Financial Modeling Interview

Prepared by

Corporate Bridge Must Know Toolkit

www.educorporatebridge.com

Dheeraj Vaidya, CFA, FRM

CEO & MD, Corporate Bridge, Ex- JPMorgan, CLSA India

COMMON MODELING APPROACHES INCOME STATEMENT: LINE ITEM DRIVERS

a) Revenues For most companies revenues are a fundamental driver of economic performance. A well designed and logical revenue model reflecting accurately the type and amounts of revenue flows is extremely important. There are as many ways to design a revenue schedule as there are businesses. Some common types include: 1. Sales Growth: Sales growth assumption in each period defines the change from the previous period. This is simple and commonly used method, but offers no insights into the components or dynamics of growth. 2. Inflationary and Volume/ Mix effects: Instead of a simple growth assumption, a price inflation factor and a volume factor are used. This useful approach allows modeling of fixed and variable costs in multi product companies and takes into account price vs volume movements. 3. Unit Volume, Change in Volume, Average Price and Change in Price: This method is appropriate for businesses which have simple product mix; it permits analysis of the impact of several key variables. 4. Dollar Market Size and Growth: Market Share and Change in Share Useful for cases where information is available on market dynamics and where these assumptions are likely to be fundamental to a decision. For Example: Telecom industry

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5. Unit Market Size and Growth: This is more detailed than the preceding case and is useful when pricing in the market is a key variable. (For a company with a price-discounting strategy, for example, or a best of breed premium priced niche player) e.g. Luxury car market 6. Volume Capacity, Capacity Utilization and Average Price: These assumptions can be important for businesses where production capacity is important to the decision. (In the purchase of additional capacity, for example, or to determine whether expansion would require new investments.) 7. Product Availability and Pricing 8. Revenue driven by investment in capital, marketing or R&D 9. Revenue based on installed base (continuing sales of parts, dis posables, service and add-ons etc). Examples include classic razor-blade businesses and businesses like computers where sales of service, software and upgrades are important. Modeling the installed base is key (new additions to the base, attrition in the base, continuing revenues per customer etc). 10. Employee based: For example, revenues of professional services firms or sales-based firms such as brokers. Modeling should focus on net staffing, revenue per employee (often based on billable hours). More detailed models will include seniority and other factors affecting pricing. 11. Store, facility or Square footage based: Retail companies are often modeled based on the basis of stores (old stores plus new stores in each year) and revenue per store. 12. Occupancy-factor based: This approach is applicable to airlines, hotels, movie theatres and other businesses with low marginal costs.

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Company XYZ Revenue Buildup Case 1 FY05 FY06 Historical FY07 FY08E FY09E FY10E FY11E Forecast FY12E FY13E FY14E

Applicable for companies with multiple segments; Most commonly used method by research analysts

Business Segment 1 YoY % Business Segment 2 YoY % Business Segment 3 YoY % Others YoY % Total Revenues
Case 2

843 345 128 25 1,341 1,500 YoY % YoY % 1,750 YoY % 86% 800 1,200

964 14% 365 6% 178 39% 38 52% 1,545 1,575 5% 1,825 4% 86% 825 3% 1,299

1,021 6% 423 16% 212 19% 48 26% 1,704 1,630 3% 1,850 1% 88% 850 3% 1,386

1,103 8% 457 8% 254 20% 58 20% 1,872 1,712 5% 23% 2,000 8% 86% 893 5% 1,528

1,191 8% 493 8% 300 18% 68 18% 2,052 1,848 8% 23% 2,100 8% 88% 937 5% 1,732

1,286 8% 533 8% 348 16% 79 16% 2,246 2,033 10% 14% 2,100 0% 97% 1,003 7% 2,039

1,389 8% 575 8% 397 14% 90 14% 2,451 2,100 3% 3% 2,100 0% 100% 1,073 7% 2,253

1,500 8% 622 8% 453 14% 102 14% 2,677 2,100 0% 2,100 0% 100% 1,148 7% 2,411

1,620 8% 671 8% 507 12% 115 12% 2,913 2,100 0% 2,100 0% 100% 1,228 7% 2,580

1,750 8% 725 8% 568 12% 129 12% 3,171 2,100 0% 2,100 0% 100% 1,314 7% 2,760

Applicable for Metals & mining companies, Oil & Gas companies

Production (mn tonnes) Maximum permissible growth Capacity (mn tonnes) Capacity utilization (%) Average Selling Price or ASP (USD per tonne) YoY % Total Revenues (USD bn)
Case 3

Used Data validation to ensure production is below capacity

Applicable for hotels; same logic can be applied to airlines, restaurants etc

No of Rooms YoY % No of days Occupancy (%) Average Rent per room per day YoY % Total Revenues (INR mn)
Case 4

2,500 365 80% 1,000 730

2,750 10% 365 75% 1,100 10% 828

3,000 9% 365 78% 1,050 -5% 897

3,250 8% 365 80% 1,200 20% 1,139

3,500 8% 365 80% 1,260 5% 1,288

4,000 14% 365 80% 1,323 5% 1,545

4,500 13% 365 80% 1,389 5% 1,825

5,000 11% 365 80% 1,459 5% 2,130

5,000 0% 365 80% 1,532 5% 2,236

5,000 0% 365 80% 1,608 5% 2,348

Applicable for ITES, IT companies

No of employees YoY % No of average work days No of billable hours per day YoY % Average Billing rate - USD (per hour) YoY % Total Revenues (USD mn)

2,500 330 8 50 330

2,750 10% 330 8 0% 55 10% 399

3,000 9% 330 8 0% 55 0% 436

3,250 8% 330 8 0% 58 5% 498

3,500 8% 330 8 0% 56 -3% 517

4,000 14% 330 8 0% 59 5% 623

4,500 13% 330 8 0% 62 5% 737

5,000 11% 330 8 0% 64 3% 845

5,000 0% 330 8 0% 65 2% 858

5,000 0% 330 8 0% 68 5% 898

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B) COSTS

Drivers include: 1. Percentage of Revenues: Simple but offers no insight into any leverage (economy of scale or fixed cost burden 2. Costs other than depreciation as a percent of revenues and depreciation from a separate schedule: This approach is really the minimum acceptable in most cases, and permits only partial analysis of operating leverage. 3. Variable costs based on revenue or volume, fixed costs based on historical trends and depreciation from a separate schedule: This approach is the minimum necessary for sensitivity analysis of profitability based on multiple revenue scenarios c) Operating expenses 1. General and Administrative: Generally treated as % of Revenues 2. Sales and Marketing: Generally modeled as % of Revenues. In some cases, it is actually a revenue driver and not driven by revenues. For example, brokerage business or pure plays trading and marketing firms. 3. R&D: Generally R&D costs are treated as % of revenues. d) Interest expense (or Net interest expense): 1. This is one of the few income statement items that is driven by balance sheet information. A interest schedule is generally developed to i) calculate interest received on cash and short term investments and ii) calculate interest expenses arising from all types of debt. Interest rate assumptions are needed. 2. Ending balance of previous year can be used to calculate interest expenses to avoid circular reference in excel 3. Average balance can be used as well (it will give circular reference though) e) Income taxes: 1. Effective tax rate is generally used. Effective rate is calculated as Taxes paid / Pre-Tax income. For future years, either the marginal tax rate equivalent to the country of incorporation is taken or if the effective rate is much lesser than the marginal tax

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ate then during the initial years, tax rate can be low but gradually would have to be moved to marginal tax rate. For example, In India, marginal corporate tax rate is 33%.
BALANCE SHEET: LINE ITEM DRIVERS (ASSETS)

1. Cash and Cash Equivalents: 1.1. Linked to cash from Cash Flow Statement 2. Accounts Receivable (Part of Working Capital Schedule): 2.1. Generally modeled as Days Sales Outstanding; 2.2. Receivables turnover = Receivables/Sales * 365 2.3. A more detailed approach ma include aging or receivables by business segment if the collections vary widely by segments 2.4. Receivables = Receivables turnover days/365*Revenues 3. Inventories (Part of Working Capital Schedule): 3.1. Inventories are driven by costs (never by sales); 3.2. Inventory turnover = Inventory/COGS * 365; For Historical 3.3. Assume an Inventory turnover number for future years based on historical trend or management guidance and then compute the Inventory using the formula given below 3.4. Inventory = Inventory turnover days/365*COGS ; For Forecast 4. Other Current Assets (Part of Working Capital Schedule): 4.1. Modeled as % of sales 5. Fixed Assets (Property, Plant and Equipment) 5.1. Separate schedule is prepared taking into account various components 5.2. Ending Balance for PPE = Beginning balance + Capex Depreciation - Adjustment for Asset Sales 5.3. Sample Schedule is shown below:

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Fixed Assets (Property, Plant and Equipment) Sample Snapshot

Company XYZ Depreciation Schedule FY05 FY06 Historical 3,002 220 3,408 230 4,069 161 4,395 190 4,746 175 5,126 FY07 FY08E FY09E FY10E FY11E Forecast 5,536 5,979 6,457 6,974 FY12E FY13E FY14E

Net Sales Capital Expenditures

Capital Expenditures as % of Net Sales

179.4
3.5%

7.3%

6.7%

4.0%

4.3% 965.6 190.0 (154.8) 1,000.8

3.7% 1,000.8 175.0 (166.9) 1,008.9

193.8 3.5% 1,008.6 193.8 (194.2) 1,008.2

209.3 3.5% 1,008.2 209.3 (210.6) 1,006.8

226.0 3.5% 1,006.8 226.0 (229.2) 1,003.7

244.1 3.5% 1,003.7 244.1 (250.0) 997.8

Beginning Net PP&E Capital Expenditures (Depreciation Expense) (Asset Sales and write offs) Ending Net PP&E Existing Net PP&E, net Land Depreciable PP&E, net Useful Life SYD

851.9 965.6 19.3 $946.3

941.3
From:

965.6

1,008.9 179.4 (179.7) 1,008.6

Existing PP&E Years

131.0

121.3

111.6

101.9

92.2

82.5

72.8

13.5 Years 97.5

Capex

13.5 Useful Life 8.0 Years 8.0 8.0 8.0 8.0 8.0 8.0 127.5 13.5% 55.5% 135.5 14.0% 84.0%

12.5

11.5

10.5

9.5

8.5

7.5

2008 2009 2010 2011 2012 2013 2014 Total Depreciation Expense Depreciation as % of PP&E, net Depreciation as % of Capex

$190.0 175.0 179.4 193.8 209.3 226.0 244.1 101.9 12.0% 46.3%

23.8

23.8 21.9

23.8 21.9 22.4

23.8 21.9 22.4 24.2

23.8 21.9 22.4 24.2 26.2

23.8 21.9 22.4 24.2 26.2 28.3

23.8 21.9 22.4 24.2 26.2 28.3 30.5 250.0 25.1% 102.4%

154.8 15.5% 81.5%

166.9 16.5% 95.4%

179.7 17.8% 100.1%

194.2 19.3% 100.2%

210.6 20.9% 100.7%

229.2 22.8% 101.4%

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BALANCE SHEET: LINE ITEM DRIVERS (LIABILITIES)

6. Current Liabilities 6.1. Accounts Payables (Part of Working Capital Schedule): 6.2. Payables turnover = Payables/COGS * 365; For Historical 6.3. Assume Payables turnover days for future years based on historical trend or management guidance and then compute the Accounts Payables using the formula given below 6.4. Accounts Payables = Payables turnover days/365*COGS Complete working Capital Schedule will look like an example given below:
Company XYZ Working Capital Schedule FY05 3,001.7 2,068.9 FY06 Historical 3,407.9 2,333.5 4,069.3 2,739.1 4,394.8 2,944.5 4,746.4 3,180.1 5,126.1 3,434.5 FY07 FY08E FY09E FY10E FY11E Forecast 5,536.2 3,709.3 5,979.1 4,006.0 6,457.5 4,326.5 6,974.0 4,672.6 FY12E FY13E FY14E

Net Sales Cost of Sales (excluding D&A)

Working Capital Balances

Accounts Receivable, net Inventory Other Current Assets Total Non Cash Current Assets Accounts Payable Accrued Liabilities Other Current Liabilities Total Non-Debt Current Liabilities
Net Working Capital/ (Deficit)

462.9 327.0 87.4 877.3 206.4 180.7 68.3 455.4 421.9

473.7 350.2 82.8 906.7 221.4 161.3 62.8 445.5 461.2 (39.3)

473.0 383.8 83.5 940.3 279.1 176.7 81.8 537.6 402.7 58.5 42.4 51.14 2.1% 37.19 6.5% 3.0%

505.7 411.4 90.2 1,007.3 298.5 190.0 88.3 576.8 430.5 (27.8)
42.0 51.0 2.1% 37.0 6.5% 3.0%

546.2 444.3 97.4 1,087.9 322.4 205.1 95.4 622.9 465.0 (34.4) 42.0 51.0 2.1% 37.0 6.5% 3.0%

589.9 479.9 105.2 1,174.9 348.2 221.6 103.0 672.8 502.2 (37.2) 42.0 51.0 2.1% 37.0 6.5% 3.0%

637.0 518.3 113.6 1,268.9 376.0 239.3 111.3 726.6 542.4 (40.2) 42.0 51.0 2.1% 37.0 6.5% 3.0%

688.0 559.7 122.7 1,370.4 406.1 258.4 120.2 784.7 585.7 (43.4) 42.0 51.0 2.1% 37.0 6.5% 3.0%

743.0 604.5 132.5 1,480.1 438.6 279.1 129.8 847.5 632.6 (46.9) 42.0 51.0 2.1% 37.0 6.5% 3.0%

802.5 652.9 143.1 1,598.5 473.7 301.4 140.2 915.3 683.2 (50.6) 42.0 51.0 2.1% 37.0 6.5% 3.0%

(Increase)/ Decrease in Working Capital

Ratios & Assumptions

Accounts Receivable, net (Collection period in days) Inventory (Days outstanding) Other Current Assets (% of Net Sales) Accounts Payable (Days Payable) Accrued Liabilities (% of COGS) Other Current Liabilities (% of COGS)

56.3 57.69 2.9% 36.41 8.7% 3.3%

50.7 54.78 2.4% 34.63 6.9% 2.7%

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BALANCE SHEET: LINE ITEM DRIVERS (LIABILITIES)

7. Current Liabilities (contd.) 7.1. Short Term Debt: Usually modeled as part of debt schedule 7.2. Accrued Liabilities: Kept constant most often; Can be modeled as % of sales 7.3. Deferred taxes: Kept constant most often; Can be modeled as % of sales 7.4. Other Current Liabilities: Can be modeled as % of COGS or as % of Sales 8. Long term Liabilities: 8.1. Deferred taxes: Kept constant most often; Can be modeled as % of sales 8.2. Post retirement Pension Cost: Kept constant most often 8.3. Long term Debt: Usually modeled as part of debt schedule (please refer debt schedule on next page) 8.3.1. Key feature of the debt schedule is to use the Revolver facility and how it works so that the minimum cash balance is maintained and ensures that the Cash account does not become negative in case the operating cash flow is negative (Companies in investment phase who need lot of debt in initial years of operation Telecom cos for example) 8.3.2. Overall range of Debt to equity ratio should be maintained if there is any guidance by the management 8.3.3. Debt balance can also be assumed to be constant unless there is a need to increase the debt 8.3.4. Notes to the accounts would give repayment terms and conditions which need to be accounted for while building the debt schedule 8.3.5. For some industries, like Airlines, Retail etc Operating Leases might have to capitalized and converted to debt. However, this is a complex topic and beyond the scope of discussion at this point

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Debt Schedule - Sample

Company XYZ Debt Schedule Cash Flow Available for Financing Activities Proceeds from/ (Repurchase of) Equity Dividends Option Proceeds Effects of Exchange Rates on Cash + Beginning Cash Balance - Minimum Cash Balance Cash Available for Debt Repayment Long Term Debt Issuance Long Term Debt (Repayments) Cash Available for Revolving Credit Facility Revolving Credit Facility Beginning Balance Discretionary (Paydown)/ Borrowings Ending Balance Long Term Debt Beginning Balance Issuance (Repayment/ Amortization) Ending Balance Revolving Credit Facility FY05 FY06 Historical FY07 FY08E 278.9 (116.8) (84.3) 20.0 28.6 (25.0) 101.4 (140.2) (38.8) 112.9 38.8 151.7 586.7 (140.2) 446.5 132.3 7.0% 9.3 516.6 8.5% 43.9 53.2 Average Balance Interest Rate Interest Income 26.8 2.50% 0.7 FY09E 338.8 (132.3) (93.1) 20.0 25.0 (25.0) 133.4 (95.4) 38.0 151.7 (38.0) 113.7 446.5 (95.4) 351.1 132.7 7% 9.3 398.8 8.5% 33.9 43.2 25.0 2.50% 0.6 FY10E 387.1 (149.7) (102.7) 20.0 25.0 (25.0) 154.6 (24.5) 130.1 113.7 (113.7) 351.1 (24.5) 326.6 56.8 7% 4.0 338.9 8.5% 28.8 32.8 33.2 2.50% 0.8 FY11E Forecast 429.7 (169.1) (113.0) 20.0 41.4 (25.0) 183.9 (133.5) 50.4 326.6 (133.5) 193.1 7% 259.9 8.5% 22.1 22.1 58.4 2.50% 1.5 171.5 8.5% 14.6 14.6 144.1 2.50% 3.6 FY12E 474.1 (190.0) (123.6) 20.0 75.4 (25.0) 231.0 (43.3) 187.7 193.1 (43.3) 149.8 7% 132.3 8.5% 11.2 11.2 291.9 2.50% 7.3 FY13E 520.1 (212.3) (134.4) 20.0 212.7 (25.0) 381.0 (35.0) 346.0 149.8 (35.0) 114.8 7% 99.8 8.5% 8.5 8.5 459.3 2.50% 11.5 FY14E 569.4 (237.0) (145.9) 20.0 371.0 (25.0) 552.5 (30.0) 522.5 114.8 (30.0) 84.8 7%

55.5

112.8

112.9

547.6

557.8

586.7

Average Balance Interest Rate Interest Expense Average Balance Interest Rate Interest Expense

Long Term Debt

Total Interest Expense Cash Balances Total Interest Income

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