3 - Flow of a Model

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




The Core of the ModelThree Financial Statements




Income StatementRevenue – Expenses = Profit




Balance Sheet Assets = Liabilities + Equity




Statement of Cash Flows

Cash inflows – Cash outflows =

Cash Balance




The three statements are

interrelated… there is endogeneity




Income statement links to balancesheet through retained earnings




Balance sheet links to income

statement through…

Interest expense

Depreciation

Amortization




Cash flow statement delineates theamount of cash generated

This drives the amount of debtrequired on the Balance Sheet




What does all this mean

for you? You cannot forecast one of the

financial statements, without alsodoing the other two




Start your model with

the Income StatementIt is the most straightforward to

model




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




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.




Finance Jargon:

Above the Line

Operating Profit is above the Interest

Expense line of an Income Statement




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.




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).




Operating Projects are themost important projections

in valuing a business You can project the Operating

Assumptions of a businessindependently of any transaction




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




So what does that mean forforecasting the Income

Statement?Begin with the Operating Items

that drive EBIT




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




Income Statement

Statement ofCash Flows

Balance Sheet

Operating Projections

→

Linked




Crucial assumptions

Growth Rates

Profit Margins

Together these drive Operating Profits




WAIT!

What about Depreciation, Amortization, EBIT, EBITDA and

Capital Expenditures?




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?




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.




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.




Meanwhile,

The cash picture is different:

$1,000 is spent today for the machine and$0 for the next 10 years.




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




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)




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




EBITDA

Earnings Before Interest, Taxes,

Depreciation and Amortization




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




I can’t find EBITDA!

It doesn’t appear on the Income

Statement. You will need tocalculate it.




EBITDA can be calculated by either:

Starting with Revenue and subtractingonly the "cash" expenses

Or

Starting with EBIT and adding back thenon-cash expenses




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




Get comfortable withEBITDA

You will be calculating it… A LOT!




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).




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



S i h 0

Next up… Excel Basics

3 - Flow of a Model

Documents

Transcript of 3 - Flow of a Model