《Building Financial Models》读后感1000字

阅读《Building Financial Models》让我对金融模型有了更深入的了解。书中详细介绍了建立财务模型的方法和技巧，强调了数据分析和预测的重要性。通过学习这本书，我对如何有效地评估和分析财务数据有了更好的认识，对金融建模的实践也有了更多的信心。

Building Financial Models读后感(一)

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Building Financial Models读后感(二)

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Building Financial Models读后感(三)

Chapter 1 A Financial Projection Model

1.1 STRUCTURE

The income statement

The balance sheet

The cash flow statement

1.1.1 The Income Statement

The top line of the statement is the revenue line; the bottom line is the net income line, showing what the company has earned for the year after all expenses have been accounted for.

Most companies’ fiscal year coincides with the calendar year,that is to say, the reporting period ends on December 31. Others set their fiscal year to end on June 30 (e.g., Microsoft), or in fact any other month end. The main reason is to show the best possible seasonal condition,such as a point after the year-end holiday sales when inventories are low and cash holdings are high.

1.1.2 The Balance Sheet

The balance sheet is a snapshot of the company’s periods at one point in time, specifically the end of the reporting period.

1.1.3 The Cash Flow Statement

The cash fl ow statement ties the two other statements together.This statement starts with the net income from the income statement, makes adjustments for non cash charges, and then keeps

track of the changes in every account, except the cash account itself, on the balance sheet.The change is between the current yea’s balance sheet (Year t) and the prior year (Year t-1).

Each change in each balance sheet account represents a source of cash (e.g., a sale of an asset or an increase in borrowing means there is more cash on hand) or a use of cash (e.g., an inventory increase or a repayment of debt means less cash on hand).

At the end of the cash fl ow statement, we have a combined net source or net use of cash, equivalent to the change in cash between the current year and the prior year. This change should tie in with, or “foot” to, the difference in cash between Year t and Year t-1.Because the cash fl ow statement needs to look at the current period’s balance sheet and the prior period’s to determine the changes, the first year column in the cash fl ow statement is typically left blank, since there is no “prior period” at the beginning of the modeling periods.

1.1.4 How They Are Interlinked

1.1.5 Other Parts of the Financial Model

Once the three statements are in place and working together, we have a modeling engine that can be put to good use to drive other forms of analysis, such as credit analysis, discounted cash flow valuation, and leveraged buyout (LBO) analysis. (Having two financial models to represent two companies, we can also combine them for an merger model.)

We can add ratio pages to show the critical performance metrics, and also common-size statements. A common-size income statement shows the statement as percentages of revenue; a common-size balance sheet shows the line items as percentages of total assets.

1.2 AN ESTIMATOR, NOT A PREDICTOR

A financial model is not a crystal ball and its output does not dictate what the future will be. It is merely a tool to estimate what a company’s future financial profile might be, given certain assumptions about its future performance.

1.3 CRITICAL OUTPUTS

A financial model should allow you to reviews these measures of a company’s performance:

Earnings before interest and taxes (EBIT): EBIT is revenue less expenses directly related to its revenue-generating operations. Thus, EBIT is a measure of the earning power of its core operations. Non operating elements such as interest income or expense are not included.

Earnings before interest and taxes, depreciation and amortization EBITDA: This is EBIT but without depreciation and amortization expenses, both of which are non cash expenses, so there is no actual cash that the company has to pay out. So EBITDA is a good way to arrive at cash earnings, the amount of cash generated by a company’s core operations.

Revenue and net income: This shows revenue-generating ability and profitability. Net income is basically EBIT less interest and taxes.

Cash flow from operations: This shows net income plus add backs of the non-cash expenses less the cash that needs to be invested in the increase in operating working capital.

Operating working capital: Working capital by definition is current assets minus current liabilities, but often the term “working capital” denotes current assets excluding cash, less current liabilities excluding short-term debt (both short-term notes payables and current portion of long-term debt). It might be useful to call this definition operating working capital (OWC).Thus OWC is a measure of the cash investments required to keep the company in operation. Cash and debt are separate financing decisions.

Net plant, property, and equipment (PPE) and capital expenditures: Capital expenditures, or capex, is a major use of cash in the balance sheet. Capex is an ongoing expense because a company must continue to invest in its production equipment, which needs to be maintained, upgraded, or replaced over time.

Levels of debt and equity: A company’s level of debt may appear high or low relative to its equity, but the important measure is the company’s ability to service the debt-to pay the ongoing interest expense and to repay the debt on a timely basis.

1.4 A ONE-OFF MODEL

One-off means that the model is built for a specific project, to be used only for that one purpose. It can be used again, of course, but it will probably require substantial modifications to accommodate the specifics of the next project. A one-off model is easier to build in one sense: because it is built for a specific project.

1.5 A TEMPLATE MODEL

A template model, on the other hand, is meant to be used again and again, as the analysis workhorse for a group or even a whole organization.

1.6 YOU AS THE MODEL DEVELOPER

1.6.1 Three Hats

You are the finance expert, working with the elements of the financial statements and your knowledge of accounting to produce the correct representation of the results.

You are the spreadsheet wizard, pushing Excel to squeeze the last ounce of performance out of your model.

You are the virtual architect, manipulating the screen and the structure of your model to produce a final product that is transparent (easy to follow), flexible (easy to change),and robust (hard to break down).

1.6.2 Three Versions

Version 1: This is the first attempt, and involves gathering the required data and compiling the

calculations. This model is not likely to be pretty and has lots of shortcuts and errors, but at least it gives a first picture of what the analysis should be like.

Version 2: This corrects the errors as well as the shortcomings of Version 1. This version is easier to use and has more refinements in its calculations. After you develop this version and it has been in use for a little bit, suddenly you have a sense of what the model should have been doing all along, which leads to . . .

Version 3: This version is the first “real” version. It is more elegant in structure and easier to use. Often, this is also a radical departure from Versions 1 and 2 and comes after a smack-your-forehead moment of insight. This version is the one that satisfies the original concept of the model much more fully and elegantly.

1.7 SOME NOTES FOR WORKING BETTER

1.7.1 Two Monitors

1.7.2 Mouse or Keyboard

Chapter 2 Best Practices

2.1 STARTING OUT

2.1.1 Have a Clear Idea of What the Model Needs to Do and Start Slowly

2.1.2 Understand the Users’ Level of Expertise

a discounted cash fl ow valuation model requires at least the following steps:

1.Specifying the date of the valuation for the discounting

2.Defining income statement forecasts down to the EBIT level, working capital levels and capital expenditure requirements

3.Estimating the weighted average cost of capital (WACC)

4.Selecting the terminal value approach

5.Setting the discounting method, i.e., whether using mid-period or period-end discounting

2.1.3 Set Your Global Settings First

2.1.4 KISS

Keep It Simple, Stupid.

2.2 LAYING OUT THE MODEL

2.2.1 A Logical Arrangement for an Audit Trail

2.2.2 Separate Input and Output Areas

2.2.3 Be Consistent

2.2.4 Keep Formatting Simple

2.2.5 One Input for One Data Point

2.2.6 Think Modular

2.2.7 Keep Formulas Simple

2.2.8 No Hard-Coded Inputs in Formulas

2.2.9 Make All Calculations Visible

2.3 GUARDING AGAINST ERRORS

2.3.1 Errors in References

2.3.2 Errors in Functions

2.3.3 Errors in Range Definitions

2.4 WORKING IN EXCEL

2.4.1 Become Familiar with Excel’s Functions

2.4.2 Document as You Develop

2.4.3 Provide Ways to Catch Errors

2.4.4 Save and Save Often

Chapter 3 Setting the Stage

3.1 THE APPEARANCE OF THE SCREEN

3.1.1 Gridlines

3.1.2 Colors

3.1.3 Column Widths

3.2 TOOLBARS

3.3 STYLES

3.4 CALCULATION SETTINGS

3.5 EDITING SETTINGS

3.6 AUTOSAVE

Chapter 4 Accounting for Modeling

4.1 THE THREE FINANCIAL STATEMENTS

The income statement keeps track of the revenues and expenses over the accounting period, typically a year, although the income statement can be prepared for shorter periods, such as a quarter or a month. The top line is revenue, and the bottom line is net income after dividends. If the company does not pay dividends, then it is just net income.

The balance sheet is a record of a company’s holdings: its assets, liabilities, and equity at the end of the reporting period.The reporting period is typically at the end of the fiscal year,but balance sheets can also be prepared for shorter periods, such as at the end of quarters or even months. It is a snapshot of the company at this point in time. The total assets on the left side must equal total liabilities and the equity on the right side: the balance sheet must balance.

The cash flow statement shows how cash is being used during the year. The top line in the cash fl ow statement is the net income (before dividends) from the income statement. Subsequent lines show sources of cash (from revenues, selling assets or increasing liabilities or equity), and the uses of cash (in expenses or in buying assets or reducing liabilities in the balance sheet). The bottom line shows the total cash sources (or if the bottom line is negative, cash uses) in the company.

The cash fl ow statement puts the sources and uses of cash into three categories:

Cash from operating activities

Cash from investing activities

Cash from financing activities

The full layout looks something like this:

Net income

+ Cash sources (uses) from operating activities

+ Cash sources (uses) from investing activities

+ Cash sources (uses) from financing activities

= Total cash sources (uses)

+ Beginning cash on the balance sheet

= Ending cash on the balance sheet

4.2 THE MAIN COMPONENTS

4.3 THE ACCOUNTING EQUATION

Total Assets = Total Liabilities + Shareholders’ Equity

4.4 DOUBLE-ENTRY BOOKKEEPING

Assets represent what we have

Liabilities represent what we owe

Equity (also called shareholders’ equity or owners’ equity) represents what we own

4.5 THE BALANCE SHEET OF A START-UP

Retained earnings are the accumulated earnings of the company. The earnings of the business from the income statement are recorded in the balance sheet as retained earnings.For a company that is just starting, the first year’s retained earnings will be the same as its net income after dividends, if any. In subsequent years, the retained earnings is the accumulated net income after dividends of all preceding years plus the current year’s net income.

4.6 SOURCES AND USES OF CASH: DEBITS AND CREDITS

4.7 DOUBLE-ENTRY BOOKKEEPING AND CHANGE IN CASH

4.8 CHANGE IN CASH AND MODELING

4.9 BALANCING THE BALANCE SHEET

4.10 TWO WAYS OF BALANCING

Use only the balance sheet and the income statement.This is a mechanistic way that involves checking one side of the balance sheet against the other and putting in either an excess cash or a revolver number to make both sides balance. This approach requires only the current year’s income statement and balance sheet.

Use the balance sheet, the income statement and the cash fl ow statement. This is a more accounting-oriented approach. The cash fl ow statement is used to determine the net change in cash with the change in each balance sheet account in the assets, liability and equity sections.

If the change in cash is positive, then the model adds that to the existing excess cash number. If the model has a revolver, then the positive cash reduces that revolver.It may well be that the positive cash changes a prior revolver amount to a current excess cash amount. The reverse holds true if the change in cash is negative. To build the cash flow statement in this approach requires the current year’s income statement and both the current and prior year’s balance sheets.

4.11 PRODUCING CASH: PROFIT FOR MORE PROFIT

4.12 MANAGEMENT LEVERS IN THE CASH GENERATING CYCLE

4.13 MODELING FOR BUSINESS MANAGEMENT

Chapter 5 The Model Building Toolbox: F Keys and Ranges

Chapter 6 The Model Building Toolbox: Functions

Within a function, arguments can be:

A number or a text string

A cell or range reference, or multiple references, such as the SUM function shown above

A whole column: COUNT(A:A)

A whole row: MAX(20:20)

A range name: AVERAGE(Revenues)

Another formula or expression: SUM(250/3,12*43.5)

Other functions: SUM(AVERAGE(C1:C10),AVERAGE(C21:C30))

Optional with a marker: OFFSET(B1,0,2) or OFFSET(B1,,2).The space between the double commas is where the 0 has been left out. Excel considers such an omission to be the same as 0.

Optional without a marker: HLOOKUP(D5,B2:B3,2) or HLOOKUP(D5,B2:B3,2,TRUE). Excel considers the omission of the last argument as being the equivalent of the TRUE argument.

Any combination of the preceding.

6.1 LIST OF USEFUL FUNCTIONS

6.1.1 Exponential Power

6.2 WORK NOTES

6.3 LET’S START

The starting point: IF

Alternatives to IF

Functions for adding

Functions for counting

Functions for dates

Functions for looking up data

Dealing with errors

Other functions to know

6.4 THE STARTING POINT: IF

6.5 ALTERNATIVES TO IF

6.5.1 CHOOSE

6.5.2 OFFSET

6.5.3 Comparing IF, CHOOSE, and OFFSET

6.5.4 AND

6.5.5 OR

6.6 FUNCTIONS FOR ADDING

6.6.1 SUM

6.6.2 SUMIF

6.6.3 SUMPRODUCT

6.7 FUNCTIONS FOR COUNTING

6.7.1 COUNT

6.7.2 COUNTA

6.7.3 COUNTIF

6.7.4 AVERAGE

6.8 FUNCTIONS FOR DATES

6.8.1 How Excel Keeps Track of Dates

6.8.2 To Get the Year, Month, and Day from a Date

6.8.3 To Get a Date from the Year, Month, and Day

6.8.4 Monthly Dating

6.8.5 Yearly Dating

6.8.6 Non-annual Intervals

6.9 FUNCTIONS FOR LOOKING UP DATA

6.9.1 CHOOSE

6.9.2 OFFSET

6.9.3 MAX and MIN

6.9.4 MIN and MAX Together

6.9.5 MIN and MAX with Negative Numbers

6.9.6 MATCH

6.9.7 INDEX

6.9.8 Using MATCH and INDEX Together

6.9.9 HLOOKUP/VLOOKUP

6.10 HANDLING ERRORS

6.10.1 #DIV/0! Errors

6.10.2 The #VALUE! Error

6.10.3 The #NAME？ Error

6.10.4 The #REF! Error

6.10.5 The ISERROR Function for Trapping Errors

6.11 OTHER FUNCTIONS TO KNOW

6.11.1 ROUND, MROUND, INT, and MOD

6.11.2 ABS, CEILING, FLOOR, ROUNDUP, ROUNDDOWN

6.11.3 ISNUMBER, ISTEXT, ISBLANK

6.11.4 LEFT, RIGHT, MID, LEN, LOWER, UPPER,PROPER, TEXT, VALUE

6.12 FINANCIAL FUNCTIONS: NPV, XNPV, IRR, XIRR

NPV (net present value) and IRR (internal rate of return) deal with the time value of money. Time value of money is a way of saying that a dollar today is not worth the same value as a dollar will be in the future, or as it was in the past.

6.12.1 NPV

NPV(rate, value1,value2, . . .) returns the net present value of the annual flows represented by the values. These values can be positive or negative numbers, representing, by the usual convention, inflows and outflows of cash, respectively. Instead of individual values, you can use a range of values. Rate is the annual discount rate.

6.12.1.1 NPV at mid-year

6.12.2 XNPV

6.12.3 IRR

IRR(values,guess) returns the internal rate of return on the range of values. An IRR is the rate that would bring the NPV on a set if it flows to 0. The values must contain at least one number that is positive and one that is negative. The guess rate is a rate you can enter, such as 0.10 (10%), to help the function to begin its calculations correctly. You can omit this guess, in which case Excel will begin its calculations with the guess rate of 10%.

6.12.4 XIRR

XIRR(values,dates,guess) returns the IRR on a range of values associated with the dates. These two ranges must span the same columns so that Excel will know which period’s data are associated with which period. The dates in XIRR can have irregular intervals of months or years.

Chapter 7 Building a Pilot Model

7.1 HOW TO READ THE ILLUSTRATIONS

7.2 TO START, ADD A NEW BLANK WORKBOOK IN EXCEL

7.2.1 Set the Normal Style

Set the Normal style to have the following format:

One decimal place

Use thousand separators

Black parentheses for negative numbers

7.2.2 Gridlines

Select whether or not you want to see gridlines in the workbook.

In the illustrations, the gridlines are turned off.

7.3 PILOT MODEL NO. 1

In this example, we will build a model whose balance sheet balances without the use of a cash fl ow statement. Lay out the following lines in your new workbook (Fig. 7-3):

Column A has a width of 1.5.

Column B has a width of 26.

Column C has a width of 5.

Columns D and onward have a width of 10.

7.4 PILOT MODEL NO. 2

7.5 TESTING THE MODELS WITH YOUR OWN NUMBERS

7.6 SOME NOTES ON THE PILOT MODELS

Chapter 8 Circular References and Iterative Calculations

8.1 TO USE OR NOT USE

8.2 TURNING ITERATIONS ON IN EXCEL

8.3 WHAT HAPPENS IN ITERATIVE CALCULATIONS

8.4 AN EXAMPLE: AN INTEREST CALCULATION

8.5 AVERAGE INTEREST CALCULATION

8.6 AVOIDING CIRCULAR REFERENCES

8.7 USING CIRCULAR REFERENCES: PRECAUTIONARY MEASURES

8.8 FUN WITH CIRCULAR REFERENCES

Chapter 9 Variations on Balancing Plugs

9.1 WORKING WITH BALANCE SHEET BALANCING NUMBERS

9.2 THE LIABILITIES PLUG DOES NOT HAVE TO BE A REVOLVER

9.3 THE ASSET PLUG DOES NOT HAVE TO BE EXCESS CASH

9.4 USING BOTH THE EQUITY PLUG AND A REVOLVER

9.5 DIVIDENDING OUT THE EXCESS CASH

Chapter 10 Preparing to Build a Full Model

10.1 EXPANDING FROM THE PILOT MODEL

10.2 A FULL INCOME STATEMENT

10.3 A FULL BALANCE SHEET

10.3.1 Assets

Excess cash [Result of total fl ows]

Operating cash CFO

Short-term investments CFI

Accounts receivable CFO

Inventory CFO

Other current assets CFO

Current assets

Net PPE CFI

Investments in affiliates CFI

Intangibles CFI

Long-term assets CFO

Total assets

10.3.2 Liabilities

Revolver [Result of total flows]

Notes payable CFF

Accounts payable CFO

Other current liabilities CFO

Current liabilities

Long-term debt 1 CFF

Long-term debt 2 CFF

Long-term debt 3 CFF

Long-term liabilities CFO

Total liabilities

10.3.3 Minority Interest CFF

10.3.4 Shareholders’ Equity

Preferred stock CFF

Common stock CFF

Retained earnings [does not appear]

Other equity account CFF

Total shareholders’ equity

10.4 THE CASH FLOW STATEMENT

All accounts on the balance sheet, except the retained earnings, appear in the cash fl ow statement. Only several accounts from the income statement appear. These are: depreciation, amortization of intangibles and other non-cash expenses, net income, and other lines that appear below the net income in the income statement, including dividends.

The capital expenditures (or “capex”) line appears in the cash flow statement only. In the model we are building, the input of this will appear as part of the inputs for the balance sheet Net PPE, as capex is most closely associated with this account.

10.4.1 Cash from Operating Activities

Net income

Depreciation

Amortization of intangibles

(Equity in earnings of affiliates)

Minority interest in earnings

(Incr) decr in Deferred tax assets

Incr (decr) in Deferred tax liabilities

Extraordinary income (expense)

(Incr) decr in Accounts receivable

(Incr) decr in Inventory

(Incr) decr in Other current assets

Incr (decr) in Accounts payable

Incr (decr) in Other payables

Incr (decr) in Other current liabilities

(Incr) decr in Net working capital

(Incr) decr in Other long-term assets

Incr (decr) in Other long-term liabilities

Cash fl ow from operating activities

10.4.2 Cash from Investing Activities

(Incr) decr in Short-term investments

(Capital expenditures)

Dividends received from Investments in affiliates

(Incr) decr in Investments

Other (Incr) decr in Goodwill

Other (Incr) decr in Intangibles

Cash fl ow from investing activities

10.4.3 Cash from Financing Activities

Incr (decr) in Notes payable

Incr (decr) in Long-term debt 1

Incr (decr) in Long-term debt 2

Incr (decr) in Long-term debt 3

Incr (decr) in Long-term debt 4

Incr (decr) in Long-term debt 5

Incr (decr) in Subordinated debt

Incr (decr) in Subordinated debt 2

Other Incr (decr) in Minority interest

Incr (decr) in Preferred stock

Incr (decr) in Common stock

Incr (decr) in Other equity account

(Preferred dividends)

(Common dividends)

Cash Flow from Financing Activities

Total Cash Flow

10.5 RATIOS AND OTHER OUTPUT PAGES

10.6 SAME SHEET OR DIFFERENT SHEETS

10.7 LAYOUT

10.7.1 Testing Layout No. 1

10.7.2 Testing Layout No. 2

10.7.3 Testing Layout No. 3

10.7.4 The COGS and SGA Inputs Layout

10.7.5 Some Excel Notes

10.7.6 The Rest of the Income Statement, and the Balance Sheet

10.7.7 The Number of Forecast Years

10.8 FORMATTING THE OUTPUT

10.9 THE INPUT SHEET AS A COMPLETE MODELING ENGINE

Chapter 11 Building an Integrated Financial Model: Part 1

11.1 SOME NOTES ON MODELING DISCIPLINE

11.2 LAYOUT

11.3 HOW TO READ THE TABLES

11.4 THE INCOME STATEMENT INPUTS

11.5 THE BALANCE SHEET INPUTS

11.6 ADDING MORE LINES TO THE MODEL

11.7 REMOVING LINES

11.8 THE INCOME STATEMENT OUTPUT REPORT

11.9 THE BALANCE SHEET OUTPUT REPORT

11.10 THE COMMON-SIZE INCOME STATEMENT OUTPUT

11.11 THE COMMON-SIZE BALANCE SHEET OUTPUT

Chapter 12 The Cash Flow Statement

The income statement and balance sheet already work together well, in that the balance sheet is now balanced;therefore, the cash fl ow statement can be viewed as a reconciliation table to track the cash fl ow from the income statement and other sources and uses of cash from the changes in the balance sheet.

The cash flow statement calculates the total cash produced for each year, adds the prior year’s excess cash or revolver, and arrives at the current year’s excess cash. If the result is negative, then it is the current year’s revolver. The ending excess cash or revolver for each year in the

cash fl ow should equal the same results in the balance sheet.

In an alternate modeling approach, however, the cash flow statement is viewed as the method by which the balance sheet is balanced. In this case, the excess cash or revolver plug that is calculated for each forecast year is calculated by the cash fl ow statement, and then used by the balance sheet.

12.1 LAYOUT

12.2 TABLE OF FORMULAS HAS TWO DIFFERENT COLUMNS

12.3 THE CASH FLOW STATEMENT

12.4 GETTING FROM CASH FLOW TO THE EXCESS CASH OR REVOLVER NUMBER

12.5 RECONCILIATION TABLES

12.6 CONNECTING THE CASH FLOW STATEMENT TO THE BALANCE SHEET

12.7 EXCESS CASH (REVOLVER) WORKS IN EITHER APPROACH

Chapter 13 The Cash Sweep

The cash sweep is a modeling technique to automatically pay down debt in addition to any scheduled amortization payments.The sweep uses the excess cash line in the model.

The cash sweep can occur:

In forecast years only

When there is excess cash

When there are tranches of long-term debt that are suitable for automatic repayment. Usually, this means only bank debt, and not issued bond debt.

13.1 CONCEPT

13.2 MODELING STRUCTURE FOR A CASH SWEEP

13.3 WHAT HAPPENS IN A SWEEP

13.4 THE EXCESS CASH FOR SWEEP

13.4.1 Excess Cash Before the Sweep and After the Sweep

13.4.2 Interest Calculations and Retained Earnings

13.4.3 Illustrative Calculations in a Cash Sweep

13.5 THE CASH SWEEP IN BALANCE SHEET BALANCING

13.5.1 Inserting New Rows in the Debt Section

13.5.2 Adding the Cash Sweep Rows

13.5.3 The Cash Sweep Formulas

13.5.4 Adjusting the Balance Sheet Excess Cash and Revolver Rows

13.5.5 Connect the Debt Input Section to the Cash Sweep

13.5.6 Interest Expense Are on After Cash Sweep Values

13.6 THE CASH SWEEP IN CASH FLOW BALANCING

13.6.1 Inserting New Rows in the Debt Section

13.6.2 Modify the Cash Flow Statement Created in Chapter 12

13.6.3 Connect the Balance Sheet to the Cash Flow Statement Numbers

13.6.4 Output Format for the Cash Flow Statement

13.7 BELLS AND WHISTLES

13.8 PERCENTAGES OF AVAILABLE CASH FOR CASH SWEEP, OR DEBT TO BE SWEPT

13.8.1 For the Balance Sheet Balancing

13.8.2 For the Cash Flow Balancing

13.9 ORDER OF CASH SWEEP

13.9.1 Order of Cash Sweep by Balance Sheet Balancing

13.9.2 Order of Cash Sweep by Cash Flow Balancing

13.10 PARI PASSU CASH SWEEP

Chapter 14 Ratios

14.1 COMPARING NUMBERS AGAINST ONE ANOTHER

14.2 NEGATIVE NUMBERS

14.3 CATEGORIES OF RATIOS

Size

Liquidity

Efficiency

Profitability

Leverage

Coverage

14.3.1 Some Important Terms

EBIT, or earnings before interest and taxes, is an important number in the income statement, because it represents the company’s ability to generate operating earnings before interest expense (a cost related to financing decisions, not operating decisions) and taxes (a cost related to running a business in a regulated economy). This is also called operating profit or operating income.

EBITDA is earnings before interest, taxes, depreciation,and amortization of intangibles. EBITDA is useful for comparing companies within and across industries, because it does not include the effects of many of the factors that differentiate companies in different sectors, such as interest (from different capital structures), depreciation (from different fixed asset bases),amortization (from different holdings of intangibles), and taxes(from different tax treatments). Because depreciation and amortization of intangibles are non-cash expenses, EBITDA shows the amount of cash a company can generate from its operations.This is the source of cash for any interest payments, so this is a measure that a company’s creditors would examine very closely.

Net debt is total debt minus cash and cash equivalents.Cash equivalents are accounts such as short-term investments or marketable securities, which can be easily turned into cash. Net debt represents the net debt load that a company has to bear after using its cash and cash equivalents. Companies with a large cash position relative to their total debt will have a negative net debt.

14.4 FOR SIZE

Revenues

Total assets

Total shareholders’ equity

14.5 FOR LIQUIDITY

These measures give an indication of how much of a company’s cash is invested in its current assets. However, they also show how well current assets can cover current liabilities if the company had to liquidate them into cash.

14.5.1 Working Capital

Working capital (sometimes also called net working capital) is current assets minus current liabilities. Working capital is a measure of the cushion that a company has for meeting obligations within the ordinary operating cycle of the business.

14.5.2 Operating Working Capital

Operating working capital (OWC) is a nonstandard term that means current assets without cash minus current liabilities without short-term debt (which includes any current portion of long-term debt). This measure looks at how much of its cash a company uses in maintaining its day-to-day operations. The higher the operating working capital, the less liquid a company is, because its cash is tied up in accounts such as accounts receivables and inventory.

14.5.3 The Current Ratio, or Current Assets/Current Liabilities

The current ratio is current assets divided by current liabilities.The ratio measures the multiple by which a company can use its current assets (if it could convert them all to cash) to cover all its current liabilities.

14.5.4 The Quick Ratio, or (Current Assets – Inventory)/Current Liabilities

The quick ratio is similar to the current ratio but is a more severe ratio (the ratio will be a lower number than the current ratio) in that it takes inventory out of the numerator. Inventory is very il-liquid and usually cannot be turned into cash at a moment’s notice,at least without resorting to deep discounts and “fire sale” prices.In regard to the last two ratios, both ratios are only indications since they do not include information about when the current liabilities are due. A company that can stretch its accounts payable over a longer period will have a better ability to pay its other bills than a second company with the same ratios but with a shorter payables payment period. These ratios are more popular in credit analysis than in mergers and acquisitions (M&A)work.

14.6 FOR EFFICIENCY

The ratios that follow indicate how well or efficiently a company makes use of its assets to generate sales. The first five look at the amount of balance sheet accounts that are tied up in the creation of earnings. The last two look at how well the company’s assets are utilized for sales.

Accounts receivable/sales * 365

Inventory/cost of goods sold * 365

Accounts payable/cost of goods sold * 365

[(Current assets – cash) – (current liabilities – short-term debt)]/sales or

Operating working capital/sales

Change in OWC and Change in OWC/sales

Sales/net fixed assets

Sales/total assets

14.6.1 Accounts Receivable/Sale * 365

Accounts receivable/sales * 365 shows how many days it takes a company to collect on its receivables: the higher the number of days, the worse its receivables management. If the company has made a sale but has not collected the money from it, it is literally extending an interest-free “loan” to that customer, tying up the cash that could be put to productive use elsewhere.

Without the * 365, the ratio shows the fraction of the year’s sales that is still tied up in receivables. By multiplying the number of days in a year into the fraction, we get not a fraction, but the number of days that represents how long the average receivable remains uncollected. Thus, the result is usually called“receivable days.” (You can use 360 as the number of days, but

if you do, you should use the same number whenever you are calculating portions of years elsewhere in the model.)Receivable days that have been increasing reflect declining sales and/or a poorly managed collection system.

A similar ratio to this is sales/accounts receivable, reversing the numerator and the denominator. This is a turnover ratio,and it describes how many times receivables turn over in the year (i.e., how many cycles of receivables are fully collected in the year). The higher the ratio, the better, since it would reflect a faster receivables collection system.

14.6.2 Inventory/Cost of Goods Sold * 365

Inventory/cost of goods sold * 365 shows how many days it takes a company to make use of a piece of inventory. The higher the number of days, the worse it is. Like the receivable days ratio, an “inventory days” ratio shows how long a company’s cash is tied up in its inventory before that inventory is put into a product and sold. A high inventory days number suggests slowing sales and/or an inefficient production system.

Sales is sometimes used as the denominator and can show the same trend. However, if there are changes in the gross margin(i.e., in the relationship between sales and cost of goods sold),then the trend shown by the ratio using sales will be different from that using cost of goods sold.

Cost of goods sold/inventory is a ratio using the same numbers but in reversed positions, and without the 365 multiplier. This is a turnover ratio; it shows the number of times that inventory is turned over during the year. Think of this as the number of times that the inventory in the warehouse is completely moved out during the year.

14.6.3 Accounts Payable/Cost of Goods Sold * 365

Accounts payable/cost of goods sold * 365 shows how many days its takes a company to pay its suppliers. The higher the number of“payable days,” the more favorable it is for the company. Not paying a supplier means that the company is able to get an interest free “loan” from its supplier. (This is a receivables collection issue from the supplier’s point of view.)

The denominator is cost of goods sold, and not sales, because the unpaid bills usually relate to purchases of inventory.In production, inventory is used up and that use is recognized as cost of goods sold.

A low payable days number means that the company has an efficient payment system, which is well and good in itself. A higher number can mean that the company has a strong enough buying power to delay its payments and still not have its suppliers abandon it. Beyond a certain limit, and this is a judgment call, a high number can mean the deterioration of its cash position, and therefore its ability to pay its bills.

Cost of goods sold/accounts payable is the payable turn over ratio. It shows how many times in the year that the company has completely repaid its suppliers.

14.6.4 [(Current Assets – Cash) – (Current Liabilities –Short-Term Debt)]/Sales

[(Current assets – cash) – (current liabilities – short-term debt)]/sales, or

Operating working capital/sales, is an interesting ratio and bears some attention. The numerator is almost like working capital, but not quite. This is why I am using the term operating working capital, or OWC.

For highlighting the operating decisions of a company,working capital (or current assets minus current liabilities) has a fl aw. Because it includes cash and cash equivalents and also short-term debt—both of which are related to financing decisions—working capital gives an unclear measure of the purely operating current investments a company has to make in its balance sheet. This is understandable as the original intent of working capital is to show the cushion that it has for meeting its current obligations.

For this reason, it is useful to look at current assets without cash and cash equivalents minus current liabilities without any sort of short-term debt. This will show only the company’s operational investments, separate from financing effects. So, operating working capital is:

Current assets – cash– (Current liabilities – short-term debt)= Operating working capital

Thus the ratio OWC/sales is a measure of how much each dollar of sales is tied up in the current accounts of a company’s balance sheet. OWC management is critical to a company’s success, especially during periods of high growth.

Companies often fail during this growth spurt because their OWC goes out of control. They run out of cash as new buildups of receivables and inventory from the increased sales—combined with additional capital expenditures for expansion—lead to a depletion of their cash holdings, even if they manage to delay their payments to suppliers.

Important corollary measures of operating working capital are the change in OWC from one accounting period to the next as a dollar number, and change in OWC/sales in percentage terms. The dollar number is the ongoing amount that the company has to invest in its current accounts to sustain its operations. The higher the number, the more cash a company has to find and use. The ratio of the change over sales gives an indication of how well a company continues to manage these required investments as a percentage of its revenue stream. A trend of increasing percentages is a cautionary one as they reflect buildups of OWC that proportionately take up more cash than what sales are bringing in.

14.6.5 Sales/Net Fixed Assets

Sales/net fixed assets measures sales as a percentage of the net fixed assets (i.e., gross fixed assets less accumulated depreciation).

The higher the ratio, the more productively a company is making use of its fixed assets. This ratio is called the fixed asset turnover ratio. Another name for it is the asset intensity ratio. In general,

industrial companies have lower ratios than service companies.

14.6.6 Sales/Total Assets

Sales/total assets measures sales as a percentage of the total assets of the company. This is the asset turnover ratio: the higher the ratio, the more productive the company. Comparing this ratio across companies in different industries is not particularly useful, as different industries can have significantly different average levels.

14.7 FOR PROFITABILITY

Gross margin, or gross profit/revenues

EBIT margin, or EBIT/revenue

EBITDA margin, or EBITDA/revenue

Net margin, or net income/revenue

Sales/(accounts receivable + inventory + net fixed assets)

EBIT/total invested capital

Return on average common equity

Return on average assets

The first four items listed in the preceding are metrics within the income statement. They look at how well the company manages its expenses relative to the revenues from sales, or alternatively, how well its pricing strategies are working. They define profitability in terms of earnings after expenses.

The final four items look at earnings relative to the balance sheet for a more complete picture and show how the earnings are relative to the investments that have been made to support those earnings. They define profitability in terms of returns on investment and compare earnings to different groups of balance sheet accounts. If revenues are small compared to the amount of

assets on the balance sheet, this indicates the company is making an unproductive use of its assets.

14.7.1 Gross Margin

The gross margin shows how much as a percentage of sales the company can make after paying for the raw materials that go into sales. The raw materials expense is seen as a cost of goods sold.

14.7.2 EBIT Margin

The EBIT margin is the percentage of sales that the company can make after paying other operating expenses such as SG&A (sales,general, and administrative expenses). This is also called operating margin.

14.7.3 EBITDA Margin

The EBITDA margin is the percentage of sales that the company can make on the EBITDA basis, with the non-cash depreciation and amortization expenses added to the EBIT measure.

14.7.4 Net Margin

The net margin is the percentage of sales that the company clears after payment of taxes.

14.7.5 Sales/(Accounts Receivables + Inventory + Net Fixed Assets)

This ratio shows the relationship between sales and the operating and investment assets. (Receivables, inventory, and net fixed assets are often called the core assets.) Accounts receivable is an operating investment, essentially the amount of cash “invested” in customers who have not paid for their purchases. Likewise, inventory represents the “investment” in the amount of goods already purchased and kept in storage ready for production. Net fixed assets are the capital equipment required to produce the company’s products, net of depreciation.

14.7.6 Return on Average Common Equity

The return on average common equity, sometimes just called return on equity (ROE), is based on the average of the starting and ending common equity for the year. (The starting common equity

in each year is equivalent to the ending number for the prior year.)

This is because the earnings accrue over the year, so the return should be calculated over the common equity level that holds over the same period. The average of the beginning and ending numbers is the best proxy for this.

14.7.7 Return on Average Assets

Likewise, the return on average assets, sometimes just called return on assets (ROA), uses the same approach of using an average for the denominator.

14.8 FOR LEVERAGE

The following ratios measure leverage, or the amount of debt that the company has relative to investments or to its earnings flow. In either case, the higher the ratio, the higher the leverage and the higher the chances for default.Cash is the measure of things for repaying debt, which is

why EBITDA is the preferred number for leverage ratios.

Total debt/shareholders’ equity

Net debt/shareholders’ equity

Total debt/total invested capital

Bank debt/EBITDA

Senior debt/EBITDA

Total debt/EBITDA

Net debt/EBITDA

14.8.1 Total Debt/Shareholders’ Equity

Total debt/shareholders’ equity shows the ratio of debt to equity.A high ratio, within limits, is not necessarily bad. This should be looked at in the context of the company’s ability to generate cash

fl ow to cover its debt service (interest payments and principal repayments).

14.8.2 Net Debt/Shareholders’ Equity

Net debt/shareholders’ equity is a ratio similar to total debt/Shareholders’ equity. Net debt is total debt minus cash and cash equivalents. Cash equivalents are accounts such as short-term investments or marketable securities that can be turned into cash easily. Net debt shows the debt load of a company as if it had used its available cash to repay some of its debt. Companies with a

large cash position relative to their total debt will have a negative net debt.

14.8.3 Total Debt/Total Invested Capital

The denominator is total invested capital—the combination of shareholders’ equity, total debt, and minority interests.

14.8.4 Bank Debt/EBITDA; Senior Debt/EBITDA; Total Debt/EBITDA; Net Debt/EBITDA

These ratios with debt measures in the numerator and EBITDA in the denominator show the size of each debt measure relative to the cash operating earnings of the company. In an annual model, the EBITDA will be the annual earnings, so each ratio is a way of expressing that the debt is equivalent to so many years’ earnings. If you start building models that have non-annual periods—for example, if each column contains quarterly data—these ratios will not be useful unless the quarterly EBITDA numbers are annualized. For quarterly EBITDA numbers, the easy “quick and dirty”way is simply to multiply them by 4. You should be careful with this approach if the company has highly seasonal flows.

14.9 FOR COVERAGE

Coverage refers to the ability of the company’s cash flows to cover its interest expense or debt obligations.

Times interest earned: EBIT/interest expense

EBITDA/cash interest expense

(EBITDA – capital expenditures)/cash interest expense

Fixed charge coverage

Cash fixed charge coverage

Operating cash fl ow/total debt

Operating cash fl ow/net debt

Operating cash fl ow/average total liabilities

14.9.1 Times Interest Earned

Times interest earned (TIE) is a ratio that compares the company’s EBIT to its interest expense. This ratio is important to the lending decisions made by banks. If a company has a TIE of 3.0×, this means that its EBIT is enough to pay its interest expense three times over. Put another way, EBIT has to shrink more than two thirds before it defaults, or cannot pay its interest payments. Lending banks want to see a high ratio because it means there is less likelihood that a loan to the company will become a nonperforming loan.

14.9.2 EBITDA/Cash Interest Expense

EBITDA/cash interest expense is TIE on a cash basis. EBITDA is the cash earnings that a company has. The denominator uses the interest expense that is cash, as there are forms of debt in which

the interest is not paid out in cash but instead added to the outstanding debt. This kind of debt is called accreting debt. It is also called payment-in-kind (or PIK, pronounced “Pick”) debt. Thus,the denominator is total interest (which may have both cash and non-cash interest) less non-cash interest. This ratio gives an extra measure of insight for coverage analysis, because EBITDA as a

measure of the cash earnings a company is being compared to the payment to cash interest expenses.

14.9.3 (EBITDA – Capital Expenditures)/Cash Interest Expense

(EBITDA – capital expenditures)/cash interest expense is a coverage measure of the ability to repay cash interest based on cash earnings after what usually is a required expense: capital expenditures. By accounting convention, capital expenditures do not appear in the income statement; they appear in the cash flow statement. By subtracting these expenditures from EBITDA, the ratio shows the company’s ability to pay its cash interest expense.

It may be that a company can reduce or defer its capital expenditures in order to pay its interest. But if it does so, it is likely to suffer diminished productivity in the long run (as its fixed assets age and fall into increasing disrepair) and jeopardize its interest-paying ability.

14.9.4 Fixed Charge Coverage

(EBIT + rent expense)/(interest expense + preferred dividends+ rent expense). This ratio is more important in analyzing retail companies.

14.9.5 Cash Fixed Charge Coverage

This is similar to the ratio in the preceding, but we use (EBITDA +rent expense)/(cash interest expense + preferred dividends + rent expense). The cash interest expense makes a distinction between interest payments that are cash and those that are non-cash.

14.9.6 Operating Cash Flow Ratios

Operating cash fl ow is an item from the cash fl ow statement and is the sum of net income (the first item on the statement) plus all the add backs of non-cash expenses. Put another way, this is net income on a cash basis and represents the cash earnings after interest and taxes from operations.

14.10 COMMON-SIZE STATEMENTS

Common-size statements, which typically are prepared for the income statement, and the balance sheet, express a firm’s performance over time as a percentage of a base number. Common-size cash fl ow statements are less often seen.

For the income statement, the typical base is each year’s revenue number. All the other income and expense numbers shown for each year are a percentage of that year’s revenue.

Revenue is shown as 100%. In effect, the whole income statement becomes a “margin statement.” By expressing all the accounts in this manner, we can see how well the company maintains its margins, even if the underlying dollar numbers have undergone sizable changes over time.

For the balance sheet, the usual base is total assets, which are shown as 100%. Every other account on the balance sheet—whether assets, liabilities, or equity—are then shown as percentages of this total.

In addition to providing a yardstick for comparisons across time within a company, common-size statements also provide useful information for looking at the economic characteristics of different companies in the same industry, as well as in different Industries.

14.10.1 Common-Size Income Statement

14.10.2 Common-Size Balance Sheet

Chapter 15 Forecasting Guidelines

15.1 KEY PRINCIPLES

Good forecasts must be consistent with historical performance and the current industry outlook.

Look at historical numbers in relationship to others and use these ratios, particularly the operating ratios, to make your projections.

All forecasts are estimates and approximations. Spend the time thinking and developing your ideas about the big picture, not the trivial details.

If the forecast looks too good to be true, it probably is.Re-examine your assumptions.

Avoid the “hockey stick”: historical trends show modest growth rates, but once the forecast begins, the rates grow at a much steeper rate, looking like the profile of a hockey stick. Again, re-examine your assumptions.

15.2 INCOME STATEMENT ACCOUNTS

15.2.1 Revenues

For industrial/manufacturing types of companies, revenues drive the other numbers in the model. Here are things to think about as you make your forecast:

Revenues are the result of three main components: price,industry growth, and market share. Isolating the price growth from inflation will give you the measure for volume growth. Understand that in the context of the economic cycle, and then concentrate on what the drivers for future industry growth and market share might be. Add back the inflation component (typically very low at 1–2% in the United States) to get the full estimate of future revenues growth.

Think drivers, drivers, drivers. To forecast revenues, for example, it is useful to break down the components that drive the revenue, and in turn to analyze what are the drivers behind those drivers. In this way, the forecast can capture the dynamics of the market.

Unless you are looking at new industries (new drugs,new telecommunications), most businesses are mature and should grow at around the growth of the economy.

Gross domestic product (GDP) growth rates would be a good proxy. Your particular company’s sales growth will also be affected at different points of the product cycle by new entrants and competing new technologies.

Remember also that fast-growing businesses have very dramatic price and volume falls as the demand reaches a certain point. Consider the experience with cell phones now compared with when they first appeared. Cell phones are now low priced, if not free. Wireless companies are not selling phones; they are selling a monthly phone service, and they are happy to give away the phones if it means that the customer can be locked into a 2-year contract. If your company does not have a position of advantage, it will lose market share, and your volume estimates must reflect that.

If your company has product lines that have very different characteristics, it would be important to forecast the individual product lines. However, if they are similar enough, it is better to think in broad aggregate terms and forecast only one revenue line. There is no need to get super precise price and volume numbers for the forecast years.

Take into account the characteristics of the industry your company is in. Some industries have price controls or regulatory restrictions, which would limit your own forecasts.

15.2.2 Margin Assumptions

Analyze the trends in the historical accounts, such as cost of goods sold as percentage of sales, SGA (sales,general & administrative) as percentage of sales, etc.

Your forecasts should be consistent with these trends,while taking into account what you know of any improvements or changes in the company’s operating systems.

If there have been striking changes in the margins, you should understand the reason.

Look at the trends in the context of the economic and product cycles.

15.2.3 Depreciation

Although it can be convenient to forecast depreciation as a percentage of revenue, the relationship to revenue is indirect. Depreciation is determined by net PPE (plant,property, and equipment), which in turn is affected by capital expenditures. Capex typically vary with revenue.

If some precision is required, the best way to model depreciation is to lay out the depreciation that is associated with each year’s new capital investments.

This will mean creating a “depreciation triangle” as shown in Table 15-1. The longer the forecast period, the“deeper” the triangle has to be. However, it is generally acceptable to use the recent relationship between depreciation and the net PPE of the prior year.

Depreciation for tax purposes and for book purposes can be different. This will lead to the creation of deferred taxes.

15.2.4 Interest Income

Look to the effective rates of interest income that the company has been paying in the historical years. You can get this information simply by looking at interest income divided by the average of the beginning and ending total interest-yielding assets. The average is used to capture the changes that have happened over the year. This may not be the actual interest earnings rate.

Many companies keep cash as an operational cushion,and it is not necessarily in the bank earning interest.However, this effective interest rate is usually good enough for projections.Interest on cash should be less than the interest on debt.

15.2.5 Interest Expense

Companies usually pay close to market rates, so get estimates of the benchmark being used (LIBOR, Prime,etc.) and then apply a spread over that. Check with the relationship banker or the debt pricing desk about what this spread should be. Generally speaking, the bigger and therefore the more creditworthy the company,the smaller the spread. Spreads can be quoted as basis points. One basis point is one one-hundredth of a percent; so 100 basis points is equivalent to 1%.Check also the historical effective interest rates that the company has been paying. (Remember to do so by dividing the interest expense by the average of the beginning and ending total debt.) If these rates seem very high, they may be due to seasonal borrowings. The company draws down on its line of credit during the year and therefore pays interest on that, but pays off the debt before the reporting date. The result is that there is a record of the interest expense in the income statement,but no record on the balance sheet of the debt that produced it. This is normal operating procedure, by the way, and there is nothing sneaky about it.

15.2.6 Taxes

Taxes should be taxed at statutory rates, and they should also reflect local rules in effect for the company.If there are any deviations from these rates, you should try to find out the reasons why, and if they are sustainable.Deferred taxes occur when the provision for taxes in the book basis is different from the actual taxes paid on the tax basis. These occur usually because of different book-basis and tax-basis depreciation schedules that the company has adopted, or from net operating losses.Their complexity puts them beyond the scope of this chapter.

15.2.7 Extraordinary Items

This is a tricky line, since by its very nature items here are not easily forecast. If you have specific information about these items from the company, by all means include it. Otherwise, it may be best not to try to do any forecasts.

15.2.8 Dividends

The best way to forecast dividends is by multiplying the number of shares by a historic dividends per share number grown at a reasonable rate. However, you should watch out for the following:

Use the correct number of shares, which is the weighted average shares outstanding. The plain shares outstanding refers to the number at the reporting date, but this does not take into account that there may have been changes in the shares outstanding over the year. It is also important to reflect the timing of the changes,which is why the weighted average number is used.Typically, this information is available in the annual reports. If you do not have this number, a proxy is to take the average of the shares outstanding at the beginning and the end of the reporting period.

Compute the historic dividends per share numbers yourself. If they reconcile with the historic figures, then you have a good basis for using them as the basis for calculations of future dividends, plus a growth rate that roughly equals the growth of the economy and/or the industry. If they do not reconcile, it may be because of stock splits or rights issues. Companies’ dividends usually grow at a steady rate, but the growth can stop if earnings go into a dip.

15.3 BALANCE SHEET

15.3.1 Cash

There are two kinds of cash account in the model. One is the cash that the company needs to have on hand to handle day-to-day expenses. We can think of this as “minimum cash.” You can attach an interest rate to this, but usually this cash is not kept in the bank and so it is not earning interest. Because this cash also reflects operational needs, it makes sense to forecast this as a percentage of sales, and to consider this as part of working capital.

The other is the cash that is automatically produced by the model when liabilities and equity exceed assets—the excess cash row. You do not forecast this account directly. Rather, it is a result of the forecast assumptions you make for other parts of the balance sheet and indeed the income statement, too. (It may be that your assumptions will create a need for additional debt, in

which case you would see the revolver line, not the excess cash line.) To the extent that you will have excess cash, make sure that you enter an interest rate.

15.3.2 Short-Term Investments

If your company has this account, you may want to forecast the same level going forward, without any growth. By holding it steady, you will be able to see more clearly the rate of buildup in excess cash or revolver.

15.3.3 Operating Assets and Liabilities

A large part of the balance sheet is there to support sales. As sales grow, these operating assets and operating liabilities must also grow by a more-or-less proportionate rate. As a result, you can

forecast them based on a relationship to revenues in the income statement.

15.3.3.1 The operating assets are:

Accounts receivable

Inventory

Other current assets

Net PPE

Other assets. You should check if these are related to operations or investments; if the latter, they should be forecast at some growth rate, not as a percentage of sales.

15.3.3.2 The operating liabilities are:

Accounts payable

Other current liabilities

You can project these items on the basis of the last historical year, but you should take into account any variations from trends that are booming or reversing. Any unusual or extreme change is a call for delving further into the information to find out what the reasons may be.

The net PPE number is a tricky one to forecast, and the forecast numbers are determined by two main flows: capital expenditures (which add to the gross PPE number) and depreciation (which flows into accumulated depreciation and reduces the gross PPE number). The production base to support sales is a function of many things, including the product being produced,the technology in place, and the scale of production. These—and other factors—represent a “habit” of the production systems in the company. The net result is a net PPE number that should have some discernible and steady relationship to sales. Thus, a good way to forecast net PPE is first to determine the net PPE to sales ratio and then to use that as the basis of forecasting net PPE. If we have a depreciation schedule, then, in fact, the capital expenditures number becomes the “plug” number that we can back into in the calculation of net PPE.

Some pointers:

If the latest net PPE to sales ratio is high, this probably reflects recent investments to modernize the plant. We can let this ratio trend down to the historical rates; as a result, future capex will also show a downward trend until the ratio meets the historical levels.

If the ratio is low, this probably means that there will be a need for heavy investments soon.

This measure of net assets to sales should be relatively steady over the forecast period. The logical test is to extend the projection period into perpetuity. If this ratio is trending upward, then we will have a company that will be extremely asset intensive. Likewise, if it is trending downward, we will have a company that will generate huge revenues on a sliver of a PPE base.

15.3.4 Other Assets

You should find out if these other assets are operating or investment assets, and then forecast them accordingly. If they are operating, you should forecast them in some relationship to sales; if they are investments, then they should grow at some rate.

15.3.5 Other Liabilities

These can be either operating or financing assets. You should project them accordingly. Sometimes, when you have no information,the best recourse would be to hold them steady at the last reported date levels.

15.3.6 Taxes Payable

You should forecast these as a percentage of current taxes. Taxes payable reflect the part of taxes not paid until the next year.

15.3.7 Dividends Payable

This should be forecast as a percentage of current dividends. Like taxes, a part of dividends is not paid out until the following year.

15.3.8 Debt

You should forecast the debt based on known amortization schedules. Where debt is being amortized, you may find that the assets side of the balance sheet is now “higher” than the liabilities and equity side. In this case, a plug debt line appears that is the Necessary to finance line in our model.

15.3.9 Common Stock and Other Equity Accounts

Unless you have specific information about these accounts, hold them at the level of the last historical year.

15.3.10 Retained Earnings

Retained earnings in the equity account should not be directly projected in the balance sheet. Instead, this should grow in the model as a result of the flows from net income, which in turn have been produced by the assumptions in use in the income statement.

Chapter 16 Discounted Cash Flow Valuation

Discounted Cash Flow (DCF) valuation method is based on the concept that the value of an entity is based on the future cash flows it can generate. The value is arrived at when those cash flows are discounted (or present-valued) at a discount rate that represents the risk of those cash flows.

DCF is not limited to just valuing a company. It can be used to value a division of a company, a project, an asset—basically any enterprise that generates a cash fl ow. For this reason,we will use the term entity instead of company in describing the elements of a DCF valuation.

The elements of a DCF analysis are:

The weighted average cost of capital

The free cash flows

The terminal value

The enterprise value

The equity value

16.1 WEIGHTED AVERAGE COST OF CAPITAL

Weighted average cost of capital (or WACC, pronounced “wack”) is the blended cost of the equity and debt capital of the entity.The cost of equity is the return required by equity holders for the risk of investing their capital into the company. The cost of debt is the return required by debt holders. However, because debt interest is tax deductible, the cost of debt required is really the after-tax cost of debt [interest rate % * (1-tax rate %)]. The blended value is based on the portion of equity and debt in the entity’s capitalization.

In an acquisition scenario where there is an acquirer and a target, and the target is being valued by DCF, the WACC to use in valuing the target is the target’s WACC, not the acquirer’s. The reason is that discount rate should reflect the risk of the cash flows; the risk in this case is attached to the cash flows of the target.

16.2 FREE CASH FLOW

The cash flows in a DCF are called “free cash flows” (FCF). The free cash fl ow is comprised of:

The operating earnings of the entity. For a company,this is typically the EBIT line. The rationale here is that the cash flows should derive from the operations of the company. The FCF should also be unlevered,i.e., they do not reflect the interest costs of debt (or“leverage”). The FCF should also be the amount before any dividends are subtracted out for the equity holders.

Less: Taxes on the EBIT. This is obviously an artificial number (tax in the income statement is on the earnings after interest, not on the EBIT), but because taxes are a real cost, this is computed. The taxes are on EBIT, not EBITDA, because depreciation and amortization are tax-deductible.

Add back depreciation and amortization. These are non-cash expenses so they are added back.

Add back any increases in deferred tax liability. An increase in this balance sheet account represents taxes that have been deferred (typically because of different book and tax-basis basis calculations), and represents cash that the entity still has in hand.

Less: any increases in operating working capital. Any increase in net working capital is a use of funds.Operating working capital is defined as [current assets excluding cash and short-term investments] less [current liabilities less short-term debt and current portion of long-term debt].

Less: Capital expenditures.The increase in operating working capital and ca