StartUp Accelerator 2014: Financial modeling by Atul Dhawan_23 Feb 2014

A Refresher and Continuous Improvement

Refining Financial Modeling

February, 2014

© 2014 Deloitte Touche Tohmatsu India Private Limited

Section Context

What is a Financial Model? A Refresher

Need for Dynamic Financial Model

Shortcoming of Static Financial Model and

introduction of Dynamic financial model

framework

Significance of Scenario Planning Scenario Planning parameters and linkage

with Dynamic financial modeling

Example - Financial Model Example to illustrate impact of various

scenarios

Contents

2


Understanding Finance

• Financial Measurement

• Reading Income statements

• Balance Sheets

• Cash flows

• And more…

• Art of Finance – separating hard data from assumptions and estimates

• Mechanics of Analysis – Calculating ratios, ROI, Working capital

• Separating Cash and Profit

• Financial literacy and transparency – recognising how they can boost

performance

3


What do you need to do?

• Speak the language

• Ask questions

• Use the information

4

What is a Financial Model?



Definition

Important Considerations

A financial model is a tool for

valuation of your business/

project/ financial decision

The valuation is an estimate

based on assumptions for future

growth, cash flows etc., based on

past experience and future outlook

The simpler and flexible a

financial model, the better it is

Grounded assumptions, flexible

structure and scenario analysis is

the key to a successful financial

model

Define your objectives and

intended audience before finalizing

your financial model

A Financial Model constructs a financial

representation of some, or all, aspects of a

firm, a project, or a decision.

It is the task of building an abstract

representation of a financial decision making

situation

It is designed to represent the performance

of:

a financial asset or a portfolio

a business

a project

Any other form of a financial investment

It is a set of assumptions about future

business conditions that drive projections of

a company’s revenue, earnings, cash flows

and balance sheet accounts

v/s v/s


Financial Model vs. Financial Statements vs. Business Plan

7

Financial Model

• Past and future performance

based on sensitivities and

represents of some, or all,

aspects of the firm.

• The model is usually

characterized by performing

calculations, and makes

recommendations based on

that information.

• Typical uses:

o Calculating returns from

capital investments

o Analyzing a potential

merger / acquisition

o Forecasting financial

performance

Financial Statements

• Previous performance and

provides the records that

outline the financial activities

of a business

• It is a standard practice for

businesses to present

financial statements that

adhere to generally accepted

accounting principles (GAAP),

to maintain continuity of

information and presentation

across international borders

• Includes:

o Profit and Loss account

o Balance Sheet

o Cash flow statement

Business Plan

• Future performance based on

key assumptions typically

derived from Financial model

& in-line with key trends from

financial statement.

• It provides set of business

goals, the reasons they are

believed attainable, and the

plan for reaching those goals.

It may also contain

background information about

the organization or team

attempting to reach those

goals.

• It may be externally focused,

targeting investors or

customers. OR

• Internally focused to frame the

strategy of the firm to reach

business goals.

Tool for executing a business

idea

Tool to assess past and

existing business health

Tool for evaluating a business

plan, i.e. efficacy of a BP



Example

Here’s a basic example of a financial model to ascertain the present value of projected net sales. The main components of

this financial model are:

1. Projected costs and sales – While Year 0 is actuals but year 1 to 5 are forecasted based on certain assumptions of

future micro and macro economic conditions

2. Discounting factor – this represents the time value of money. “Money in hand is more valuable than possible cash

flow in the future”

3. Net Present Value, IRR, Payback period – These are the outcomes of a financial model that can allow to value your

business, take financial decisions etc.

Particulars

(INR) Year 0

(current yr.) Year 1 Year 2 Year 3 Year 4 Year 5

Cost of Equipment 1,000,000

Installation Cost 100,000

Maintenance and other

running costs 50,000 55,000 60,500 66,550 73,205

Cost 1,100,000 50,000 55,000 60,500 66,550 73,205

Sales 200,000 220,000 242,000 266,200 292,820 322,102

Net Sales/ Cash flow (900,000) 170,000 187,000 205,700 226,270 248,897

Discounting Factor 1 0.9091 0.8264 0.7513 0.6830 0.6209

Net Present Value (127,273)

IRR 4.64%

Payback period (in Years) 4.81

Note:

1. Cost and

Sales are

assumed to

increase by

10% y-o-y

2. Discounting

factor is

assumed at

10%

Financial

Data,

including

assumptions

Output

Valuation

assumptions

8

Illustrative


How to do Financial Modeling?

The Financial Modeling Framework

Define Assumptions

Collect Data

Build Model

Test and Validate

Report and

Review

9

• Should explain how business model works, and

encapsulate the main drivers of your business

• Consists of identifying the list of input variables –

internal and external – and determining the inter-

linkages between them

• Once the inputs for the financial model are

finalized, the next step is to collect data

• Data should be gathered from reputable

sources such as historical financial

statements and published reports and

statistics

• Any judgment-based data points should

be backed by sound rationale

• Spreadsheet-based

modeling remains the most

popular method for building

financial models

• Some key guiding principles for

a spreadsheet model are:

─ Planning the layout of the

model in advance

─ Breaking up different

modules of the model

(assumptions, calculations,

financial statements, etc.)

─ Planning out scenarios to

analyze key drivers of the

model that have the most

impact on the projections

• The most basic way to test the model is to play with the inputs, i.e.,

testing every input variable with values that reflect all possibilities

• Validation of the model takes two forms: i) audit or diagnostic review of

the model by a credible third-party, and ii) continued validation

wherein the results are continuously tested against actual performance

• Start with the ultimate business

users in mind, and accordingly

define KPIs and supporting analytics

for reporting the model

• Any feedback from stakeholder

reviews should feed back into the

model assumptions

Need for Dynamic Financial Model


Evolution of Dynamic Financial Modeling

Types of Financial Models

Conventional financial forecasting and Dynamic financial analysis are worlds apart, even though dynamic

models have evolved from more traditional models

Conventional Financial Model Dynamic Financial Model

11

• Starting with a conventional financial model, ranges

are defined for key parameters, and values within

ranges are associated with a probability distribution

• The model is then recalculated multiple times,

generating a range of results

• Feedback loops and “management intervention

decisions” are incorporated into the model

• Differences in financial results arising from alternative

strategic decisions can be evaluated

What is a Dynamic Financial Model

• In a conventional financial model, the output is based

on 2-3 business scenarios only (expected, best

case, worst case)

• Variability of possible outcomes cannot be quantified

• Multiple variable scenario simulation and risk

mitigation design are not possible

• Since the full depth and breadth of possible

outcomes is not captured, it is not a reliable stand-

alone tool for strategic decision making

Drawbacks of a Conventional Model


Dynamic Financial Modeling framework

Components of dynamic financial modeling

Framework and Components of Dynamic Financial Model Significance of components

Dynamic Financial Model provides business with:

─ Quantitative look at the risk-and-return trade-offs inherent in emerging Strategic Opportunities

─ Structured process for evaluating alternative operating plans

─ Solid information about the interaction of decisions from all areas of company operations

Calibration

Scenario Generator

Company model

Analysis/Presentation Interpretation/Optimization

Strategy Evaluation

Output variables

Risk factors

Process of finding suitable

parameters for the model to produce

scenarios

Dynamic models for risk factors

affecting the company e.g.

economic/business risk

Modeling reaction of company on

the behaviour of risk suggested by

various scenarios

Identify and study input scenarios

giving rise to particularly bad results

Readjust strategy for optimization of

target values of the company

Identify variables that need to be

modified to optimize results

1

2

3

4 5

6

1

2

3

4

6

5

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Scenario Planning


Scenario Planning

Parameters of Scenario planning

Input Parameters/variables in Dynamic Financial

Modeling

External/Internal

Influencers

Significance in Dynamic

modeling (H/M/L)

Macro Economic External H

Interest Rates

Inflation

Exchange Rate Fluctuation

Taxation and regulatory structure

Cost External H/M

Cost for major raw materials/Salaries

Sales Internal M

Pricing for finished goods/services

Capital Structure Internal M

A Scenario is a collection of sensitivity changes resulting in changes to financial model e.g.

• High inflation and high input cost

• Unexpected competition so lower price and volume, together with higher labour costs

• Financial risks – e.g. higher interest rates (where these are not hedged), currency fluctuations

• Sales risk – e.g. will the price and / or volume be achieved

Typical Parameters Considered for Dynamic Financial Modeling

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Business Value measurement

Parameters and linked financial metrics

15

• profitability

• performance Performance

• Future growth

• Future profitability

• Business stability

• Financial leverage

Business Indicators

Efficiency

Risk Perception

Expectation

Financial

Metrics/Ratios

• Operational

leverage

• ROCE (Return on Capital

Employed)

• PBDIT

• Gross Margin

• Accounts payable days and

Accounts receivable days

• Current ratio and Quick ratio

• Interest turnover ratio

• Estimated Market Share

• Future earnings/cash flow

projections

Impacted

parameters Key lever

• Volume/ Price

• Cost of RM

• Conversion Cost

• Overheads

• Inventory

• Receivables and payables

• Margin

• Cost of Debt

• Amount of leverage

• Stock adjustments / times

inventory

• CAGR

• Inflation and expected

Margins

• Future leverage


Identifying the key financial drivers through Financial Modeling…

16

Which is a better business scenario….?

• Volume increase as planned

AND the price increases by

atleast 2% on y-o-y basis

• To meet the new scenario:

‒ Purchase more RM & thus

cost increases to 8%

‒ Aggressive manufacturing

thus conversion cost

increase by 10%

‒ Other cost inc. by 8%

• Increase CAPEX to meet

higher demand

• Carry higher inventory to meet

orders and avoid stock-out

• Provide credit hence receivable

increase to 2 month

• Volume increase by only 5%

AND price decrease by

atleast 2% on y-o-y basis

• To meet the new scenario:

‒ Raw material, conversion

distribution remain same

‒ Overhead remains same

• Have same CAPEX as no

urgency

• Borrowings becomes limited

hence infuse more Equity

• Provide credit hence receivable

increase to 2 month

• Control inventory to similar

levels

Though scenario 2 looks grim… but

• key business performance indicators

are better in 2nd scenario. Higher

EBITDA, Net Profit Margin, ROI & ROE

in the initial years

• The cash outflow from business is

better managed and you incur lesser

loss in the initial years

• On overall basis 2nd scenario has:

‒ Better NPV (though still negative);

‒ Positive IRR

‒ Marginally lower WACC

Results Year 1 Year 5 Year 1 Year 5 Year 1 Year 5

Revenue (in '000) 3,000 4,392 3,000 5,680 3,000 3,363

COGS (in '000) 1,958 3,088 1,958 4,117 1,958 2,426

EBIDTA 693 1,304 603 1,563 783 938

EBITDA % 23% 30% 20% 28% 26% 28%

Net profit % 2% 14% -2% 13% 6% 11%

ROI % 15% 124% 6% 124% 18% 45%

ROE % 10% 84% -7% 84% 14% 30%

Fixed Asset turnover (times) 1.41 7.03 1.18 7.57 1.41 5.38

Net cash flow (in '000) -185.07 608.06 -674.91 602.68 -241.24 481.73

WACC

NPV (in '000)

IRR

Pay back period (years)

Scenario 2: (-) Dec

10.07%

-74

8%

5

403 -538

19% 1%

4 5

Base Case Scenario 1: (+) Inc

10.09% 10.09%

Assumption Units Year 1

(+)Inc /

(-)Dec (+)Inc (-)Dec

Sales Volume Tons 1,500 10% 15% 5%

Selling Price INR / ton 2,000 0% 2% -2%

Raw Material INR / ton 1,350 5% 8% 5%

Conversion costs INR / ton 300 5% 10% 5%

Distribution costs INR / ton 105 5% 8% 5%

Selling & Admin Exp INR 000s 440 5% 8% 2%

CAPEX INR 000s

Debt portion %

Equity portion %

Cost of equity %

Cost of Debt %

Receivables Months

Inventory Months

Payables Months

2

1

1

Scenario 2

2,500

30%

70%

10%

15%

1 2

1 2

1 1

30% 30%

10% 10%

15% 15%

Base Case Scenario 1

2,500 3,000

70% 70%


Key sensitivities to guard upon

Impact of Volume & Price …(illustrative)

17

At same Volume

Sales volume has high sensitivity to the NPV and IRR of the investment, even though ratios remain same

Price has the HIGHEST sensitivity to the NPV & IRR and also greatly impacts the performance ratios

Results Year 1 Year 5

Revenue (in '000) 3,000 3,000

COGS (in '000) 1,958 2,085

EBIDTA 693 915

EBITDA % 23% 31%

Net profit % 4% 12%

NPV (in '000)

IRR


75

12%

5

(+)10% increase in Volume


Revenue (in '000) 3,000 4,392

COGS (in '000) 1,958 3,088

EBIDTA 693 1,304

EBITDA % 23% 30%

Net profit % 4% 14%

NPV (in '000)

IRR


365

18%

4

(-) 10% decrease in Volume


Revenue (in '000) 3,000 1,968

COGS (in '000) 1,958 1,394

EBIDTA 693 574

EBITDA % 23% 29%

Net profit % 4% 7%

NPV (in '000)

IRR


-218

5%

5

At same Price


Revenue (in '000) 3,000 3,000

COGS (in '000) 1,958 2,085

EBIDTA 693 915

EBITDA % 23% 31%

Net profit % 4% 12%

NPV (in '000)

IRR


75

12%

5

(+)10% increase in Price (-) 10% decrease in Price


Revenue (in '000) 3,000 4,392

COGS (in '000) 1,958 2,155

EBIDTA 693 2,238

EBITDA % 23% 51%

Net profit % 4% 29%

NPV (in '000)

IRR


1,446

37%

4


Revenue (in '000) 3,000 1,968

COGS (in '000) 1,958 2,033

EBIDTA 693 -65

EBITDA % 23% -3%

Net profit % 4% -15%

NPV (in '000)

IRR


-1,064

-25%

>5


Key sensitivities to guard upon

Impact of Borrowings & Working Capital …(illustrative)

18

Cash flow Statement Year 1 Year 2 Year 3 Year 5

EBITDA 693 800 1,001 1,304

Interest (210) (158) (105) -

Tax (35) (87) (169) (301)

Change in Working Capital (283) (38) (36) (45)

Loan raised / (repaid) 1,400 (350) (350) (350)

Equity raised 750 - - -

CAPEX (2,500) - - -

Net cash flow (185) 167 341 608

Opening Balance 0 (185) (18) 784

Closing Balance (185) (18) 323 1,393


EBITDA 693 800 1,001 1,304

Interest (90) (68) (45) -

Tax (74) (116) (188) (301)

Change in Working Capital (283) (38) (36) (45)

Loan raised / (repaid) 600 (150) (150) (150)

Equity raised 1,750 - - -

CAPEX (2,500) - - -

Net cash flow 96 428 582 808

Opening Balance 0 96 524 1,787

Closing Balance 96 524 1,106 2,595

Debt to Equity Ratio: 70:30 Debt to Equity Ratio: 30:70

Cash flow positive from year 1, thus helping in reducing dependence of external funding & business insolvency

One month of Payable, Receivable and Inventory Increase in Receivables to 2 & Inventory to 3 month

Working capital gets adversely impacted due to lower cash flow, thus significantly reducing NPV and IRR

Working Capital Unit Value

Receivables Months 1

Inventory Months 1

Payables Months 1


Net cash flow (45) 298 461 708

Opening Balance 0 (45) 253 1,286

Closing Balance (45) 253 715 1,994

NPV 365

IRR 18%

Working Capital Unit Value

Receivables Months 2

Inventory Months 3

Payables Months 1


Net cash flow (520) 244 415 645

Opening Balance 0 (520) (276) 653

Closing Balance (520) (276) 139 1,297

NPV -225

IRR 6%


Summary & Wrap-up

• Financial models can investigate a range of decisions, but Super Models create

additional value through advanced analytical techniques and dynamic reporting

• A range of scenarios and simulation tools can highlight the economics / impact of

financial decisions on financial and operating metrics

– The right tool should be selected based on client / project needs and requirements, and

financial model objectives and complexity

• Auditing a model and validating assumptions is a critical step – one wrong

number can destroy a client’s trust in the results and underlying analyses

• "A picture is worth a thousand words" - displaying information is crucial to

information processing and decision-making

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StartUp Accelerator 2014: Financial modeling by Atul Dhawan_23 Feb 2014

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