Best practices in financial modeling

1,183 views

Published on

Agenda:
Modeling depleting items
Consistency in the format
Modeling the Taxes
Modeling of Debt and Cash Balances
Edupristine offers Financial Modeling Course in US a practical approach for financial analysts to come to the business valuation of any organization
More info take a look at:http://www.edupristine.com/ca/courses/financial-modeling/

Best practices in financial modeling

  1. 1. © Pristine For Webinar-Best Practices in Financial Modeling (Confidential)© Pristine – www.edupristine.comBest Practices in Financial ModelingWebinar 1
  2. 2. © Pristine For Webinar-Best Practices in Financial Modeling (Confidential) 1Agenda Modeling depleting items Consistency in the format Modeling the Taxes Modeling of Debt and Cash Balances
  3. 3. © Pristine For Webinar-Best Practices in Financial Modeling (Confidential)Key conceptsI. ScalabilityII. RobustnessIII. Modeling cash balance and debtIV. Modeling Taxes2
  4. 4. © Pristine For Webinar-Best Practices in Financial Modeling (Confidential)Introduction Financial modeling is the building of a mathematical model that helps in financial decision-making situations It is a skill widely used in the financial services Building a financial model is a challenging task and often simple mistakes can lead to major lossesfor both the firm and their client In this series we take you through some of the common mistakes that are committed by analystswhen preparing financial models and the best practices to make a robust and scalable financialmodel3
  5. 5. © Pristine For Webinar-Best Practices in Financial Modeling (Confidential)1. Modeling depleting items Depleting items (at constant rate) should be modeled with caution Use “min” function to cap the depletion For example depreciation, debt repayment should be modeled with usage of MIN function so thatthe value in a year is the depletion rate or the balance amount whichever is lower4
  6. 6. © Pristine For Webinar-Best Practices in Financial Modeling (Confidential)1.1 Common mistake5No Capex, asset is depreciated bystraight line method @30%, depreciation formula andlinkage is correct but it has notbeen capped On dragging to the nextcolumn, the formula fordepreciation remains correct butthe Net Block turns negative. Depreciation in FY17 can’t begreater than the residual value inthe previous year
  7. 7. © Pristine For Webinar-Best Practices in Financial Modeling (Confidential)1.2 Correct modeling technique6Depreciation should be cappedusing MIN function. It should bethe minimum of the residual valuefrom previous year and normaldepreciationOn dragging to the nextcolumn, the depreciation isnow restricted to theresidual value at the end ofthe previous year. NetBlock is zero now
  8. 8. © Pristine For Webinar-Best Practices in Financial Modeling (Confidential)2. Consistency in the format It is important to maintain the consistency in the format of modeling across all the items• Separate headings, sub headings etc. by different font size and row colors. Maintain consistency offormatting scheme across the model• Report a particular year in the same column across sheets. For example, if FY17 has been reported inColumn G on P&L sheet, it should be reported in the same column across all the sheets(assumption, balance sheet, build up, cash flow, valuation etc)7
  9. 9. © Pristine For Webinar-Best Practices in Financial Modeling (Confidential)2.1.1 Common mistakes8P&L has been rolled outlaterally i.e. years changingcolumn wise debtamortization schedule isrolled out vertically whereyears are changing acrossrows
  10. 10. © Pristine For Webinar-Best Practices in Financial Modeling (Confidential)2.1.2 Common mistakes9Since the format istransposed, dragging theinterest expense laterallyforces Excel to pick up theincorrect value placedlaterally adjacent to thecell D16, while we actuallywanted the value D17
  11. 11. © Pristine For Webinar-Best Practices in Financial Modeling (Confidential)2.2 Correct modeling technique10Had the formatbeen keptconsistent, dragging to the nextcolumn wouldhave picked upthe value from thecorrect cell
  12. 12. © Pristine For Webinar-Best Practices in Financial Modeling (Confidential)3. Calculating taxes A model is robust if it does not break down when assumptions are changed from one end of thespectrum to another• A frequently noticed error in this category is incorrect / inconsistent tax computation if assumptionsare changed such that PBT changes sign from positive to negative• Another frequently noticed error is that balance sheet starts showing negative cash if capitalexpenditure in a year is doubled or tripled. Ensure all the possible scenarios are modeled. For example, if tax is modeled simply as• Tax = Tax Rate x PBT• Or Tax = if (PBT <0, 0, Tax Rate x PBT)• Your model will break down in case PBT is negative for a few years in succession. It will not return thebenefit of accumulated losses.11
  13. 13. © Pristine For Webinar-Best Practices in Financial Modeling (Confidential)3.1 Common Mistake12Look at the formula.The formula for taxesand the linkage to thecell is correct.However the formuladoes not take intoaccount the case of anegative EBTIn this case ourformula handles thecondition when PBT isnegative but howeverdoes not give us thebenefit of carryingforward our losses
  14. 14. © Pristine For Webinar-Best Practices in Financial Modeling (Confidential)3.2 Correct modeling technique13No tax due to negativePBTBenefit ofaccumulatedlosses, only earnings inexcess of accumulatedlosses (= USD 2 Mn) istaxedTax = IF (PBT<0, 0, IF(Cum PBT<0, 0, Tax ratex MIN(PBT, Cum PBT)
  15. 15. © Pristine For Webinar-Best Practices in Financial Modeling (Confidential)4. Modeling of Debt and Cash Balances Another common error in modeling is not to link debt balances with cash balance Any drastic change in assumption may make the cash flow during the year highly negative wipingout previous balances, the closing cash balance on the balance sheet will turn negative Provision for shortfall should always be incorporated in model Model should automatically draw more debt to make up for the shortfall and bring the cashbalance back to threshold level14
  16. 16. © Pristine For Webinar-Best Practices in Financial Modeling (Confidential)4.1.1 Common mistake15No provision forshortfall in cash, noprotection against cashbalance going negativeSuppose Capex in FY15 is now increased to $10 million.
  17. 17. © Pristine For Webinar-Best Practices in Financial Modeling (Confidential)4.1.2 Common Mistake16As soon as Capex inchanged, cash balanceon the balance sheetturns negative and ourmodel breaks down
  18. 18. © Pristine For Webinar-Best Practices in Financial Modeling (Confidential)4.2.1 Correct modeling technique17Instead, model theprovision for shortfall sothat the model drawsdown additional debt ifshortfall in cash isexpected
  19. 19. © Pristine For Webinar-Best Practices in Financial Modeling (Confidential)4.2.2 Correct modeling technique18Now see the impact ofchanging capex, modelautomatically drawsadditional debt to restorecash balance to thresholdlevel – induces robustnessin model
  20. 20. © Pristine For Webinar-Best Practices in Financial Modeling (Confidential)SummaryToday we’ve learnt some common mistakes that can and should be avoided when modeling in Excel Model must be made scalable by protecting the formula with dollar referencing “MIN” function should be used to cap the depletion when depleting items like depreciation aremodeled It is important to maintain the consistency in the format of modeling across all the items A sound financial model must be able to handle all boundary conditions. For e.g. when calculatingtaxes, we should check for a negative PBT and model loss carryforward in case of consecutiveyears of negative PBT When modeling cash and debt balances, a provision for shortfall in cash should always beincorporated in model19
  21. 21. © Pristine For Webinar-Best Practices in Financial Modeling (Confidential)Thank you!© Pristine – www.edupristine.com

×