Financial Modeling – Complete Guide to Terms & Concepts
Financial modeling refers to the process of creating a summary of a company’s expenses, earnings, and performance.
It’s used to predict, understand, and optimize the company’s financial performance, particularly in terms of cash flow, the required return, terminal value, and forecasted financial statements.
Key Takeaways – Financial Modeling
- Financial Modeling: Creating summaries of a company’s financial performance to predict, optimize, and understand expenses, earnings, and cash flows is the core of financial modeling.
- Cash Flow Management: Cash flow represents cash moving in and out of a business. Accurate forecasting is essential for liquidity, meeting obligations, and growth.
- Valuation and Capital Structure: Determining a company’s value involves assessing its required return, using discounted cash flows, and considering its capital structure (equity, debt, and hybrid securities) to evaluate profitability and risk.
Cash flow is an important element in financial modeling.
It refers to the amount of cash or cash-equivalents moving in and out of a business.
It’s a critical measure of liquidity, flexibility, and overall financial performance.
The value of a business is the amount of cash you can take out of it over its life, discounted back to the present.
Cash Flow Forecasting
Cash flow forecasting involves predicting the amount, timing, and uncertainty of future cash flows.
It’s an essential tool for managing liquidity and ensuring that the company can meet its future obligations.
Cash Flow Statement
It provides a detailed breakdown of the cash inflows and outflows from operating, investing, and financing activities.
Operating Cash Flow
Operating cash flow (OCF) is the cash generated from the core business operations, excluding external sources like investors or bank loans.
It provides insight into the company’s ability to generate sufficient cash to maintain and grow operations.
EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is a measure of a company’s operating performance.
It shows earnings from core business operations, ignoring the effects of capital structure, tax rates, and asset depreciation.
Depreciation and its Effect on Cash
Depreciation is the systematic allocation of the cost of an asset over its useful life.
It’s a non-cash expense that reduces reported earnings but does not impact the cash flow directly.
Net Operating Profit After Tax (NOPAT) is the potential cash earnings if the company has no debt.
It would be the equivalent of “EBI” if thinking of metrics like EBIT and EBITDA.
It measures profitability for all stakeholders before the effects of financing.
Free Cash Flow
Free cash flow (FCF) represents the cash a company generates after accounting for cash outflows to support operations and maintain its capital assets.
It’s an important measure of profitability, as it shows how much cash is available for distribution among security holders.
Free Cash Flow to the Firm
Free Cash Flow to the Firm (FCFF) is the cash flow available to the company’s suppliers of capital after all operating expenses and taxes are paid and necessary investments in working capital and fixed capital are made.
Free Cash Flow to Equity
Free Cash Flow to Equity (FCFE) is the cash flow available to the company’s equity shareholders after all expenses, reinvestment, and debt repayments.
Dividends are the distribution of a company’s earnings to its shareholders.
They’re typically expressed as a dividend per share (DPS) or dividend yield.
In financial modeling, dividends are an important part of the equity cash flow.
Cash is King
“Cash is king” is a phrase that emphasizes the importance of cash flow in a company’s financial health.
While income and profit are important, businesses need cash to pay their expenses and invest in their growth.
A mid-year adjustment is a technique used in financial modeling to account for the common assumption that cash flows occur evenly throughout the year.
Owner earnings, a concept introduced by Warren Buffett, refer to a company’s net cash flow, minus capital expenditures, plus depreciation and amortization.
It’s a measure of the company’s true profitability.
Required Return (Discount Rate)
The required return or discount rate is the minimum return required by an investor to invest in a particular asset or project.
This rate is used to discount future cash flows back to their present value.
Valuation using Discounted Cash Flows
In valuation using discounted cash flows (DCF), the discount rate is used to calculate the present value of future cash flows.
The discount rate reflects the riskiness of the cash flows and the time value of money.
Cost of Capital
The cost of capital is the minimum rate of return that a business must earn before generating value.
It’s used to evaluate new projects of a company and represents the opportunity cost of making a specific investment.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital (WACC) – pronounced “whack” – is the average rate of return a company is expected to provide to all its security holders, including debt holders and equity investors.
It’s often used as a discount rate in DCF analysis – specifically FCFF.
For FCFE, the cost of equity is used as the discount rate.
Cost of Equity
The cost of equity is the return a company requires to decide if an investment meets capital return requirements.
It’s used as the discount rate in DCF valuation of equity – in FCFE models, as noted above.
Cost of Debt
The cost of debt is the effective rate that a company pays on its current debt.
It’s an integral part of WACC, reflecting the risk and the tax impact of the company’s debt.
Capital Asset Pricing Model
The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between the expected return and risk of investing in a security.
It shows that the expected return on an investment is equal to the risk-free return plus a risk premium.
Beta (Finance) and its Empirical Estimation
Beta is a measure of the systematic risk of a security or portfolio in comparison to the market as a whole.
In financial modeling, the beta is used to calculate the cost of equity in the CAPM model.
Hamada’s equation is used to adjust the beta of a company to reflect the financial risk of leverage.
It helps to separate the financial risk and the business risk of a company.
Pure Play Method
The pure play method is a way of estimating a company’s beta (systematic risk).
It assumes that the beta of a similar single-line company can be used as a proxy for another company’s beta.
Arbitrage Pricing Theory
The Arbitrage Pricing Theory (APT) is a multi-factor asset pricing model.
It says that the expected return of a financial asset can be modeled as a linear function of various macroeconomic factors.
Business Valuation using the Build-Up Method
The Build-Up Method is a business valuation method that calculates the risk premium associated with investing in a particular company.
This method is frequently used in the valuation of small businesses and private companies.
Total Beta is a measure of the total risk of an individual stock, including both its systematic risk and its unsystematic risk.
It is particularly useful for valuing private companies and small public companies with significant unsystematic risk.
The T-model is a simplified version of the Gordon growth model, and it is often used in financial modeling to calculate the intrinsic value of a stock based on future dividends.
The cash-flow T-model is a version of the T-model that uses future cash flows instead of future dividends to estimate the intrinsic value of a stock.
Terminal value (TV) is the value of a business or project beyond the forecast period when future cash flows can be estimated.
It’s often used in multi-stage DCF models to calculate the lump sum value of all future cash flows.
Valuation using Discounted Cash Flows and Determining the Continuing Value
In DCF valuation, terminal value represents the value of all future cash flows beyond a forecast period.
It’s typically calculated using the Gordon Growth model or the Exit Multiple method.
Forecast Period (Finance)
The forecast period in financial modeling is the period for which detailed future cash flows can be estimated.
After the forecast period, the terminal value is used to estimate the remaining future cash flows.
Long-Term Growth Rate
The long-term growth rate is a projection of a company’s year-over-year revenue growth rate beyond a typical forecast period.
It’s used in the Gordon Growth model to calculate the terminal value.
Sustainable Growth Rate from a Financial Perspective
The sustainable growth rate is the rate at which a company can increase its sales, earnings, and dividends, financed through its existing equity and retained earnings.
It helps to determine whether the company’s long-term growth is achievable.
Equity Valuation Using Growth Rates
In equity valuation, the growth rate is used to project future earnings or dividends.
The present value of these future cash flows is then calculated to determine the intrinsic value of the stock/company’s equity value.
Forecasted Financial Statements
Forecasted financial statements are projections of a company’s financial performance for a specific period.
They are typically prepared as part of a financial model and include forecasted income statements, balance sheets, and cash flow statements.
A financial forecast is a financial plan or budget for a business.
It provides an estimate of future revenues, expenses, and cash flows based on historical data, market research, and various assumptions.
Financial Modeling in Accounting
In accounting, financial modeling involves preparing detailed company-specific models used for financial analysis and decision-making.
The output of these models includes a set of financial statements, key ratios, and key performance indicators.
Pro Forma Financial Statements
Pro forma financial statements are used for financial planning and analysis.
They provide information about a company’s potential earnings if certain strategies, events, or plans are carried out.
Revenue, or sales, is the income generated by a business from its operating activities.
It’s the top line on the income statement and the starting point for calculating net income.
What follows from revenue are expenses that get at various forms of “___ profit” (e.g., operating profit) and “___ margins” (e.g., operating margins).
A revenue model outlines the ways a business generates income from its products or services.
It forms the basis for the revenue projections in the financial model.
Financial Statement Analysis for Revenue
In financial statement analysis, revenue is scrutinized to understand the business’s profitability.
Revenue forecasting involves estimating the future sales of a business.
It’s an essential part of financial modeling, as it directly impacts profit projections and cash flows.
Net sales is the amount of revenue generated by a business after deducting returns, allowances, and discounts.
It represents the actual revenue available to cover operating expenses and contribute to profit.
Costs refer to the expenses incurred by a business in the process of generating revenues.
They are subtracted from revenues to calculate the profit of the business.
Profit margin is a profitability ratio that shows the percentage of sales that has turned into profits. It’s calculated by dividing net income by total revenue.
Gross margin is the difference between revenue and cost of goods sold (COGS), divided by revenue.
It represents the percentage of total sales revenue that the company retains after incurring the direct costs associated with producing the goods and services sold.
Net margin is the percentage of revenue remaining after all operating expenses, interest, taxes and preferred stock dividends (but not common stock dividends) have been deducted from a company’s total revenue.
Cost of Goods Sold
Cost of goods sold (COGS) is the direct costs attributable to the production of the goods sold by a company.
This amount includes the cost of the materials and labor directly used to create the good.
Some companies have high COGS when their business has to do with value-added manufacturing (i.e., selling of goods).
However, many services business may not have COGS.
Operating expenses are costs associated with the day-to-day operations of a business, such as rent, utilities, and salaries.
These are subtracted from gross profit to calculate operating profit.
The operating ratio is a measure of operational efficiency and performance.
It’s calculated as the ratio of operating expenses to net sales.
A cost driver is a factor that causes a change in the cost of an activity.
Understanding cost drivers is essential for accurately predicting future costs and cash flows in a financial model.
Fixed costs are expenses that do not change in proportion to the activity of a business.
They are an essential part of financial modeling and impact the company’s break-even point and margin of safety.
An example would be the recurring costs associated with keeping a business in good standing with local jurisdictions.
Variable costs are expenses that vary directly with the level of output or sales in a company.
They play a key role in the financial model, particularly in calculating the gross margin and the contribution margin.
Overhead costs are business costs not directly contributing to the production of goods or services.
They’re essential to running a business and must be included in a financial model to ensure accurate profitability projections.
The value chain is a concept that describes the full range of activities required to bring a product or service from conception to market and beyond.
It’s used in cost analysis to identify where value is added and costs are incurred in a business.
Activity Based Costing
Activity-based costing (ABC) is a costing method that assigns overhead and indirect costs to related products and services.
It helps in understanding product and customer cost and profitability.
Common-size analysis, also referred to as vertical analysis, is a tool that financial managers use to analyze financial statements.
It evaluates financial statements lines as a percentage of a total, such as sales or assets, to make comparisons between different periods or companies easier.
A profit model is a company’s plan for how it will generate its profits, including its revenues, costs, and profit margins.
It’s an integral part of financial modeling, underpinning the revenue and cost projections.
Capital in financial modeling refers to the financial resources available to a company for use in its business.
It includes equity, debt, and working capital.
Capital structure refers to how a corporation finances its operations and growth with different sources of funds, such as debt, equity, and retained earnings.
It’s important in financial modeling, particularly in estimating the cost of capital.
Some traders/investors pursue a strategy called capital structure arbitrage.
Common-Size Analysis for Capital
In common-size analysis for capital, each line item on the balance sheet is expressed as a percentage of total assets.
This allows for easy comparison across different periods or companies.
In finance, equity is the ownership interest in a company, represented by shares of stock.
In financial modeling, equity includes share capital, retained earnings, and other equity accounts.
Shareholders’ equity, also referred to as stockholders’ equity, is the remaining amount of assets available to shareholders after all liabilities have been paid.
It’s the net assets of the company and an important part of the company’s balance sheet in financial modeling.
The book value of a company is the total value of the company’s assets, minus its liabilities. It’s often used as a starting point for determining a company’s intrinsic value in financial modeling.
Retained earnings are the accumulated net income of a company that is retained by the company rather than distributed to its owners as dividends.
They are part of equity and are used to invest in the business or pay down debt.
Financial capital refers to the funds provided by lenders and shareholders, which are used to run a business.
It includes debt, equity, and retained earnings.
Long-term Assets / Fixed Assets
Long-term assets, also known as fixed assets, are those that are expected to provide value for more than one year.
They include property, plant, and equipment, and are used in financial modeling to calculate depreciation, amortization, and capital expenditure.
Fixed-asset turnover is a ratio of net sales to fixed assets.
It indicates how well a company is using its fixed assets to generate sales.
Long-term liabilities are obligations due beyond one year.
They include loans, bonds payable, and long-term lease obligations.
They’re important in financial modeling, particularly in estimating the cost of debt and determining the capital structure.
The debt-to-equity ratio is a financial ratio indicating the relative proportion of shareholders’ equity and debt used to finance a company’s assets.
It’s a measure of financial leverage and is used in financial modeling to analyze the company’s capital structure.
The debt-to-capital ratio measures a company’s financial leverage.
It is the ratio of total debt (long-term and short-term) to total capital (the sum of shareholders’ equity and debt).
It’s used in financial modeling to analyze the capital structure and estimate the cost of capital.
Working capital is a measure of a company’s operational liquidity.
It’s calculated as current assets minus current liabilities and is used in financial modeling to analyze short-term financial health and efficiency.
Current assets are assets that are expected to be converted to cash within one year.
They include cash, accounts receivable, and inventory.
They’re essential in calculating working capital and liquidity ratios in a financial model.
Current liabilities are obligations that are due within one year.
They include accounts payable, short-term debt, and accrued expenses.
Like current assets, they’re used in financial modeling to calculate working capital and liquidity ratios.
Inventory Turnover / Days in Inventory
Inventory turnover is a ratio showing how many times a company’s inventory is sold and replaced over a period.
Days in inventory is the number of days on average that items are in inventory before they are sold.
Both metrics are used in financial modeling to assess inventory management efficiency.
Debtor & Creditor Days
Debtor days is a measure of how quickly cash is collected from customers.
Creditor days is a measure of how long a company takes to pay its suppliers.
Both are important for managing cash flows and are often modeled in a financial model.
Days Sales Outstanding / Days Payable Outstanding
Days sales outstanding (DSO) measures the average number of days that it takes a company to collect payment after a sale has been made.
Days payable outstanding (DPO) measures how long it takes a company to pay its invoices from trade creditors.
Both are important in cash flow management and are used in financial modeling.
This guide provides an overview of the most important terms and concepts related to financial modeling.
A well-constructed financial model can aid in decision-making, financial analysis, and business valuation.