Financial Forecasting, Analysis, and Modelling

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1 Financial Forecasting, Analysis, and Modelling

2 Financial Forecasting, Analysis, and Modelling A Framework for Long-Term Forecasting MICHAEL SAMONAS

3 This edition first published Michael Samonas Registered office John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex, PO19 8SQ, United Kingdom For details of our global editorial offices, for customer services and for information about how to apply for permission to reuse the copyright material in this book please see our website at All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, except as permitted by the UK Copyright, Designs and Patents Act 1988, without the prior permission of the publisher. Wiley publishes in a variety of print and electronic formats and by print-on-demand. Some material included with standard print versions of this book may not be included in e-books or in print-on-demand. If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at For more information about Wiley products, visit Designations used by companies to distinguish their products are often claimed as trademarks. All brand names and product names used in this book are trade names, service marks, trademarks or registered trademarks of their respective owners. The publisher is not associated with any product or vendor mentioned in this book. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with the respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. It is sold on the understanding that the publisher is not engaged in rendering professional services and neither the publisher nor the author shall be liable for damages arising herefrom. If professional advice or other expert assistance is required, the services of a competent professional should be sought. Library of Congress Cataloging-in-Publication Data Samonas, Michael. Financial forecasting, analysis, and modelling : a framework for long-term forecasting / Michael Samonas. pages cm Includes bibliographical references and index. ISBN (cloth) 1. Corporations Finance Mathematical models. 2. Corporations Finance Forecasting. I. Title. HG4012.S dc Cover Design: Wiley Cover Image: Top: istock.com/marsbars; Bottom: istock.com/studiocasper Set in 10/12pt Times by Laserwords Private Limited, Chennai, India Printed in Great Britain by TJ International Ltd, Padstow, Cornwall, UK

4 To Konstantinos, Eleftheria, my Mom and Dad

5 Table of Contents Preface Acknowledgments About the Author xi xiii xv PART ONE Developing Corporate Finance Models 1 Chapter 1 Introduction What is Financial Modelling? Defining the Inputs and the Outputs of a Simple Financial Model The Financial Modelling Process of More Complex Models Step 1: Defining the Problem the Model Will Solve: The Fundamental Business Question Step 2: Specification of the Model Step 3: Designing and Building the Model Step 4: Checking the Model s Output Excel as a Tool of Modelling: Capabilities and Limitations 13 Chapter 2 A Short Primer in the Accounting of Financial Statements The Accounting Equation The Balance Sheet The Income Statement Cash Accounting Versus Accrual Accounting The Cash Flow Statement Operating Activities Investing Activities 27 vii

6 viii TABLE OF CONTENTS Financing Activities Income Flows and Cash Flows Preparing the Statement of Cash Flows The Articulation of Income Statement, Balance Sheet, and Cash Flow Statements Financial Statement Analysis: Ratio Analysis Profitability Ratios Liquidity Ratios Solvency Ratios Other Ratios The Limitations of Financial Ratios 40 Chapter 3 Financial Statement Modelling Introduction How Financial Models Work Collecting and Analyzing Historical Data Selecting the Key Forecast Drivers Modelling the Income Statement Modelling the Balance Sheet Modelling Interest and Circular References Modelling the Cash Flow Statement 69 Chapter 4 Forecasting Performance Introduction: Designing a Dashboard-like Control Panel Basic Statistical Methods Used for Forecasting Forecasting Sales Bottom-up Versus Top-down Forecasting Forecasting Sales of Existing Products or Services Forecasting Costs Forecasting CAPEX and Depreciation Forecasting CAPEX and Depreciation for Existing Companies Forecasting Working Capital and Funding Needs Forecasting Funding Needs 113 Chapter 5 Business Valuation Valuation Approaches Steps for Applying the DCF Method Rewriting Financial Statements Calculation of Free Cash Flows Calculating the Weighted Average Cost of Capital Calculating the Weighted Average Cost of Capital of SteelCo 128

7 Table of Contents ix 5.5 Estimating the Terminal Value DCF Summary Enterprise Value Adjustments 132 PART TWO Planning for Uncertainty 137 Chapter 6 Using Sensitivity Analysis Introduction One-Dimensional and 2-Dimensional Sensitivity Analysis Choosing the Variables to Change Modelling Example Selecting the Variables to Change Assigning a Range of Values Constructing the 2-dimensional Sensitivity Analysis Table Interpreting the Results 153 Chapter 7 Using Scenarios Introduction Using Scenario Analysis with Excel s Scenario Manager Adding 2 More Scenarios Alternative Ways to Create Scenarios in Excel Applying Scenarios to SteelCo s Case Deciding on the Number of Scenarios and Input Variables under each Scenario Deciding on the Output Variables Assigning Values to the Input Variables under Each Scenario Building the Scenarios in Excel s Scenario Manager Interpreting the Results 176 Chapter 8 Using Monte Carlo Simulation Introduction Building Uncertainty Directly Into the Modelling Process Probabilities, Cumulative Probabilities, and Frequency Distribution Charts Modelling Example Identifying the Key Risk Variables Choosing a Probability Distribution for Each Input Variable Performing the Simulation Runs The Simple VBA CODE Creating a Histogram (Frequency Distribution Chart) in Excel Interpreting the Results Some Issues of Concern 201

8 x TABLE OF CONTENTS Appendix Walking through the Excel Model Provided with the Book (SteelCo SA 4yr Business Plan) 203 Introduction 203 Structure of the Model Other Excel Files Provided with the Book 205 Index 207

9 Preface Over the past several years, spreadsheet models have been the dominant vehicles for finance professionals to implement their financial knowledge. Moreover, in the aftermath of the recent financial crisis the need for experienced Financial Modelling professionals has steadily increased as organizations need to plan and adjust to the economic volatility and uncertainty. The level of risk in taking certain decisions needs to be projected using proper financial models and the alternative possible outcomes need to be analyzed. One benefit of this type of analysis is that it helps companies to be proactive instead of reactive. They can avoid or at least mitigate potential negative results that may stem from influences in their industry or within the business itself. This book provides a step-by-step guide that takes the reader through the entire process of developing long-term projection plans using Excel. In addition, by making use of various tools (Excel s Scenario Manager, sensitivity analysis, and Monte Carlo simulation) it provides practical examples on how to apply risk and uncertainty to these projection plans. Although these projections are not guarantees they can help organizations to be better informed, and thereby provide peace of mind. Financial Forecasting, Analysis and Modelling: A Framework for Long-Term Forecasting covers financial models in the area of financial statement simulation. It provides clear and concise explanations in each case for the implementation of the models using Excel. It is relevant to a variety of situations. At the most fundamental level, it can help: Project a company s financial performance; Forecast future cash flows and perform a DCF valuation; Present the good, basic, and bad scenarios of the evolution of the company s debt covenants. At a more advanced level it ensures that the financial analyst or decision-maker is properly informed and comfortable when called to decide the following types of question: What will be the double impact on the liquidity of the organization of a simultaneous increase of 35% in turnover and a decrease of 10 days in the credit period provided to clients? What will be the range of the company s net debt at a 95% confidence level based on selected assumptions? xi

10 Acknowledgments owe a debt of gratitude to many individuals who helped me with this book. Foremost is my I wife Eleftheria for the support and encouragement she provided to me. Furthermore, I would like to thank my parents for their tireless efforts to support me in every step of my life. Their determination and drive have been a constant inspiration. My special thanks go to Nikos Karanikolas, a magnanimous reviewer, who provided detailed written suggestions in a response to the publisher s request for his review. Also I really appreciate the insightful comments of my esteemed colleague Carmen Mihaela Bulau on many of my manuscripts in spite of her hectic schedule. Finally, I appreciate the efforts of all the people at John Wiley & Sons who have helped make this book happen. In particular I would like to thank Werner Coetzee (Commissioning Editor), Jennie Kitchin (Assistant Editor), Caroline Quinnell (Copy Editor), and last but not least Kelly Cracknell and Abirami Srikandan - Hoboken (Production Editors), who guided me through the production process. xiii

11 About the Author Michael Samonas is a finance professional with extensive experience in Financial Planning, Analysis and Modelling. He is currently the Group CFO of SIDMA S.A., a member of the Viohalco Group of companies. He has worked in the past for various multinationals including Vodafone S.A. and the Hellenic Telecommunications Organization conducting a range of models for business planning, valuations, mergers, projects, and data analysis. For a number of years Michael was an instructor at the School of Business & Economics of the University of Laverne, Athens Campus. A regular contributor to financial and business journals, Michael has taught specialized courses in Financial Analysis & Business Modelling, Credit Analysis & Cash Flow Forecasting, and Investment Evaluation & Appraisal. Michael holds both MSc and PhD degrees from the Department of Physics and the Electronic & Electrical Engineering Department of University of Surrey as well as an MBA from the University of La Verne California. He also holds a BSc degree in Applied Accounting from University of Oxford Brookes (with honours) and is a Fellow of the Association of Chartered Certified Accountants (ACCA). xv

Financial. Analysis, and. ModeHIng. Long-Term Forecasting

Financial. Analysis, and. ModeHIng. Long-Term Forecasting _ Financial Forecasting. Analysis, and ModeHIng A Framework for Long-Term Forecasting MICHAEL SAMONAS WlLEY TaWe of Contents Preface Acknowledgments About the Auttior xi xiii xv MRT ONE :, 4 Developing