Financial Statement Modeling & Spreadsheet Engineering “Training in spreadsheet modeling improves both the efficiency and effectiveness with which analysts use spreadsheets” Steve Powell, Dartmouth College

Understand the Decision What is the problem? What questions must be answered? What is the time horizon of the problem? What happens then? What kind of output information is needed? Who will use the information? What level of detail is necessary?

Modules Data Inputs Assumptions Decision Variables Internal Data and Data Structures Outputs Pro-forma statements Other structural relationships Documentation

Plan Your Layout On paper, map out the different sections of your model and their planned locations within the workbook Consider how readable the model layout will be for the user easy it will be to modify the assumptions easy it will be to extend the model to include more time periods or new line items.

Layout Strategies Modules on different worksheets Stair-step format in same worksheet For each strategy, Consider how difficult it will be to insert or delete a row or column Consider how much linking needs to be done between different modules Consider linking a data input to the computation area or output for later reference

Other Layout Considerations Gaps between logical areas improve readability Isolate blocks of similar formulas for safe and convenient copying Use styles, fonts and colors with consistent meanings Assumptions –vs- decision inputs Key outputs

Data Inputs Internal data that describes the current state of the system Firm’s financial statements Resources and capacities External data that describes the firm’s operating environment Economic conditions such as interest rate, costs, stock prices Assumptions about future relationships

Data Input Guidelines Isolate constants into their own cells Do not use constants in formulas unless number has a mathematical foundation (e.g. , 1 in percentage calculations) Don’t allow an input value to be entered in multiple places in the model Organize decision variables and model parameter/assumptions logically into separate physical areas or color schemes Use Data > Data Validation

Modeling Sales Forecasts Simple Method: Assume average or different growth rate for each period Develop detail forecast by product, business unit, customer or geographic market and aggregate forecasts Forecast the unit price and volume Forecast size of market and estimate market share Forecast costs and apply a margin assumption to derive revenues

Financial Planning Model Assumptions Items that are functional relationships of sales – Percent of sales Operating expenses Working capital and fixed assets Items that are functional relationships of other financial statement items – Interest, depreciation, dividends, marketable securities, cash flows Items that involve policy decisions (e.g. long- term debt, equity, capital expenditures)

11 Generating the Income Statement Expenses in period t Related to asset and liability balances at the end of period t – 1 Interest Expense t based on Debt t-1 Depreciation t based on Gross Fixed Assets t-1 Or Related to Sales in period t COGS t = COGS/Sales * Sales t

12 Balance Sheet Sector Track financial state of firm through time Results in period (t – 1) become inputs for period (t) EXAMPLE: Debt t = Debt t-1 + Debt Issued t – Debt Repaid t which feeds into income statement Interest Expense t = Debt t-1 * Interest Rate

The “Plug” The balance-sheet item which will “close” or balance the balance sheet model so that Total Assets will always equal Total Liabilities & Equity Models the assumption of how the firm finances itself Examples are cash & marketable securities, debt, debt & equity

To Reduce Formula Errors Use relative and absolute cell addressing where appropriate Set up common structures in different parts of the model (e.g. same row labels, order and vertical positioning) Use formulae for a cell which are consistent in their relationship to adjacent cells Minimize linking formulas across worksheets Split complex formulas into multiple intermediary formulas

Document the Spreadsheet Use range names to make individual formulas more readable and module layouts clearer Use comments to document assumptions and modifications in a formula’s logic as well as sources of data Use textboxes to describe portions of the model’s logic and assumptions as well as instructions for use Create a worksheet to describe the purpose of the model and document changes

16 Testing the Model Compare a second calculation method to verify accuracy Ask intuitive questions: Does it balance under different conditions? Does it make sense? Extreme growth Set growth rate to -50% and 50% Does it still balance? Do debt or equity go negative? What happens to excess cash flow? What happens when Net Income is negative?

Circular References Created when expenses in period t refer to assets and liabilities in period t Iterative process is required to produce a consistent and correct final set of financial statements To solve, use File> Options> Formulas> Enable Iterative Calculation Not all circularities are convergent. Make sure to verify accuracy!

Verify Formula Reliability Use Excel’s Auditing Toolbar Formulas>Formula Auditing Use [Ctrl] ` to toggle between formulas and calculations Use Conditional Formatting to flag undesirable results Highlight cell to be watched and add rule Home>Conditional Formatting