What is a financial model?

 Definition:
 A financial model is a tool used to forecast a business's financial performance into the future.
 It utilizes historical data, assumptions, and various financial statements to project future outcomes.
 Components: Income Statement Balance sheet, Cash flow
 Income Statement :Forecasts revenues, expenses, and profits over a specific period
 Balance sheet : Estimates assets, liabilities, and shareholders' equity at a given point in time.
 Cash Flow Statement:
 Predicts cash inflows and outflows to assess liquidity and financial health.
 Supporting Schedules:
 Detailed breakdowns of specific financial components supporting the main statements.
 What is a financial model used for?

 Decision Making:
 Financial Analysis
 Capital Raising:
 Acquisitions and Divestitures:
 Budgeting and Forecasting:
 Capital Allocation:
 Business Valuation
What is Year over Year (YoY) analysis?

 YoY stands for Year over Year and is a type of financial analysis used to
compare time series data.
 Analysts utilize YoY analysis to deduce changes in the quantity or quality of
certain business aspects.
 In finance, investors often compare the performance of financial instruments
on a year-over-year basis to assess performance against expectations.
 YoY analysis is valuable for identifying growth patterns and trends in various
industries.
 Economic analysts also use YoY analysis to assess countries' overall economic
situations.
 For example, YoY analysis revealed that Japanese GDP grew 2% in 2016
compared to 2015, exceeding previous projections of 1.8%.
Year over Year (YoY) Analysis and
Seasonality
 The YoY approach is valuable for analyzing monthly revenue growth,
especially in industries with cyclical sources of revenue.
 YoY comparisons provide an apples-to-apples comparison of revenue,
mitigating the impact of seasonal fluctuations.
 In industries like chocolate, where sales are seasonal, comparing revenue
growth between December 2016 and December 2017 offers more relevant
insights.
 Comparing months YoY allows for a more accurate assessment of growth
trends, avoiding distortions caused by varying seasonality or other factors.
 YoY analysis helps in identifying underlying growth patterns, irrespective of
short-term fluctuations due to seasonality.
Common Year over Year (YoY) Financial Metrics

 Sales Revenue: Measures changes in sales over the previous year, indicating
business performance.
 Cost of Goods Sold (COGS): Evaluates management of gross margin by
comparing production expenses.
 Selling and General & Administrative Expenses (SG&A): Assesses efficiency
in controlling corporate expenses.
 Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA):
Indicates operating profit and cash flow.
 Net Income: Compares overall profitability over time.
 Earnings Per Share (EPS): Analyzes bottom-line performance on a per-share
basis for investors.
 Common Year over Year (YoY) Economic
Indicators]
 Inflation:Indicates the trend in the general level of prices
over a one-year period.
 Unemployment Rates: Reflects the trend in workforce
participation rates over the previous year.
 GDP (Gross Domestic Product): Measures the total value
of goods and services produced by a country.
 InterestRates: Identifies whether the economy is
experiencing a rise or fall in interest rates.
 Alternatives to YoY analysis
 As an alternative to YoY analysis, an analyst may
also want to look at other time-series data such
as:
 Month-over-Month
 Quarter-over-Quarter
 Year-to-date
What is DuPont Analysis?
 Definition: DuPont Analysis, also known as the DuPont Identity, is a financial analysis method
that breaks down Return on Equity (ROE) into its constituent parts to understand the drivers of
profitability.

 Components of DuPont Analysis:

 Profitability Ratio: Measures the company's ability to generate profits from its operations.
Calculated as net income divided by total revenue.

 Asset Turnover Ratio: Evaluates how efficiently the company utilizes its assets to generate
sales. Calculated as total revenue divided by average total assets.

 Financial Leverage Ratio: Assesses the extent to which the company relies on debt financing.
Calculated as average total assets divided by average shareholders' equity.

 Importance: DuPont Analysis helps identify strengths and weaknesses in a company's operations,
profitability, and financial structure. It provides insights for strategic decision-making and
performance improvement.
Profitability and Return on Equity (ROE)]
 Profitability: Profitability measures a business's ability to generate earnings relative
to its expenses and costs. It is a crucial metric for assessing a business's success and
financial health.
 Return on Equity (ROE): ROE is a commonly used accounting ratio that evaluates a
company's profitability. It represents the amount of profit returned as a percentage
of the shareholders' equity or capital invested.
 Calculation of ROE: ROE = Net Income / Equity or Capital
 Example Calculation: Net Profit for 2019: $80,000 Equity/Capital Invested: $400,000
ROE = $80,000 / $400,000 = 0.2 or 20%
 Benchmark Comparison:
 Historical ROE: 2018: 8%, 2017: 12%
 Industry Standard ROE: 6%, 15%, 25%
 Minimum Expected ROE from Other Investments: e.g., 10% from other businesses
 Alternative Investment Returns: e.g., 7% from a trust fund, 6.5% from a bank
savings account
Example
 Decision Making:
 Investors can compare ROE across companies to identify the most promising investment opportunities.
 Higher ROE indicates better profitability and potential returns for investors.
 Calculation of ROE: ROE = Net Income / Equity or Capital
 Example,
 Co. A----- Sales = $120000; CGS = $80000; S&A exp = $10000; Equity/Capital -
$300000
 Co. B –--- Sales =650,000; CGS =600,000; S&A exp = 40,000; Equity/ Capital
$500,000.
 Calculate ROE and decide where you prefer to invest.
 1st – Net income – 120000-80000-10000= $30,000
 ROE = 30000/300000 = $0.10 = 10%
 2nd –Net income – 650000 – 600000 – 40000 = $10,000
 ROE = 10000/500,000 = $0.02 = 2%
 Basic DuPont Model

 1.Operating Efficiency:
 Measured by Net Profit Margin.
 Indicates the amount of net income generated per dollar of sales.
 2. Asset Efficiency:
 Measured by Total Asset Turnover.
 Represents the sales amount generated per dollar of assets.
 3. Leverage:
 Determined by the Equity Multiplier.
 Equation for the Basic DuPont Model: ROE = Net Profit Margin × Total Asset Turnover × Equity Multiplier
 Components as Ratios: ROE = (Net Income / Sales) × (Sales / Total Assets)
 Profit Margin = Net Income / Sales
 Asset Turnover = Sales / Total Assets
 Understanding the Components:
 The first two components assess business operations. Higher values indicate greater productivity.
 Depending on the industry, Net Profit Margin and Total Asset Turnover may trade off against each other. For example, machinery
manufacturers may have high profit margins but low asset turnover.
 Fast-food restaurants may have high asset turnover but lower profit margins due to lower prices.
 Leverage:
 Captures the company’s financial activities.
 Higher leverage increases the risk of default and negatively affects ROE.
 Additional leverage leads to higher interest payments, reducing net income and, subsequently, Net Profit Margin.
What is Net Working Capital?

 Net Working Capital (NWC) is the difference between a company’s current assets
and current liabilities on its balance sheet.
 NWC is a measure of a company’s liquidity and its ability to meet short-term
obligations and fund operations.
 Ideal Position: Having more current assets than current liabilities, resulting in a
positive NWC balance.
 Calculation Methods:
 Broad Method: Net Working Capital = Current Assets – Current Liabilities
 Narrow Method: Net Working Capital = Current Assets (less cash) – Current Liabilities
(less debt)
 Narrowest Method: NWC = Accounts Receivable + Inventory – Accounts Payable
 Interpretation:
 Positive NWC indicates sufficient liquidity to cover short-term obligations and support
operations.
 Negative NWC suggests potential liquidity issues and reliance on short-term borrowing
or asset sales.
Example

 Net Working Capital = Current Assets – Current Liabilities

 Total Current Assets= $52,000; Total Current liabilities =$55000

 Working Capital = 52000- 55000 = ($3,000.00) (Negative)

 Total CA = $120000; Total CL = $80000

 Working Capital = 120000 – 80000 = $40000 (Positive)

 What is the Asset Turnover Ratio?

 The Asset Turnover Ratio, also known as the Total Asset Turnover Ratio, measures the
efficiency with which a company utilizes its assets to generate sales.

 Formula: Asset Turnover Ratio = Net Sales / Total Assets (or Average Assets)

 Interpretation:
 Net Sales: Revenue generated after deducting sales returns, discounts, and allowances.

 Total Assets: The sum of all assets on the balance sheet.

 Higher Ratio: Indicates greater efficiency in asset utilization.

 Lower Ratio: Suggests less efficient use of assets compared to competitors.

 Formula Components:
 Net Sales: Gross sales adjusted for returns, discounts, and allowances.

 Total Assets: Aggregate assets at year-end or average assets over a period.

Example of Asset Turnover Ratio

 Asset Turnover Ratio = Net Sales / Total Assets (or Average Assets)

 Company “A” reported beginning total assets of $199,500 and ending total
assets of $199,203. Over the same period, the company generated sales of
$325,300 with sales returns of $15,000.

 The asset turnover ratio for Company A is calculated as follows:

 Asset Turnover Ratio = 325,300 – 15,000 = $310,300 (net sales)

 / (199500+199203)/2 = $ 199,351.5;

 $310,300/$199,315.5 =$1.55: 1

 Therefore, for every dollar in total assets, Company A generated $1.55 in sales.

 Sales - $20000; Assets - $1000000

 ATO = 20000/1000000 = $ 0.02:1

Interpretation of the Asset Turnover Ratio
 The Asset Turnover Ratio measures the efficiency of how effectively a company
utilizes its assets to generate sales.
 Higher Ratio: Favorable, indicating more efficient asset utilization.
 Indicates effective use of resources to generate revenue.
 Reflects potential for higher profitability and return on investment.
 Lower Ratio: Unfavorable, suggesting inefficient asset usage.
 Possible causes include excess production capacity, ineffective collection methods, or
inventory mismanagement.
 Indicates potential for improvement in operational efficiency and profitability.
 Industry Variations:
 Benchmark ratios vary significantly across industries.
 Industries with low profit margins (e.g., restaurants) may have higher asset turnover
ratios.
 Capital-intensive industries (e.g., machinery manufacturing) typically report lower asset
turnover ratios.
Asset Turnover ratio = Net Sales/Average Assets

 Asset Turnover Ratio = Net Sales / Total Assets (or Average Assets)

 Co. X – Beginning total Assets of $250,000 and ending total assets of $290,000
The Co. has gross sales of $350,000 for the year; besides they have $40,000
sales returns during the year.

 CO Y – Beg Assets - $75000; Ending Assets - $85000; Net Sales - $180000

 Calculate ATO of both Cos. And determine which one is more efficient.

 250000 + 290000 = 540000/2= $270,000 (Average Assets)

 350000 – 40000 = $310,000 (Net Sales); 310000/270000 = $1.14:$1

 75000 + 85000 = 160000/2 = $80000; 180,000/80,000 = $2.25:$1

 What is Fixed Asset Turnover?

 Fixed Asset Turnover (FAT) is an efficiency ratio that assesses how effectively a
company utilizes its fixed assets to generate sales.
 Formula: Fixed Asset Turnover = Net Sales / Average Fixed Assets
 Interpretation:
 Net Sales: Revenue generated from sales.
 Average Fixed Assets: Net value of property, plant, and equipment after depreciation
over a period.
 Higher Ratio: Indicates more efficient utilization of fixed assets to generate
revenue.
 Suggests effective management of investments in fixed assets.
 Implies potential for higher profitability and return on investment.
 Analysis:
 Fixed Asset Turnover is often analyzed alongside leverage and profitability ratios to
provide a comprehensive view of a company's operational efficiency and financial
performance.
Example calculation

 Fisher Company has annual gross sales of $10M in the year 2015, with sales
returns and allowances of $10,000. Its net fixed assets’ beginning balance was
$1M, while the year-end balance amounts to $1.1M. Based on the given
figures, the fixed asset turnover ratio for the year is 9.51, meaning that for
every one dollar invested in fixed assets; a return of almost ten dollars is
earned. The average net fixed asset figure is calculated by adding the
beginning and ending balances, then dividing that number by 2.

 Fixed Asset Turnover = Net Sales/Net fixed assets

 10,000,000 – 10,000 = Net sales$9,990,000

 1,000,000 + 1,100,000 = $2,100,000/2 = $1,050,000

 9,990,000/1,050,000 = $9.51 per $1.00 of investing in fixed assets

Financial Analysis Best Practices

 Be Organized with Data:

 Maintain structured data sets to facilitate analysis and interpretation.
 Simplify Formulas and Calculations:
 Keep formulas and calculations straightforward to minimize errors and enhance clarity.
 Documenting:
 Make use of comments and notes in cells to explain assumptions, methodologies, and interpretations.
 Audit and Stress Testing:
 Conduct thorough audits and stress tests of spreadsheets to identify and rectify errors or inconsistencies.
 Review by Multiple Individuals:
 Have multiple individuals review the analysis to enhance accuracy and reliability.
 Incorporate Redundancy Checks:
 Implement redundancy checks to validate calculations and ensure data integrity.
 Utilize Data Tables and Visualizations:
 Present data using tables, charts, and graphs to facilitate understanding and visualization of trends and patterns.
 Base Decisions on Data:
 Make sound, data-driven assumptions and conclusions to support decision-making processes.
 Attention to Detail:
 Maintain extreme attention to detail while keeping the overall objective and context in mind.
What is the Debt to Equity/Capital Ratio?

 The Debt to Equity Ratio, also known as the "debt-equity ratio", "risk ratio", or
"gearing", is a leverage ratio that assesses the proportion of total debt and
financial liabilities relative to total shareholders' equity or capital.
 Formula: Debt to Equity/Capital Ratio = Total Debt / Total Shareholders' Equity or
Capital
 Interpretation:
 Total Debt: Sum of all financial liabilities, including long-term and short-term debt.
 Total Shareholders' Equity or Capital: Represents the total equity capital contributed by
shareholders.
 Comparison with Debt-Assets Ratio:
 Unlike the debt-assets ratio, which uses total assets as the denominator, the Debt to
Equity Ratio focuses solely on the proportion of debt relative to equity.
 Significance:
 Indicates how a company's capital structure is balanced between debt and equity
financing.
 Higher ratio suggests higher financial risk due to increased reliance on debt financing.
 Lower ratio indicates a more conservative capital structure with greater reliance on
equity financing.
Example

 Co. A – Equity/Capital = $1,200,000; while your LTD

(Long Term Debt) is $800,000
 D/E ratio = $800000/$1200000 = $0.66/$1.00
 *In most cases $0.5/$1.00 – 50%/50%
 Asset = Liabilities + Capital (Accounting Equation)
 1.66 = 0.66 + 1.00
 What are leverage (gearing) ratios?

 Leverage ratios, also known as gearing ratios, are financial ratios that measure the level of debt
incurred by a business relative to other accounts in its financial statements.
 These ratios provide insights into how a company finances its assets and operations, whether
through debt or equity.
 Common Leverage Ratios:
 Debt to Equity Ratio:
 Compares a company's total debt to its total shareholders' equity.
 Formula: Debt / Equity
 Debt to Capital Ratio:
 Compares a company's total debt to its total capital (equity + debt).
 Formula: Debt / (Equity + Debt)
 Interpretation:
 Higher leverage ratios indicate higher levels of debt relative to equity or total capital.
 Higher ratios imply increased financial risk and potential for financial distress.
 Lower ratios suggest a more conservative capital structure with lower debt levels relative to equity or
total capital.
 Significance:
 Helps assess a company's financial risk and solvency.
 Provides insights into capital structure decisions and financing strategies.
 Allows comparison of leverage levels across companies and industries.
 What is the Net Debt to EBITDA Ratio?
 The Net Debt to EBITDA Ratio is a financial leverage ratio that measures a
company's ability to pay off its debt by comparing its net debt to its earnings
before interest, taxes, depreciation, and amortization (EBITDA).
 Formula: Net Debt to EBITDA Ratio = Net Debt / EBITDA
 Interpretation:
 Net Debt: Calculated as short-term debt + long-term debt - cash and cash
equivalents.
 EBITDA: Earnings before interest, taxes, depreciation, and amortization.
 The ratio indicates how many times a company's EBITDA can cover its net debt.
 A higher ratio suggests lower financial risk and greater ability to repay debt obligations.
 Lower ratio may indicate higher financial leverage and potential challenges in
servicing debt.
 Significance:
 Widely used by credit rating agencies to assess a company's creditworthiness and
likelihood of default.
 Helps investors and creditors evaluate a company's debt repayment capacity and
financial health.
Example

 Net Sales $120000; CGS $70000; Total Expenses $30000 (Depreciation exp
$3000; Interest exp $2000; taxes : $5000). Net debt $80,000. Calculate
Debt to EBITDA ratio.

 Net Debt to EBITDA Ratio = Net Debt / EBITDA

 120000 – 70000 = $ 50000 (Gross profit) - $ 30000 (T. Expenses) = $20000

 20000 + 2000+3000 +5000 = $30000 EBITDA

 $30000 - $10000 = $20000

 $80000/30000 = $2.66 :1
 The Interest Coverage Ratio (ICR
 The Interest Coverage Ratio (ICR) is a financial ratio used to assess a company's ability to
meet its interest payment obligations on outstanding debts.
 Also known as the "times interest earned" ratio, the ICR is crucial for lenders, creditors,
and investors to evaluate the risk associated with lending capital to a company.
 Formula: Interest Coverage Ratio = Earnings Before Interest and Tax (EBIT) /
Interest Expense
 Interpretation:
 EBIT: Represents a company's operating profit before deducting interest and taxes.
 Interest Expense: Indicates the interest payable on borrowings such as bonds, loans, and lines of
credit.
 The ratio measures how many times a company's operating profit covers its interest expenses.
 Higher ratio suggests better ability to service debt and lower financial risk.
 Lower ratio may indicate potential challenges in meeting interest obligations and higher risk of
default.
 Significance:
 Used by lenders and creditors to assess creditworthiness and determine lending terms.
 Helps investors evaluate a company's financial health and risk profile.
 Allows comparison of interest coverage across companies and industries.
Example,

 Interest Coverage Ratio = Earnings Before Interest and Tax (EBIT) / Interest
Expense

 Sales = $50000; CGS = $35000; other expenses = 5000; Interest expense -

8000, taxes - 6600
 EBIT – 50000 -35000 -5000 = 10000 (EBIT)–
 Interest coverage = 10000/8000 = 1.25 times


 EBIT – interest – taxes = Net profit

 10000 – 8000 = 2000 – 6600 = (4600)
