The Art and Science of

Financial Modeling
The Art and Science of
Financial Modeling

Anurag Singal
The Art and Science of Financial Modeling

Copyright © Business Expert Press, LLC, 2018.

All rights reserved. No part of this publication may be reproduced,

stored in a retrieval system, or transmitted in any form or by any
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permission of the publisher.

First published in 2018 by

Business Expert Press, LLC
222 East 46th Street, New York, NY 10017
www.businessexpertpress.com

ISBN-13: 978-1-94897-694-7 (paperback)

ISBN-13: 978-1-94897-695-4 (e-book)

Business Expert Press Finance and Financial Management Collection

Collection ISSN: 2331-0049 (print)

Collection ISSN: 2331-0057 (electronic)

Cover and interior design by Exeter Premedia Services Private Ltd.,

Chennai, India

First edition: 2018

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Printed in the United States of America.

 Abstract
To use a cliché, we live in a volatile uncertain complex and ambiguous
(VUCA) world.
Organizations simply cannot afford to try out new strategies in reality
and correct mistakes, once they’ve occurred. The stakes are too high. Thus
emerges the utility of this technique across functions like financial plan-
ning and risk management. Financial models help a business manager
simulate the future and see the impact of their change, without risking
costly setbacks of real world trials and errors.
Mastering the art of financial modeling is imperative for those who
want to enter the ultra-competitive world of corporate finance, investment
banking, private equity, or equity research. Only those who excel (pun
intended) in modeling early on are often the most successful l­ong-term.
The book will help readers dive deep into the vocabulary and the
syntax, the art and science of financial modeling and valuation. Readers
will be able to prepare/use existing models more competently, interpret
the results and have greater comfort over the integrity and accuracy of the
model’s calculations.

Keywords
cash flow at risk, corporate finance, financial analysis and modeling,
financial modeling, how to build a financial model, investment banking,
mergers and acquisitions, startup valuation, valuation
 Contents
Chapter 1 Introduction���������������������������������������������������������������������1
Chapter 2 Approach to Financial Modeling........................................9
Chapter 3 Deep Dive into the Construction Phase...........................17
Chapter 4 Guidelines for Creating an Effective Financial Model......47
Chapter 5 Scenario Analysis and Sensitivity.....................................59
Chapter 6 Financial Modeling—Real Life Illustrations.....................65
Chapter 7 Case Studies....................................................................81
Chapter 8 Cash-Flow-at-Risk (CFaR) Model—A Useful Tool for
Risk Management in Corporates.....................................95

About the Author��������������������������������������������������������������������������������105

Index�������������������������������������������������������������������������������������������������107
 CHAPTER 1

Introduction
What Is a Financial Model?
Let our advance worrying become advance thinking and planning.
—Winston Churchill

In times when the demand-supply equation may not really be conducive

to business operations or may undergo erratic swings, corporate needs to
have a dynamic mechanism to gauge the likely impact of the market tur-
bulence on their fortunes and thus arises the need for financial modeling.
Among the various possible uses of the same, generating the revenue
and expense forecasts is of paramount importance. In conjunction with
the proposed capital expenditure plans and debt servicing obligations
of the company, this could be a source of crucial insights for decision-­
making and foresee the possible scenarios of profitability and liquidity.
Often we build calculations depicting a real life situation, quantifying
inputs/outputs of an operation or a process. We call it a calculation as
long as quantum of variables and scenarios are limited. As you continue
to add variables and scenarios, it takes the shape of model. In a nutshell,
a model is nothing but a series of calculations (simple and/or complex)
structured in a particular fashion so that it’s comprehensible.
The exercise would then act as a baseline for management’s adoption
of contingency measures:

• Sprucing up their marketing efforts to streamline revenues or

adopting cost-rationalization initiatives
• Scaling down of capex plans (or alternatively prioritizing
between various projects) determine how much investment
capital is required and thus scout for additional funding
(if required)
2 The Art and Science of Financial Modeling

• Undertaking production cuts, as deemed to be appropriate, to

prevent inventory build-up beyond tolerable limits

While the measures as outlined above could vary according to the

unique business dynamics of the various segments of the company, it
goes without saying that the exercise of creating a sound financial model
would go a long way in helping management cope with uncertainty and
focus on the value-creation process for stake-holders.
Companies require robust financial models to help them in analyzing
the complexities of the geographies where they operate, consider mul-
tiple currencies in their projections, evaluate varying capacity as well as
capacity utilizations combinations to find out the optimal capacity under
varying industry demand-supply scenarios and a host of similar cases.

Part Science, Part Art

Building models is a fluid, creative activity, and there are as many ways to
build a model as, say, to write a book. Most of them will result in working
models, but not necessarily very good ones; there are, after all, bad books.
But there are also excellent books with very different styles.
Financial modeling is an art form; to the purest MS Excel guru
or financial theorist, the ability to model out a concept in your own
unique style is the ultimate form of professional expression. You live and
breathe a model from its inception, through multiple iterations, until its
completion.
Financial modeling is part science and part art. Maybe the art part is
just 10 percent but this 10 percent can change valuation from 1 Bn to 10
Bn (If not 100!). There are so many variables that impact valuation and
assigning weightages to them is what the art is.
A modeler must be a good mathematician as well as someone who
can think creatively and who possesses sound logic in order to pre-empt
possible outcomes and make sound and reasonable assumptions about
the business. Like a fortune teller, you need to be able to read the situa-
tion and ask the right questions, assess possible roadblocks and side-step
potential pitfalls.
 Introduction 3

The process should always be a deliberate and thoughtful process.

Spend enough time on it, step into the shoes of the user and play the
Devil’s Advocate. It’s the absolute confidence and familiarity with your
model that will let you take the investor’s questions head on and show
that cool “Steve Jobs-esque” confidence in the face of difficult questions.
Plus no matter how complex be the underlying logic, your models
should be SIMPLE TO UNDERSTAND. The intellect and interest lies
in making a simple, scalable and robust model.

Concept
So let’s say, you have a power plant as follows:

You can build a working model of the power plant.

So, a model is a representation, generally in miniature, to show the
construction or appearance of something.

Definition
The Oxford Dictionary defines the word model as a simplified mathemat-
ical description of a business/process. Model is a representation of reality.
4 The Art and Science of Financial Modeling

What Is a Financial Model?

It is a simplified representation of company performance-both past and
future performance.
In other words, financial modeling is the task of building an abstract
representation of a financial decision making situation. A mathematical
model is designed to represent the anticipated performance of a financial
asset or a portfolio of a business, a project, or any other form of financial
investment. A typical financial model would enable simulation of cost
and revenue relations to support business decisions. It is prepared when-
ever any organization is considering project finance, bidding for a project,
evaluating acquisition target, carrying out periodic financial planning,
conducting capital structure studies, and so on.

Schematic Diagram of a Typical Financial Model

A well-designed financial model has a clear purpose, flows intuitively from
inputs to final outputs, is well documented, and is easy to use and read.
The core elements of a financial model are:

1. Revenue: The channels from which your business generates revenue

and how much from each stream
 Introduction 5

Schematic Diagram of A Typical Financial Model

Model parameters
Macroeconomic
inputs and sensitivies Interest Balance sheet Cash
calculations calculations calculations
Loans calculations Asset calculations

Inputs end
Marker sheet

Inputs sheet 2 Input totals Reports

Sum from all Profit and loss Profit and loss,
input sheets calculations cash flow,
Inputs sheet 1 balance sheet

Inputs start
Marker sheet

2. Cost of Goods (COGS): The cost of selling your product or service

3. Operational Expenditures (OPEX): How much your business spends
in order to sustain the scale of its day to day operations
4. Income Statement: How much net profits or losses your business
will incur during a period of time
5. Cash Flow: How much cash your business generates and uses during
a given time period
6. Capital Expenditures (CAPEX): Money spent acquiring or upgrad-
ing physical assets that is, property
7. Balance Sheet: Summary of a company’s assets, liabilities and
share-holders equity at a given time period
8. Working Capital: How well a company manages its current assets vs.
current liabilities?
6 The Art and Science of Financial Modeling

The Three Financial Statements

INCOME CASH FLOW

BALANCE SHEET STATEMENT STATEMENT

Assets Liabilities
Cash Accounts payable Revenue Net income
Accounts receivable Other current liabilities COGS +/- change in
Inventory SGA working capital
Debt
Other current assets
Equity Interest +/- change in
Net PPE Common stock Taxes investments
Other long-term assets Retained earnings Net income
+/- change in
financial

=+/- change in cash

Beginning cash
Ending cash

Flowchart of Interlinks Among the Three Financial Statements

BALANCE SHEET INCOME STATEMENT

ASSETS LIABILITIES AND EQUITY

Revenue
Cash Expenses
Current liabilities
Current assets EBIT
Debt
Net PPE (1) Interest
Long term assets Earning before taxes
Common stock
Tax
Retained earnings
Net income

CASH FLOW STATEMENT

Net income
+
Sources of cash (2)
Uses of cash (3)
Ending cash =
Change in cash
from PRIOR YEAR

(1) PPE is plant, property and equipment.

(2) Sources of cash from decreases in assests or increases in liabilities between this year
and the prior year (e.g., sale of assets, new debt).

(3) Uses of cash from increases in assests or decreases in liabilities between this year
and the prior year (e.g., buildup of working capital,repayment of debt).
 Introduction 7

Another representation is as follows:

Income statement Balance sheet Cash flow statement

Revenue 1,000 Opening cash 275 Cash receipts 1,000
COGS (250) Change in cash held 172 Cash payments (625)
Gross margin 750 Cash 447 Interest paid (98)
Operating expenditure (375) Current assets 447 Tax paid (31)
EBITDA 375 Non-current assets 2,500 Operating cash flows 247
Depn. and amort. (175) Total assets 2,947
EBIT 200 Current liabilities 45 Capital expenditure (175)
Interest expense (98) Non-current liabilities 1,500 Investing cash flows (175)
NPBT 103 Total liabilities 1,545
Tax expense (31) Ordinary Equity 750 Debt draw down 200
NPAT 72 Opening retained profits 580 Debt repayments (100)
Net profit during period 72 Financing cash flows 100
Retained profits 652
Total equity 1,402 Change in cash held 172

Net assets 1,402

 Index
Accelerated depreciation, 30 overview of, 61
Amortization types of, 62
cash-flow statement and, 33 uses of, 61
definition of, 32 DCF. See Discounted cash flows
income statement, 33–34 Debt and interest
balance sheet, 44–45
Balance sheet preparing for, 42–43
debt and interest, 44–45 schedule, 41
definition of, 5 Depreciation
depreciation and, 32 accelerated, 30
equity schedule and, 40 adding back, 31
Bottom-up approach, 10 balance sheet, 32
cash-flow statement, 31
CAPEX. See Capital expenditures definition of, 30
Capital expenditures (CAPEX), 5 income statement, 31
Cash flow, 5 straight line, 30
Cash-flow-at-risk (CFaR) models Depreciation schedule, 29
calculation methodology, 101–102 Discounted cash flows (DCF)
concept, 95 example of, 77–79
decision making, strategic level, Gordon growth method, 77
100–101 illustration, 73–77
definition of, 95–96 principle of, 71–72
illustration of, 97 shortcomings of, 79
impact on liquidity, 98 using, 72–73
mapping across interdependent valuation, 70–71
paths, 103–104 Documentation, 47
rationale, 96–97
risk matrix and constituents, Equity schedule
98–100 balance sheet and, 40
Cash-flow statement cash-flow, 39
amortization and, 33 flow of, 38
depreciation and, 31 simplified, 38
equity schedule and, 39 Error check, 52–53
Circularity, 49–50
COGS. See Cost of goods Facebook, financial model for, 86–90
Cost of goods (COGS), 5 FCFE. See Free Cash Flow to Equity
FCFF. See Free Cash Flow to the Firm
Data tables Financial model
essentials for, 62–63 of company, 19–22
in Excel, 62 contingency measures, 1–2
formatting tips for, 63 core elements of, 4–5
108 Index

definition of, 4 Gordon growth method, 77

Facebook, 86–90 Granularity, 50
overview of, 1–2
steps involved in preparing, 11–15 Hardcodes, 48
steps to creating, 11
Time Warner, 90–92
types of, 10–11 Income statement
Uber, 81–86 amortization and, 33–34
WhatsApp, 92–93 definition of, 5
Financial model guidelines depreciation and, 31
checklist, 56–57 Income statement logic, 34, 37
circularity, 49–50 Input tabs, 47
documentation, 47 Investment banking, 65
error check, 52–53
flexibility, 51 Long-term items, 35–37
granularity, 50
hardcodes, 48 One page DCF, 10
input tabs, 47 Operating revenue, forecasting
link directly to source cell, 52 expense assumptions, 24
pitfalls, 55–56 overview of, 22
pre-launch testing, 54–55 revenue assumptions, 23
present ability, 52 working capital schedule, 24–25
ruler testing, 54 Operational expenditures (OPEX),
Financial modeling 5
investment banking, 65 OPEX. See Operational expenditures
for start-ups, 65–70
types of, 65 Personal financial model
Forecasting current asset items building, 17–18
inventory, 26 underlying assumptions, 18
other items, 26 Post start-ups, 70
trade receivables, 25 Pre-launch testing, 54–55
working capital schedule, 27 Pre-revenue start-ups, 66–68
Forecasting current liability items Present ability, 52
flow of funds, 29 Profitable and growing start-up, 70
other items, 28
payables, 28
working capital to cash flow, 29 Revenue, 4
Forecasting operating revenue Ruler testing model, 54
expense assumptions, 24
overview of, 22 Scenario analysis
revenue assumptions, 23 sources for, 59–60
working capital schedule, 24–25 uses of, 59
Free Cash Flow to Equity (FCFE), Start-up types
78–79 pre-revenue, 66–68
Free Cash Flow to the Firm (FCFF), profitable, and growing, 70
78–79 some revenue, 68–70
Fully integrated DCF, 11 Straight line depreciation, 30
 Index 109
Time Warner, financial model for,
90–92
Top–down approach, 9
Treasury stock method (TSM),
39
TSM. See Treasury stock method
Uber, financial model for, 81–86
WhatsApp, financial model for,
92–93
Working capital, 5
Working capital schedule, 24–25, 27