Financial Modeling • Keep in mind that the general process These reports provide key stakeholders,

CHAPTER 3-Financial Statement Modelling of creating pro forma financial investors, and creditors the foresight
HOW FINANCIAL MODELS WORK? statements isn’t significantly different needed to make decisions and
PROFORMA FINANCIAL STATEMENTS – from that of creating traditional strategically plan. Managers and
able to monitor the possible range of the statements. The difference lies in the individual contributors can also benefit
loan covenants. assumptions and adjustments made from creating pro forma statements,
Pro forma financial statements are about various inputs, while the format enabling them to understand different
defined as “financial statements forecasted and calculations remain the same. factors impacting business units.
for future periods. They may also be • There are, however, specific methods • Remember: There are limitations to pro
referred to as a financial forecast or used for these forecasts. The percent forma financial statements. Since these
financial projection.” of a sales forecasting method, for documents are based on assumptions,
The course notes that these projections can example, involves determining future they shouldn’t be taken as fact. Rather,
be used “as a depiction of what the financial expected sales and finding trends they can inform decisions using
statements for the business will look like across accounts in statements. This is hypothetical data based on historical
over a certain period of time, if the typically used when creating pro trends.
assumptions made when preparing them formas internally. 3 RATIOS NEEDED FOR COMPLETE &
hold true.” • Other individual line items can also FULLY OPERATIONAL FINANCIAL
Since the term “pro forma” refers to be easily forecasted, such as the cost MODEL
projections or forecasts, it can apply to a of goods sold, since it can be assumed 1. QUICK RATIO – measure of
variety of financial statements, including: it will proportionally grow with sales. liquidity.
• Income statements Line items like income tax expense, Forecast 2 balance sheet accounts that is
• Balance sheets on the other hand, typically don’t current assets and current liabilities.
• Cash flow statements change directly with sales. Stable Current assets- need to forecast trade
HOW ARE PRO FORMA FINANCIAL businesses can generally estimate receivables and inventory.
STATEMENTS USED? income tax expense as a percentage Current liabilities-need to forecast trade
Traditionally, financial statement analysis is of income before taxes. payables and short –term debt.
used to better understand a company’s • All in all, the process of preparing a 2. Solvency Ratio – forecast total liabilities
performance over a specified period. While pro forma balance sheet is much the and equity requires a complete balance
this provides insight into a company’s same as preparing a normal balance sheet plus an income statement.
historical health, creating pro forma financial sheet. The same holds true for the  Equity at the year end depends on the
statements focuses on its future. For this process of preparing income net income or net loss of the income
reason, these reports can be leveraged in statements and cash flow statements. statement.
several ways, including analyzing risk, It differs when you begin forecasting  Long term liabilities – include the
projecting investments, and showing various line items and calculating how portion of debt that has been used to
expected results before the end of a those projections impact your bottom finance long lived assets such as
reporting period. line. heavy machinery and production
CREATING PRO FORMA FINANCIAL BEYOND THE NUMBERS machinery. So in order to, forecast
STATEMENTS • The true value of pro forma statements long term liabilities Financial Planning
goes beyond the numbers they show. and Analysis manager or FP&A needs
 to understand the future strategic such as manufacturer, brand, style, color,  Customer churn rate
investment plan of the company. and size. Churn rate, sometimes known as attrition
3. EBITDA – Earnings before interest,  Store ROI (Return on Investments) rate, is the rate at which customers stop
taxes, depreciation and amortization. Return on investment (ROI) is calculated by doing business with a company over a given
- widely used to measure company’s dividing the profit earned on an investment period of time. Churn may also apply to the
financial health & ability to generate cash. by the cost of that investment. number of subscribers who cancel or don't
(operating profits) and interest expense.  Customer satisfaction renew a subscription. The higher your churn
Interest expense depends on the level of  Sales per square foot rate, the more customers stop buying from
debt the company needs to operate. Sales per square foot is your store's your business.
 But the level of debt depends on the average revenue for every foot of sales The churn rate formula is: (Lost Customers
profits or losses of the year which space, including non-selling space such as ÷ Total Customers at the Start of Time
include interest expense. This is your stock room, fitting room, and receiving Period) x 100. For example, if your business
called a circular reference. areas. To calculate it, divide your sales by had 250 customers at the beginning of the
Other information FP&A needs to the store's total square feet of sales space. month and lost 10 customers by the end,
collect in order to complete task:  Payroll by store you would divide 10 by 250.
 Projected sales growth rates for the Payroll means salaries and wages of  Yield
period under analysis salaries Yield is defined as to produce or give
 Projected profit margins  Margins by region/product something to another. An example of yield
 Projected operating expenses SKU/business unit is an orchard producing a lot of fruit. An
 Breakdown of company’s debt and cost  Year on Year sales growth by product example of yield is giving someone the right
of debt category/region/business unit of way while driving.
 Investment plans  ARPU (Average Revenue Per User)  Machine productivity
 Depreciation information Average revenue per unit (ARPU) is an Machine productivity = (Number of total
Key Performance Indicator – forecast in indicator of the profitability of a product garments produced / Total stitching
order to address the problem in question based on the amount of money that is machines used) Productivity is the ratio of
are the 3 covenants: quick ratio, leverage, generated from each of its users or output and input of a process in a defined
interest cover. subscribers. It is a particularly useful time frame. Divide garment output of a line
Typical KPIs include: measurement for companies in the by machine input.
 Product SKU (stock-keeping unit) telecommunications and media industries,  Capacity Utilization
revenue which rely on subscribers or users. Capacity utilization refers to the
SKU- just like a number in the barcode. ARPU can be calculated by dividing the manufacturing and production capabilities
SKU numbers means taxonomy or naming total revenue generated during a specific that are being utilized by a nation or
and describing an organisms. For the time period (e.g. week, month, quarter) by enterprise at any given time. It is the
business, key number for specific products. the total number of active users during that relationship between the output produced
is used by retailers to identify and track same time. For example, if you generated with the given resources and the potential
its inventory, or stock. A SKU is a unique $200 last month and had 4000 active user output that can be produced if capacity was
code consisting of letters and numbers that during that month, your Average Revenue fully used.
identify characteristics about each product, Per User would be $0.05. COLLECTING AND ANALYZING
 Visiting Customers per day Historical Data
There are lot of sources from which closely with the accounting, commercial, the revenue line is also calculated and will
someone can collect past financial procurement, technical and HR be used as a proxy of the evolution of sales
information. To name a few: SEC, Reuters Departments in order to check to cross in the forecast period. After the revenue
Fundamentals database, S&P check and validate model assumptions. line, FP&A monitors the gross margin.
Capital IQ Platform & Company The very first thing that FP&A do is to Gross margin percentage is calculated as a
Websites. collect the proper raw data from the percentage of sales.
 Secondary sources of company’s financial statements, footnotes, Following the gross margin are the other
information:Credit reports, company and external reports in one place. These operating income, the operating expenses,
newsletters, press releases and raw data should include: and the other operating expenses.
executive speeches 1. The number of diff. product groups Operating expenses – include a provision
 General information- includes Ex. SteelCo’s revenues can be grouped for bad debts. This provision refers to credit
company name , BOD, industry and into 2 product groups. “LONG” products losses that pertain to the period of income
sector codes, contact details, web group and “FLAT” products group. statement.
addresses, business, financial 2. Unit volumes and prices per product A provision – is a double entry that debits
summaries, officer details, major group. (increases) an expense account of the
customers and competitors. 3. Information about Profitability income statement and credits(decreases) a
Secondary research – is the collection of 4. Information about Operating Cycle balance sheet asset account.
the above information, which is previously 5. Information about debt structure The Balance sheet account – is the
published in any public platform or report. 6. Information about depreciation that is accounts receivable and is reduced by the
- The biggest problem is that the info charged in the income statement amount about which there are doubts as to
available could be out-dated or old resulting Raw data should include: whether it will be collected(that is allowance
inaccurate outcomes.  Effective tax rate for bad debts).
The alternative is to perform so called  Information about the investment Next, EBITDA – used to indicate the ability
Primary Research. plans, if any of the company. of a company to service its debt and allow
 Primary research techniques mean  Any macroeconomic indicators such us to analyze the performance of its
collecting the information directly by as (GDP) and Inflation Rate operations while eliminating all non-
speaking to several key participants forecasts respectively. operating and non-recurring items.
and gathering the latest intelligence In the specification part of the modelling EBITDA margin- which is EBITDA as a
about the organization as well as the process we discussed the single sheet on percentage of sales. Is helpful when
industry. It can be quite challenging which we collect all the assumptions that we analysing the growth of a company year
as one needs first to identify the will use in the model. over year.
correct correspondents they would Units of Measure – is in a separate Net interest is recorded.
want to interview, next persuade column. - interest expense minus interest income.
them to engage in a dialogue and FP&A needs to transform the income Depreciation – is also recorded and the
interview them in depth. statement, balance sheet and statement of profits before tax calculated after
cash flows to the right level of detail subtracting depreciation and interest
FP&A will have this information available The first line of the income statement is the expenses.
from his colleagues at the various company revenue line. Revenues are product of units In the balance sheet,
departments. He will have to cooperate sold times price per unit. Rate of change for
  Assets are broken down into CA and investing and financing activities are other expenses, as these items usually vary
N-CA recorded at the minimum level of with sales.
 Non- Current Assets are divided into detail. Following drivers from each financial
net fixed assets, that is: Now that FP&A (Financial Planning and statement:
 Fixed asset purchase price (Gross Analysis manager collected the historical  Income Statement
Fixed Assets) + Subsequent financial statement of the last 3 fiscal years, ◦ Rate of change of sales
additions to existing assets – Now that FP&A (Financial Planning and ◦ Gross profit margin- gross profit as
Accumulated Depreciation. Analysis) manager collected the historical percentage of sales (%)
 And other non- current assets which financial statement of the last 3 fiscal years, ◦ Other operating income as a percentage
include intangible assets and he needs to do some analysis and compute of sales (%)
investments in subsidiaries, joint the key forecast drivers of interest. That is, ◦ Operating expenses as a percentage of
ventures, and associates. for each line item in the financial sales – opex (%)
 Current assets – include the statements, he will have to build historical ◦ Other operating expenses as a
receivables from the credit sales to ratios, as well as forecasts of future ratios. percentage of sales (%)
customers, inventory, cash and other These ratios will form the basis for the ◦ Income tax as a percentage of net
assets. forecast financial statements. income – effective tax rate (%)
 Inventory – is the value of materials Selecting the key Forecast Drivers ◦ Dividends as a percentage of income
and goods held by the company to In order to forecast the financial statements, after tax
support its sales and is divided into 2 classical forecasting methods and a ◦ Depreciation as a percentage of gross
merchandise, finished goods, and variety of hybrids that use parts of each fixed assets.
spare parts. method:  Balance sheet
- is a large item in the current assets. 1. T- Account forecasting Days sales outstanding – DSO
 Other assets – include all the other Starts with a base year of financial Days Sales Outstanding (DSO) represents
categories of assets not described statements and determines through double the average number of days it takes
explicitly above. entries how each account will change and credit sales to be converted into cash or
On the equity and liabilities side, owner’s what the resulting balance will be. how long it takes a company to collect
equity is grouped into share capital and Is mainly used to estimate balance sheet its account receivables. DSO can be
retained earnings or losses, that is accounts like shareholder’s equity, fixed calculated by dividing the total accounts
accumulated earnings and losses over the assets, and the cash flow statement. receivable during a certain time frame by
years of operation of the company. 2. percent-of-sales forecasting the total net credit sales.
 The liabilities part is divided into Starts with a forecast of sales and then Days inventory outstanding – DIO
long-term debt, short – term debt, estimates other income statement accounts Days inventory outstanding (DIO) is a
payable to suppliers and other based on some presumed relationship working capital management ratio that
liabilities. between sales and that account. measures the average number of days
 Cash flow- recorded at a certain Simple to execute, this technique can lead that a company holds inventory for
level of detail. The adjustment of tax, to false conclusions before turning it into sales.
depreciation, and the changes in Is used to estimate mainly income Days Inventory Outstanding = (Average
working capital are recorded from statements accounts such as gross margin, inventory / Cost of sales) x Number of
the operating activities. The operating expenses, other income, and days in period
Average inventory- Beg Inv+Ending Inv/2
Days payable outstanding – DPO
Days payable outstanding (DPO) is the
average number of days a company
takes to pay invoices for goods and
services obtained on credit. DPO is a key
financial metric for tracking and managing
cash flow. A high DPO is generally
favorable because it means more cash is
available to fund operations.

No drivers need to be calculated for the