Post on 03-Jun-2018
8/12/2019 3 - Flow of a Model
http://slidepdf.com/reader/full/3-flow-of-a-model 1/40
Ben J. Sopranzetti, Ph.D. 1
Flow of a Model
Chapter 3
Building your operating assumptions
8/12/2019 3 - Flow of a Model
http://slidepdf.com/reader/full/3-flow-of-a-model 2/40
Ben J. Sopranzetti, Ph.D. 2
The Core of the ModelThree Financial Statements
8/12/2019 3 - Flow of a Model
http://slidepdf.com/reader/full/3-flow-of-a-model 3/40
Ben J. Sopranzetti, Ph.D. 3
Income StatementRevenue – Expenses = Profit
8/12/2019 3 - Flow of a Model
http://slidepdf.com/reader/full/3-flow-of-a-model 4/40
Ben J. Sopranzetti, Ph.D. 4
Balance Sheet Assets = Liabilities + Equity
8/12/2019 3 - Flow of a Model
http://slidepdf.com/reader/full/3-flow-of-a-model 5/40
Ben J. Sopranzetti, Ph.D. 5
Statement of Cash Flows
Cash inflows – Cash outflows =
Cash Balance
8/12/2019 3 - Flow of a Model
http://slidepdf.com/reader/full/3-flow-of-a-model 6/40
Ben J. Sopranzetti, Ph.D. 6
The three statements are
interrelated… there is endogeneity
8/12/2019 3 - Flow of a Model
http://slidepdf.com/reader/full/3-flow-of-a-model 7/40
Ben J. Sopranzetti, Ph.D. 7
Income statement links to balancesheet through retained earnings
8/12/2019 3 - Flow of a Model
http://slidepdf.com/reader/full/3-flow-of-a-model 8/40
Ben J. Sopranzetti, Ph.D. 8
Balance sheet links to income
statement through…
Interest expense
Depreciation
Amortization
8/12/2019 3 - Flow of a Model
http://slidepdf.com/reader/full/3-flow-of-a-model 9/40
Ben J. Sopranzetti, Ph.D. 9
Cash flow statement delineates theamount of cash generated
This drives the amount of debtrequired on the Balance Sheet
8/12/2019 3 - Flow of a Model
http://slidepdf.com/reader/full/3-flow-of-a-model 10/40
Ben J. Sopranzetti, Ph.D. 10
What does all this mean
for you? You cannot forecast one of the
financial statements, without alsodoing the other two
8/12/2019 3 - Flow of a Model
http://slidepdf.com/reader/full/3-flow-of-a-model 11/40
Ben J. Sopranzetti, Ph.D. 11
Start your model with
the Income StatementIt is the most straightforward to
model
8/12/2019 3 - Flow of a Model
http://slidepdf.com/reader/full/3-flow-of-a-model 12/40
Ben J. Sopranzetti, Ph.D. 12
Revenue $118.0 Cost of Goods Sold - 87.5
Gross Profit 30.5 Selling, General & Administrative Expenses - 10.3
Operating Profit (EBIT)___________________ 20.2
Interest Expense (net) - 7.7 Pretax Income 12.5
Income Taxes - 5.4 Net Income 7.1
Sample Income Statement
8/12/2019 3 - Flow of a Model
http://slidepdf.com/reader/full/3-flow-of-a-model 13/40
Ben J. Sopranzetti, Ph.D. 13
Bifurcating the Income Statement
The Income Statement can be divided intotwo categories
– Operating items – Non-operating items
“Operating” refers to Revenues, expenses,and expenditures that are not impacted byInterest Expense.
8/12/2019 3 - Flow of a Model
http://slidepdf.com/reader/full/3-flow-of-a-model 14/40
Ben J. Sopranzetti, Ph.D. 14
Finance Jargon:
Above the Line
Operating Profit is above the Interest
Expense line of an Income Statement
8/12/2019 3 - Flow of a Model
http://slidepdf.com/reader/full/3-flow-of-a-model 15/40
Ben J. Sopranzetti, Ph.D. 15
Why is Operating Profit soimportant?
Below the Operating Profit line, thecompany’s results are impacted by itsCapital Structure.
Operating profits are not “directly”affected by the choice of capital structure.
We’ll discuss the indirect impact in AdvancedCorporate Finance.
8/12/2019 3 - Flow of a Model
http://slidepdf.com/reader/full/3-flow-of-a-model 16/40
Ben J. Sopranzetti, Ph.D. 16
For example,
A company goes public and raises $75 million ofEquity to repay Debt
Ceterus Paribus, Interest Expense will decreaseand its Net Income will increase
But Operating Income will stay unchanged
Operating Income is also called Operating Profitor Earnings Before Interest and Taxes (EBIT).
8/12/2019 3 - Flow of a Model
http://slidepdf.com/reader/full/3-flow-of-a-model 17/40
Ben J. Sopranzetti, Ph.D. 17
Operating Projects are themost important projections
in valuing a business You can project the Operating
Assumptions of a businessindependently of any transaction
8/12/2019 3 - Flow of a Model
http://slidepdf.com/reader/full/3-flow-of-a-model 18/40
Ben J. Sopranzetti, Ph.D. 18
Below the Line
Nearly all transactions have an impact onnon-operating line items because of theireffect on Interest Expense.
With non-operating items, forecastsdepend on what kind of deal is analyzed,whereas operating items are independentof capital structure choices
8/12/2019 3 - Flow of a Model
http://slidepdf.com/reader/full/3-flow-of-a-model 19/40
Ben J. Sopranzetti, Ph.D. 19
So what does that mean forforecasting the Income
Statement?Begin with the Operating Items
that drive EBIT
8/12/2019 3 - Flow of a Model
http://slidepdf.com/reader/full/3-flow-of-a-model 20/40
Ben J. Sopranzetti, Ph.D. 20
Should we directly hard-wire theprojections?
NO!
Makes it impossible to analyze multipleforecast scenarios and makes it difficult toshow key summary data about theforecast
Create a separate Operating AssumptionsPage
8/12/2019 3 - Flow of a Model
http://slidepdf.com/reader/full/3-flow-of-a-model 21/40
Ben J. Sopranzetti, Ph.D. 21
Income Statement
Statement ofCash Flows
Balance Sheet
Operating Projections
→
Linked
8/12/2019 3 - Flow of a Model
http://slidepdf.com/reader/full/3-flow-of-a-model 22/40
Ben J. Sopranzetti, Ph.D. 22
Crucial assumptions
Growth Rates
Profit Margins
Together these drive Operating Profits
8/12/2019 3 - Flow of a Model
http://slidepdf.com/reader/full/3-flow-of-a-model 23/40
Ben J. Sopranzetti, Ph.D. 23
WAIT!
What about Depreciation, Amortization, EBIT, EBITDA and
Capital Expenditures?
8/12/2019 3 - Flow of a Model
http://slidepdf.com/reader/full/3-flow-of-a-model 24/40
Ben J. Sopranzetti, Ph.D. 24
Depreciation and CapitalExpenditures
Suppose Ajax spends $1,000 on a new
machine. The machine is expected to lastfor 10 years. How do we handle this?
8/12/2019 3 - Flow of a Model
http://slidepdf.com/reader/full/3-flow-of-a-model 25/40
Ben J. Sopranzetti, Ph.D. 25
The accountant does not show a gigantic$1,000 expense on the Income Statement
Instead, the $1,000 is capitalized
Increasing PP&E line item on the BalanceSheet.
$1,000 is recorded as a CapitalExpenditure on the Cash Flow Statement.
8/12/2019 3 - Flow of a Model
http://slidepdf.com/reader/full/3-flow-of-a-model 26/40
Ben J. Sopranzetti, Ph.D. 26
Money was spent on the machine, shouldn’t
the Income Statement be impacted?
The expense is recognized over the periodof time that the benefits of the machineare received.
A Depreciation expense of $100 per yearfor the next 10 years would be a very
typical treatment.
8/12/2019 3 - Flow of a Model
http://slidepdf.com/reader/full/3-flow-of-a-model 27/40
Ben J. Sopranzetti, Ph.D. 27
Meanwhile,
The cash picture is different:
$1,000 is spent today for the machine and$0 for the next 10 years.
8/12/2019 3 - Flow of a Model
http://slidepdf.com/reader/full/3-flow-of-a-model 28/40
Ben J. Sopranzetti, Ph.D. 28
What about Amortization?
Very similar concept to depreciation
Amortization is usually categorized as aSG&A expense instead of COGS.
Collectively, Depreciation and Amortizationare often called D&A
8/12/2019 3 - Flow of a Model
http://slidepdf.com/reader/full/3-flow-of-a-model 29/40
Ben J. Sopranzetti, Ph.D. 29
Capitalizing an Expense
Line Item
Now
Years
1-10
Notes
Depreciation $0 $100 •Categorized as a non-cash expense on the
Income Statement (COGS)• Also appears on the Cash Flow Statement
CapitalExpenditures
$1000
$0 •Impacts the Cash Flow Statement•Flows into Property, Plant and Equipment
(PP&E) on the Balance Sheet•Has no direct impact on the IncomeStatement (until depreciated)
8/12/2019 3 - Flow of a Model
http://slidepdf.com/reader/full/3-flow-of-a-model 30/40
Ben J. Sopranzetti, Ph.D. 30
So what is a Capital Expense?
CAPEX represent the amount actuallyspent on PP&E
Depreciation and Amortization (D&A) aremerely accounting entries to record a non-cash expense
8/12/2019 3 - Flow of a Model
http://slidepdf.com/reader/full/3-flow-of-a-model 31/40
8/12/2019 3 - Flow of a Model
http://slidepdf.com/reader/full/3-flow-of-a-model 32/40
Ben J. Sopranzetti, Ph.D. 32
EBITDA
Earnings Before Interest, Taxes,
Depreciation and Amortization
8/12/2019 3 - Flow of a Model
http://slidepdf.com/reader/full/3-flow-of-a-model 33/40
Ben J. Sopranzetti, Ph.D. 33
EBITDA
Equals EBIT plus D&A expense
Take Operating Profit and add back thenon-cash Depreciation and Amortizationexpenses that are buried in the OperatingExpenses
Proxy for Operating Cash Flow
8/12/2019 3 - Flow of a Model
http://slidepdf.com/reader/full/3-flow-of-a-model 34/40
Ben J. Sopranzetti, Ph.D. 34
I can’t find EBITDA!
It doesn’t appear on the Income
Statement. You will need tocalculate it.
8/12/2019 3 - Flow of a Model
http://slidepdf.com/reader/full/3-flow-of-a-model 35/40
Ben J. Sopranzetti, Ph.D. 35
EBITDA can be calculated by either:
Starting with Revenue and subtractingonly the "cash" expenses
Or
Starting with EBIT and adding back thenon-cash expenses
8/12/2019 3 - Flow of a Model
http://slidepdf.com/reader/full/3-flow-of-a-model 36/40
Ben J. Sopranzetti, Ph.D. 36
Sample EBITDA Calculation Revenue $118.0
"Cash" COGS - 86.0 Depreciation - 1.5
Gross Profit 30.5 "Cash" Selling, General &
Administrative Expenses - 9.3 Amortization - 1.0
Operating Profit (EBIT)
20.2
EBITDA $22.7
8/12/2019 3 - Flow of a Model
http://slidepdf.com/reader/full/3-flow-of-a-model 37/40
Ben J. Sopranzetti, Ph.D. 37
Get comfortable withEBITDA
You will be calculating it… A LOT!
8/12/2019 3 - Flow of a Model
http://slidepdf.com/reader/full/3-flow-of-a-model 38/40
Ben J. Sopranzetti, Ph.D. 38
What about the cost of new PP&E?
The CAPEX line does not appear on the P&L, butwe need to focus on it.
Why?
If we just add back D&A, we're missing a largepiece of the cost picture -- the cost of investingin the infrastructure of the company (PP&E).
8/12/2019 3 - Flow of a Model
http://slidepdf.com/reader/full/3-flow-of-a-model 39/40
Ben J. Sopranzetti, Ph.D. 39
We will break out the Depreciationcomponent of COGS and the Amortizationcomponent of SG&A for easy calculation ofEBITDA
Also, CAPEX is a part of the Operating
Assumptions page. This may seem odd, since this page primarily feeds
the P&L, whereas CAPEX is a Cash Flow Statementline item.
Concluding comments
8/12/2019 3 - Flow of a Model
http://slidepdf.com/reader/full/3-flow-of-a-model 40/40
S i h 0
Next up… Excel Basics