally Accepted Accounting
Principles (GAAP)
SEC authorizes FASB to
determine U.S. accounting rules
GAAP vary across different
countries
There is unprecedented
convergence of international
accounting standards
All European companies report
under IFRS since the end of
2005

Daddy doesn't know any magic tricks. Daddy knows accounting tricks.
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Gathering Historical Information
10Ks and 10Qs should be read carefully
They include financial statements and management
commentary
10Ks are more detailed
Company-specific and industry information
Details of stock options, debt schedules
Financial footnotes must be reviewed carefully
Forward looking management discussion which may shed some
light
One of the best sources to gain a sense of the business

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Basic Accounting Principles
Assumptions
1. Accounting Entity
A company is considered a separate living enterprise
2. Going Concern
A company is considered a viable and a going concern for a
foreseeable future
3. Measurement
Financial statements show only quantifiable activities they are
reported in the national monetary unit
4. Periodicity
A continuous life of an entity can be divided into measured
periods of time
U.S.: Quarterly (10-Q) and Annual (10-K) financial reports
Fiscal year may not mach the calendar year
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Basic Accounting Principles
Principles
1. Historical Cost
Financial statements report companies resources at an initial historical
cost. (Book Value vs. Market Value)
Avoids management discretion and subjectivity in determining fair value
2. Accrual Accounting: Revenue Recognition
Revenues must be recorded when earned and measurable
3. Accrual Accounting: Matching Principle
Costs of a product must be recorded during the same period as
revenue from selling it
4. Full Disclosure
Companies must reveal all relevant economic information determined to
make a difference to its users by;
Financial statements
Notes to financial statements
Supplementary information

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Basic Accounting Principles
Constraints
1. Estimates and Judgments
Certain measurements cannot be performed completely
accurately, and must utilize conservative estimates and
judgments
2. Materiality
Inclusion of certain financial transaction in financial statements
hinges on their size and that of a company performing them
3. Consistency
For each company, preparation of financial statements must
utilize measurement techniques and assumptions which are
consistent from one reporting period to another
4. Conservatism
Assets and revenues should not be overstated while liabilities
and expenses should not be understated

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Financial Reporting Overview
The laws and rules that govern the securities industry in the United Sates derive from a simple and
straightforward concept; all investors, whether large institutions or private individuals should have access
to certain basic facts about an investment prior to buying it.
To achieve this, the SEC requires public companies to disclose meaningful financial and other information to
the public, which provides a common pool of knowledge for all investors to use to judge themselves if a
companys securities are a good investment.
Only through a steady flow of timely, comprehensive and accurate information can people make a sound
investment decisions.
Securities and Exchange Commission
Form 10-K (annual Filing)
Filed at the end of each fiscal year. It includes a thorough overview of
their businesses and finances as well their financial statements
Used be 90 days after the close of companies fiscal year. Shortened to
75 days as of December 2004 and to 60 days starting 12/15/05
Annual Report vs. 10-K
Annual report is not required
Companies have a considerable freedom in the structure and contents
of an annual report
Annual report may contain details not reported elsewhere but, the 10-K
presents a more detailed and unfettered picture of the companys
operations

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Financial Reporting Overview
Form 10-Q (Quarterly Filing)
Filed at the end of each quarter (for the first three
quarters) of the fiscal year. It includes financial
statements and non-financial data
Used to be due 45 days after the close of companies
fiscal year. Shortened to 40 days as of December 2004
and to 35 days starting 12/15/05
10-K vs. 10-Q
10-K reports are reviewed by an independent auditor
10-Ks are more detailed Company and Industry
information, stock options, detailed debt schedules, and
detailed financial footnotes
10-Ks include extensive management commentary and
include forward guidance
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Reading the Annual Report
Annual reports follow a fairly common structure:
Letter to Stockholders
Financial Highlights
Managements Discussion & Analysis (MD&A)
Financial Statements
Report of Managements Responsibilities
Risk Factors
Legal Proceedings
Report of Independent Auditors
Directors & Officers

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Structure of Annual Report
Letter to Stockholders
Written by top company officer(s)
Summarizes major achievements during the year and highlights of strategic
initiatives taking place
Financial Highlights
Key financial statistics for a companys most recent 2-10 fiscal year period
Managements Discussion and Analysis
Its rich in content:
1. An overview of the companys operations usually segment by segment
2. Selected financial data for the completed year
3. Projections and expectations for the following year
4. Important accounting policy changes
MD&A section provides detailed information that should be reviewed
carefully

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Structure of Annual Report
Financial Statements
Financial statements, along with the accompanying
footnotes is the hearth of an annual report

Source to analyze a companys financial performance

and health:

1. Consolidated Income Statement

2. Consolidated Balance Sheet
3. Consolidated Statement of Cash Flows
4. Consolidated statements of Stockholders Equity

Consolidated means that these financial reports contain

financial information of all businesses majority-owned
by a parent company
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Notes to Consolidated Statements
Supplemental information. Considered an integral part of
the financial report. They must be read as thoroughly as
the financial statements!
1. Summary of Accounting policies
Provides an overview of major GAAP used by company in the
preparation of its financial statements
2. Explanatory Notes
Detailed overview on a number of supplementary financial metrics:
Fixed assets
Stock options
Financing and debt
Leases
Shareholders equity
Taxes
Employee benefit plans
3. Supplementary Information Notes
Provide additional details about companys operations:
A listing of reserves for an oil & gas company
Breakdown of unit sales by product line

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Structure of Annual Report
Report of Managements Responsibilities
Three responsibilities of management include:
1. Preparing the companys financial statements and
reports
2. Being responsible for the companys internal financing
and controls
3. Allowing company directors and independent auditors to
carry out their respective roles in assuring the accuracy
of the companys financial statements

Risk Factors
Consists of legal boilerplate material covering both
industry- and company-specific risks
A close look could yield important red flags
Gives insights to industry dynamics
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Legal Proceedings
Highlights key legal proceedings (lawsuits) facing
the company
Almost every corporation faces a number of
lawsuits. You should not be alarmed to find this
section in an annual report and in 10-K
Take a close look at these legal proceedings they
may yield important information about the scope of
the lawsuits and the monetary damages being
sought against the company

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Report of Independent Auditors
Financial information is independently verified by a CPA
and typically consists of three (sometimes four)
paragraphs:
1. Indicates that this annual report has been audited and distinguishes
between the respective responsibilities of the company
management and the auditing firm
2. Indicates that auditors examination was performed in accordance
with GAAP (Scope section)
3. Describes the results of auditors examination i.e. auditors opinion
that financial statements have been prepared in accordance with
GAAP (Opinion section)
4. Discusses any accounting methods that have not been consistent
across different periods
Recently an additional audit report on Internal Control Over
Financial Reporting is issued
Its usually consists of six to seven paragraphs
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SEC Filings
Classification Form Variations Definition
Type
10-K Filings 10-K 10-K is an annual report which provides a comprehensive
overview of the company for the past year. The filing is due 90
days after the close of the company's fiscal year, and contains
such information as company history, organization, nature of
business, equity, holdings, earnings per share, subsidiaries, and
other pertinent financial information.
10-K/A Amendment to a 10-K that was filed previously.

10-Q Filings 10-Q A quarterly report which includes unaudited financial statements
and provides a continuing view of the company's financial
position during the year. The report must be filed for each of the
first three fiscal quarters of the company's fiscal year and is due
within 45- days of the close of the quarter. No filing is due for the
fourth quarter.

10-Q/A Amendment to a 10-Q that was filed previously.

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SEC Filings
Classification Form Variations Definition
Type
Proxies 114A PRE 14A 14A is notification to shareholders of matters to be brought
before shareholders meeting. It solicits proxy.
14C PRE 14C 14C is notification to shareholders of matters to be brought
before shareholders meeting, but does not solicit proxy.
Material Events 8-K 6-K An 8-K must be filed to report material events or changes
6-K/A deemed of importance to the shareholders or SEC. (6-K
8-K sometimes filed by foreign companies not required to file 8-K.)
8-K/A
Tender Offers / 13-D SC 13-D A 13-D by must be filed by 5%-or-more equity owners within 10
Acquisition days of acquisition.
Reports
14D-1 SC 14D-1 14D-1 is submitted to the SEC at the same time as tender offer is
made to holders of the equity securities of the target company.
13G SC 13G 13-G must be filed by reporting persons (mainly institutions) with
more than 5% ownership within 45 days after the end of the
calendar year.
14F-1 SC 14F-1 Statement re change in majority of directors pursuant to Rule
14f-1.

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SEC Filings
Classification Form Variations Definition
Type
Registrations S-1 S-1 S-1 registration filed by a company when it decides to go "public"
(offering) and sell securities. Known as an IPO (Initial Public Offering).
S-2 S-2 S-2 filed to register a securities offering by companies meeting
certain reporting requirements.
S-3 S-3 S-3 filed to register a securities offering by companies meeting
certain reporting requirements and also certain requirements
related to voting stock.
S-4 S-4 S-4 filed to register a securities offering in certain business
combinations or reorganization.
S-11 S-11 Filed by real estate companies, mostly limited partnership and
investment trusts.
Registrations Form 10-12B 10-12B and 10-12B/A are general registration filings of securities
(Trading) 10 pursuant to section 12(b) of the SEC Act.
8-A 8-A12B Filing used to register additional securities or classes of securities.

8-B 8-B12B Used by successor issues -- generally companies that have

changed their name or state of incorporation -- as notification that
previously registered securities are to be traded under a new
corporate identity.
20F 20-F Registration/annual report filed by certain foreign issuers of
securities trading in the U.S.

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SEC Filings

Classification Form Type Variations Definition

Prospectuses Prospectuses 424A When the sale of securities is proposed in an offering

registration statement, changes required by the SEC
are incorporated into the Prospectus.
Other Forms 10-C 10-C Report by issuer of securities quoted on NASDAQ
interdealer quotation system, pursuant to section 13 or
15(d).
11-K 11-K Annual report of employee stock purchase plans,
savings and similar. Pursuant to rule 13a-10 or 15d-10.

18-K 18-K Annual report for foreign governments and political

subdivisions.

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FINANCIAL STATEMENT
ANALYSIS

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Financial Statements and Analysis
1. Income Statement
2. Balance Sheet
3. Cash Flow Statement

Derived information
Sources and Uses Statements
Financial Ratios

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Income Statement: Typical Components

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Balance Sheet - Assets

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Balance Sheet - Liabilities

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Balance Sheet Order of Liquidity

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Tools of Financial Statement Analysis
Sources & Uses Statement
Standardized Financial Statements
Common Size
Trend

Ratio Analysis
Ratios are useful for making comparisons
Over time
Across firms

Ratios are commonly used as a rule of thumb measure to

assess performance and as a tool for identifying problems
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Sources & Uses Statement
Most basic form of financial statement analysis derived from
Balance Sheet
Used in identifying the sources of funds
Not CASH flows!
Basics:
1. Pick Balance sheet from two periods, say T & T-1
2. Calculate the difference on all line items:
BS(T) BS(T-1)
Sources:
Negative changes on the Asset side & Positive changes on the
Liability side
Uses:
Positive changes on the Asset side & Negative changes on the
Liability side
3. Report absolute values

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Ratio Analysis: A Quick Review
Categories of Ratios
Liquidity
ability to meet current obligations
Asset Utilization
how well a firm manages assets
Leverage
the mix of long-term debt and equity
Profitability
backward looking measures of how much the firm has earned
Market Value
forward looking measures reflecting the markets assessment of
firms performance

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Anatomy of a Ratio
x
R ( x, y )
y
Units:
If x & y are in the same unit then R is unit-less
Changes:
If R increased:
x increased while y stayed the same?
y decreased while x stayed the same?
x increased more than y increased?
x decreased less than y decreased?

R( x, y ) R( x, y ) 2 R ( x, y ) 2 2 R ( x, y ) 2
dR( x, y ) dx dy dx dy ...
x y x 2
y 2

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Liquidity Ratios
Current Ratio:
Current Assets
Current Ratio
Current Liabilitie s
measures ability to pay immediate obligations
If ratio is too low, the firm is in danger of bankruptcy
If ratio is too high, the firm may either be using its
current assets ineffectively or may lack new growth
opportunities

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Liquidity Ratios
Quick Ratio (Acid Test):
Current Assets - Inventories
Quick Ratio
Current Liabilitie s
A stronger measure than the Current Ratio
May be more appropriate when inventories are relatively
illiquid.

Cash Ratio

Cash
Cash Ratio
Current Liabilitie s

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Liquidity Ratios
Net Working Capital to Total Assets:

Current Assets - Current Liabilitie s

NWC / TA
Total Assets

Interval Measure:
Current Assets
Interval Measure
Op. Costs/365
How long the firm can go with no cash inflow

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Asset Utilization
Inventory Turnover:
COGS
Inventory Turn
Inventory
How frequently the inventory is sold
Higher number are generally good, so long as the
firm doesnt lose sales by being out of stock

Days Sales in Inventory:

365
Days Sales in Inventory
Inv.Turn
The number of (typical) days sales you can meet with
the inventory on hand
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Asset Utilization
Receivables Turnover:
Sales
Receiveabl es Turnover
Accounts Receivable

Measures how quickly a firm collects on its sales

High numbers are generally better

Average Collection Period:

365
Avg. Collection Period
Receivable s Turn

The length of time from sale until payment

Lower numbers are better
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Asset Utilization
Net Working Capital Turn:
Sales
NWC Turnover
NWC

Measure sales per dollar of NWC

Higher numbers are generally good, although the firm
may be losing out on additional sales.

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Asset Utilization
Fixed Asset Turnover:
Sales
Fixed Asset Turnover
Fixed Assets

Sales generated per dollar of fixed assets

Fixed assets may be misleading due to depreciation

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Leverage Ratios
Keep in mind that leverage ratios vary
considerably across industries.
Total Debt versus Long-Term Debt

Debt/Equity Ratio:
Total Debt
Debt to Equity Ratio
Total Equity
A measure of how much the firm borrows to finance
its assets
If > 1, the firm uses more debt than equity

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Leverage Ratios
Debt Ratio (Total Debt to Total Assets Ratio):
Total Debt
Debt Ratio
Total Assets
The percent of the firm financed with debt

Times Interest Earned:

EBIT
Times Interest Earned
Interest Expense
Indicates a firms ability to meet its debt service.

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Leverage Ratios
Equity Multiplier:
Total Assets
Equity Mul tiplier
Equity

The amount of assets financed by a dollar of equity.

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Profitability Ratios
Profit Margin:
Net Income
Profit Margin
Sales

The amount of income per dollar in sales

This will depend on the nature of the business and the

firms strategy (sell a lot at a low price or a smaller
amount at a higher price).

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Profitability Ratios
Return on Assets (ROA, Return on Investment):
Net Income
ROA
Total Avg. Assets

The earnings per dollar of assets.

Remember that the assets may be historical values.

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Profitability Ratios
Return on Assets (ROA, Return on Investment):

Net Income
ROA
Total Avg. Assets

The earnings per dollar of assets.

Remember that the assets may be historical values.

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Profitability Ratios
Return on Equity (ROE):
Net Income
ROE
Avg. Common Equity

Earnings per dollar of owners equity

Remember that this is an accounting measure!

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Market Ratios
Book-to-Market:
Book Value per Share
Book/Market
Share Price

The historic cost of a firms assets relative to the markets

valuation.

Another figure, the q-ratio, measures the markets

valuation relative to the replacement cost of the assets.
This gives as sense as to the value-added by the firms
management, or the value of the firms growth
opportunities.

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Tips for Remembering Ratios
Turnover Ratios generally divide Sales or COGS by
something.

Margins are typically something divided by Sales.

Many of the ratios essentially give the formula in the name.

The Days ratios typically divide 365 (days) by something.

Remember you are trying to find the number of days it takes to deplete
something.

Be careful when combining stock and flow measures

(e.g., sales and assets in ROA).
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DuPont Analysis
A system for breaking down ROE into components.

ROE Profit Margin Asset Turn Eq. Multiplie r

Net Income Sales Assets Net Income
ROE
Sales Assets Equity Equity
ROE ROA Equity Multiplie r

ROE is a function of Operating Efficiency, Asset

Utilization, and Leverage.

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Limitations of Ratio Analysis
Often based on accounting figures which may not reflect
economic value (cash flows).
Accounting treatments may vary across firms or over time
making comparisons more difficult.
Firms are often in several industries, making firm-wide
measures difficult to interpret.
Specific ratios can be targeted at the expense of overall
value.
Many measures are based on historic and/or single period
performance, resulting in a tendency to focus on the short-
run at the expense of the long-term.

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Market Ratios
Price/Earnings Ratio (PE):
Share Price
P/E
Net Income

How much it costs to buy a dollar of current earnings.

Commonly referred to by business media.
Can be viewed as a measure of growth that the market
expects.
Sometimes stated using forecasted earnings, which is
really more important than past.

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