C H A P T E R 1

A Financial ProjectionModel

This chapter will explain what projection models do and howthey differ between industries. There is an overview of howprojection models are used and what bits of information areimportant. The three roles you perform when you do financialmodeling are covered. Finally, a suggestion about where to putthe computer mouse may help in relieving arm tension.

THE CASE FOR STANDARDIZEDPROJECTION MODELS

Although this book will tell you how to create your own financialmodel, its underlying message is that a model that can be usedacross a group becomes that much more effective. It is natural tothink that a financial model is primarily a tool for quantitativeanalysis. But, to the extent that a model is the standard fora group, or even for a firm, it becomes much more than that:it becomes a communications platform. A standardized modelachieves this in several ways:

1. It conveys to its users the analytical methodologiesthat others in the group are using, because those areembedded in its structure.

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2. It becomes in its own right a teaching tool, letting newusers understand how the standard analysis should beconducted.

3. As colleagues agree to use the same model, it becomesthe common yardstick of analysis, a way to fostercooperation and partnership across groups. Credit orinvestment review committee members who are familiarwith how the numbers have been produced and how theratios have been calculated can proceed to the qualitativeanalysis that much more quickly and reach theirdecisions with greater confidence. The economic impactis usually significant: good (or better) decisions are made;and bad choices are avoided altogether.

4. When one standard model is used across differentprojects in different industries, it facilitates managementreview and oversight. To the extent that the modelincludes the preferred standard analytical methodologies,it is also a form of insurance against nonstandardapproaches to analysis.

AN ESTIMATOR, NOT A PREDICTOR

A projection model is not a crystal ball, and its output does notdictate what the future will be. It is merely a tool to estimatewhat a company’s future financial condition might be, givencertain assumptions about its performance. Conversely, it is atool to test what needs to happen in order for a particularperformance goal to be reached.

It is easy, for example, for a chief financial officer to say, ‘‘Wewill have enough cash flow in the next five years to retire $100million of our debt.’’ This may well be true, but the validity insuch a statement lies in what needs to happen. If the statement isbased on conservative forecasts consistent with the company’srecent performance and its current position and reputation inits industry, then this is good and fine. If, on the other hand,the $100 million is attainable only through rapid, unrealistic,and unprecedented increases in revenues, then it is very likelythat the CFO’s statement is just so much hot air.

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This role as a testing tool means that a projection model isbest when it can allow you to change the inputs quickly for aseries of sensitivity tests. For example, what would be the oper-ating cash flow if revenues increased by 3, 5, or 10 percent whilemargins improved, held steady, or worsened? We can add othervariations in other accounts. Given all the accounts in a com-pany’s financial statement, the permutations of the sensitivitiescan be nearly limitless. In fact, we can run the danger of having atool that can produce so much ‘‘information’’ that it becomesuseless. So part of the exercise in building and using such amodel is knowing how to make the best use of it. Chapter 13gives a review of the main points to keep in mind in developingprojections.

PROJECTION MODELS FOR DIFFERENTINDUSTRIES

Industry/Manufacturing Industries

The type of model that we will be building is most appropriatefor manufacturing- or industrial-type companies. In this type,sales are the main revenue generator, and the net income linein the income statement shows the result of revenue lessexpenses.

The balance sheet is a listing of the assets and liabilitiesrelated to the production facilities required to produce the pro-duct for sale and the financing to support these activities.Shareholders’ equity shows the amount of equity capital in thebusiness.

Service companies, where the revenues are derived from theselling of a service, can also fit this framework.

Banks

Banks produce their revenues not be selling a product or service,but by the interest yield on their main assets: the loans they havein their loan portfolio on the balance sheet. Because banks gen-erally have to borrow the money that they lend, they also incurinterest expense. Thus, the equivalent ‘‘sales revenue’’ line for

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banks is something called ‘‘net interest earnings’’: this is theinterest income they receive on their loans, less the interestexpense on their funding liabilities.

Developing a projection model for a bank is more difficult,primarily because of the need to include regulatory capitalrequirements in the model. In the United States, banks have tohave two types of capital, called Tier I and Tier II, and a bankmust meet minimum requirements for its capitalization. Whatthis means is that as the model makes its projections, it alsohas to keep these accounts in line with the requirements. Bankmodeling is not covered in this book.

Insurance Companies

Insurance companies can be described as a combination of aservice company earning premiums and an investment companymaking interest income earnings from its investments (from allthe cash received in premiums, less what has to be paid out ininsurance claims).

Insurance companies come in two types: life insurance com-panies and non-life insurance companies.

Forecasts for life insurance companies need good, extensive,and expensive actuarial data, and even then, assumptions of howmany insurees the company will have over time and the longtime horizon for its insurees can make the exercise difficult.

Non-life (property and casualty) insurance companies areeasier to model, since the claims can be more easily estimatedvia probability theories and the known finite useful lives forproperty.

Insurance companies are again a different animal from thebasic industrial/manufacturing companies that we want tomodel, so they will not be covered in the book.

WHERE PROJECTION MODELS ARE USEFUL

Credit Analysis

To lend or not to lend? Or, to put it more bluntly, will we get ourmoney back if we lend it to this particular company? Thus, mod-eling for credit analysis necessarily requires a focus on cash flows

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and ratios. If we can show that the company will be producingenough cash in excess of its operational and investment needsover the term of the loan to repay the loan, then it would be a‘‘go’’ decision to lend, at least insofar as the numbers are con-cerned. (Good lending decisions must consider other, qualitativefactors.) The challenge for the credit decisionmakers occurs whenthe company is considered a ‘‘good’’ company, but the cash flowis less robust. This is why skilled and experienced credit officersare always in demand by lending institutions.

Equity Investments

Equity investors need projections to estimate their equity returnsthrough the internal rate of return (IRR) calculations. In these cal-culations, it is important to be as precise as possible in modelingthe timing of the investments, so that they are not all the ‘‘yearend’’ according to the model. In this case, one often sees quarterlyor even monthly models. This is one reason why many equityinvestment models, such as those used in project finance andleveraged buyout situations, use periodicities shorter than a year.

Leveraged Buyout

In a leveraged buyout (or LBO), a company is bought out by agroup of investors, which usually includes the current manage-ment, using debt to finance the purchase. Modeling such a trans-action requires a focus on both the debt and equity changes atthe deal date, the effects on the stub year (the portion of the yearsubsequent to the transaction), and the remaining forecast years.On a purchase LBO, goodwill will have to be calculated; on arecapitalization LBO, it will not.

Mergers and Acquisitions

Where an LBO involves one company, a merger or acquisitionwould involve two companies. (Of course, a company could buyanother company and the new company can then buy a third,and so forth, but we can think of this as a succession of mergers,each involving only two companies.)

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Merger modeling really involves modeling three companies:the first company, which is the acquirer; the second company,which is the target; and the third, which is the combined newcompany. The acquirer and the target should be modeled sepa-rately through the forecast period, especially if the two compa-nies operate in different industries or different sectors of anindustry.

With the exception of the numbers for the period from thelast available data date to the deal date, for which some estimateswould be needed, all of the information for the pre-deal periodcan be taken straight from the historical data.

Merger accounting is complex because of the need to keeptrack of the flows of the two companies and layering in the effectsof the transaction in the capitalization and the cash flows. Assetrevaluations and goodwill calculations add to the complexity.

WHAT TO FOCUS ON

Critical Numbers in Any Projection Model

A useful projection model focuses on only five main points:

u The earnings before interest and taxes (EBIT) in theincome statement

u The earnings before interest, taxes, depreciation, andamortization (EBITDA) in the income statement

u The net income numberu The operating working capital (OWC) and capitalexpenditures levels, as measures of the use of cash onthe balance sheet

u The level of debt on the balance sheet

EBITEBIT is an important number because it shows the earningsrelated to the main operations of a company. EBIT is reven-ues less the expenses that are directly related to the revenue-generating operations. These operating earnings give you a clueas to how robust the company’s business is, outside of other

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nonoperating flows such as interest or investment. The trendover the most recent years can show you how well the companyis positioned for future growth.

EBITDAEBITDA is EBIT, but with depreciation and amortization of intan-gibles added back. Depreciation and amortization are noncashexpenses; there is no actual cash that the company has to payout. So EBITDA is a good way to arrive at the idea of ‘‘cashearnings,’’ the amount of cash generated by the operations.This can give you a good indication of a company’s absoluteability to pay interest. A zero EBIT can mean that there is stillsome cash, from the add back of depreciation and amortization; azero EBITDA, on the other hand, means that there is absolutelyno cash coming from the revenue-generating activities.

Net IncomeBelow EBIT and EBITDA, the net income number is produced bythe inclusion of other nonoperational revenues and expenses.Usually there are more expenses than revenues, and the biggestexpenses are interest expenses and taxes.

Net income is a useful number because this is the usualmeasure of whether a company is ‘‘profitable’’ or not and isthe basis of calculations such as earnings per share (EPS). However,a company can be profitable but still run out of cash because oflarge demands for working capital and/or capital expenditures,so net income (and all other measures of a company) is bestviewed in the context of other factors and ratios.

Operating Working CapitalWorking capital by definition is current assets less current lia-bilities. However, a more useful measure for working capital iswhat might be termed operating working capital (OWC). This iscurrent assets without cash or short-term investments, less currentliabilities without short-term debt (including the current portionof long-term debt). Thus, OWC is primarily:

Accounts receivable

þ Inventory

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þ Other current assets

� Accounts payable

� Other current liabilities

OWC is a measure of how much cash a company mustinvest in its operations. Cash and debt are the result of separatefinancing decisions. This is why they are excluded from OWC. Ahigh level of OWC (because of accounts receivables not beingcollected quickly and/or poor inventory management, for exam-ple) means that a company has a large amount of its cash tied upas receivables and inventory, which limits its ability to use itscash for other purposes.

Capital ExpendituresCapital expenditures, or capex for short, is the other major use ofcash in the balance sheet. Capex is generally an ongoing expensebecause a company must continue to invest in its productionequipment, which over time needs to be maintained or replaced.

DebtMost companies have debt on their balance sheet. Whether acompany has ‘‘too much’’ or ‘‘too little’’ debt is not a function ofthe dollar value of the debt, but rather its cash flow to ‘‘service’’the debt (i.e., can it pay the ongoing interest expense and maketimely repayments of the debt itself).

In modeling forecast debt levels, you would need to enterknown amortization schedules so that you would have a baseline of the outstanding (and decreasing) debt. A good model withrealistic assumptions will then show what the additional borrow-ing, if any, would be required in the forecast years.

YOU AS THE MODEL DEVELOPER

Three Hats

You will be wearing many hats when you are a model developer:

u You are the finance expert, working with the elementsof the income statement, balance sheet, and cash flow

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statement, using your knowledge of GAAP conventions toproduce the correct presentation of the results.

u You are the spreadsheet wizard, pushing your knowledgeof Excel to the limit to squeeze the last ounce of perfor-mance out of your model.

u You are the visual designer and virtual architect, manip-ulating the screen and the structure of your worksheet tomake your model as easy and fun to use as possible. Yougive meaning to the term user friendly.

Balancing the Three

How much you focus on each of the three parts will determinethe look and feel of your model. Obviously, a model that looksspectacularly attractive and is user friendly but produces inaccu-rate outputs is not what we want. On the other hand, a modelthat is powerful and provides useful analytical informationbut has an interface so forbidding that no one understandshow to use it is also not our goal. So a balance among thethree approaches is important to get to a final, optimal product.

Give Yourself Time

I hope that the model that you will create if you follow all thesteps in the book will be the first of many that you will build. Asyou develop and create more models, it will seem that there isalways a ‘‘next’’ model to do. A good model takes time andpasses through many versions. How many versions exactly?My experience is that you would need at least three:

1. The first version is the attempt to gather together theright set of calculations in the right way to get the answeryou want, but typically this results in a model that is notvery user friendly and has lots of errors.

2. The second version is the version for correcting thecalculation errors as well as the gross shortcomings in termsof its usability. This version is a little easier to use andhas better accuracy in its calculations. It is also often atthis point that there is a sudden understanding into whatthe model should have been all along, which leads to. . .

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3. The third version is much easier to use and more elegantin structure. Often, this is a radical departure from thefirst two versions and comes after a smack-your-hand-in-the-middle-of-your-forehead moment of insight. Andstrangely, this is the one that comes much closer to whatthe original concept of the model was.

MOUSE OR KEYBOARD?

The byword is ‘‘whatever works for you.’’ As you become moreand more expert at developing and working with models, youwill begin to find yourself spending more time with your PC.This brings us to the question of whether it is better to use themouse or the keyboard to operate the menus and work with theworksheets.

Using the mouse has the advantage of getting to some of thecommands more quickly and ‘‘intuitively,’’ but it has the disad-vantage of taking more time and hand motion: your hand has toleave the keyboard, find the mouse, position the cursor, click, andthen return to the keyboard. In addition, the mouse can lead towrist and elbow strain when you need to extend yourarm to handle the mouse, especially when there is little or nosupport to the forearm. Using the keyboard has the advantage ofbeing quicker, and learning this method gives you the advantageof being able to continue your work if for some reason youcannot use the mouse. The disadvantage is that it can be quitetedious to step through the menu system, especially when youare confronted with a menu box with drop-down lists, tabs,checkboxes, etc. However, some practice can make the handmovements automatic, so that your hands will seem to have a‘‘keyboard memory.’’

I do not recommend one over the other and can only say usewhatever works for you. Indeed, it might be that the best method isa combination of the mouse and the keyboard.

A Suggestion for Mouse Placement

If you place your mouse to the side of the keyboard, an arrange-ment that most people use, you can have overworked shoulder

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and elbow joints because your shoulder has to support your armas you work with the mouse. Additionally, this position forcesyour hand to point outward as you work, creating an angle at theouter edge of where the hand meets the wrist. It is possible to gettendonitis at the point where the tendon kinks through the angle.To minimize strain, place the mouse in front of you, between youand the keyboard, rather than to the side. So, a view from the topof the desk would be as follows:

Monitor screen

Keyboard

Mouse

Edge of desk

You

There are several advantages to this:

u The arm can be supported by the elbow on your desk.u The position of the hand directly in front of you is alsomore natural and closer to the center of your body. Youare more ‘‘centered,’’ to use a martial arts term.

u It is just as easy, if not more so, to move your hand fromthe keyboard toward your solar plexus than to move it outto the right and putting your elbow and your shoulder ina twist.

u In this position, the hand holding the mouse will tend topoint toward the left side of your body (if you are righthanded), extending the outer edge of the hand and wristand reducing the possibility of tendonitis at this point.

u In this location, given the curve of your arm, the mostnatural position for the mouse is ‘‘sideways’’, with thecable leading off to the left (again, if you are right-handed). You will move the mouse to the left in order toget the cursor to move ‘‘up’’ on the screen. This adjust-ment, however, will be an almost instantaneous one.

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