BIBLIOGRAPHY AND REFERENCES
5. To model interest expense
3.2 COLLECTING AND ANALYZING HISTORICAL DATA
There are a lot of sources from which someone can collect past financial information. To name a few: the Securities and Exchange Commission (SEC), Reuters Fundamentals database, S&P Capital IQ platform, and last but not least company websites are some useful sources of finan-cial data. Moreover credit reports, company newsletters, press releases, and executive speeches are further secondary sources of information. A company that offers its common stock to the public typically needs to file periodic financial reports with the SEC. Various data providers collect these data, analyze company’s financial performance, build valuations and transaction models, and create charts and reports that can be used by any analyst employing the proper application. For example Reuters Fundamentals database can be accessed by using the Thom-son Reuters application. Moreover, these databases include a number of financial and non-financial data sets, such as company non-financials reported on the annual and interim non-financial statements (income statement, balance sheet, and statement of cash flow) as well as General Information. General Information includes company name, board of directors, industry and sector codes, contact details, web addresses, business and financial summaries, officer details, major customers, and competitors. The collection of the above information, which is previously published in any public platform or report, is called Secondary research. The biggest problem with collecting information through secondary research is that the information available could be outdated or old and hence could result in inaccurate outcomes. The alternative is to perform so-called Primary research. Primary research techniques mean collecting the information directly by speaking to several key participants and gathering the latest intelligence about the organization as well as the industry. Nevertheless primary research can be quite challenging as one needs first to identify the correct respondents they would want to interview, next, somehow persuade them to engage in a dialogue and then actually interview them in depth.
As far as SteelCo’s case is concerned, the FP&A will have all this information available from his colleagues at the various company departments. He will have to cooperate closely with the accounting, commercial, procurement, technical, and HR departments in order to cross-check and validate model assumptions. The very first thing he has to do is to collect the proper raw data from the company’s financial statements, footnotes, and external reports in one place. These raw data should include:
▪ The number of different product groups. SteelCo’s revenues can be grouped into 2 product groups. The “long” products group and the “flat” products group.
▪ Unit volumes and prices per product group. Normally this kind of information is available in the notes of financial statements. Even if prices are not disclosed explicitly they can be derived easily by just dividing total revenues by unit volumes per product group.
▪ Information about SteelCo’s profitability (gross profit margins, EBITDA margins, etc.).
▪ Information about SteelCo’s operating cycle (credit terms, payment terms, etc.).
▪ Information about SteelCo’s debt structure. That is the debt breakdown between short-term debt and long-short-term debt and the cost of each debt category respectively.
▪ Information about the depreciation that is charged in the income statement. The total amount and how it splits between production and selling/administrative costs. The amount of depreciation that results from the production facilities and machinery is charged in the Cost of Goods Sold (COGS) whereas the amount of depreciation that has to do with the warehouses of the distribution network as well as that which is related to office buildings is charged in the Selling General and Administrative (SG&A) expenses.
▪Effective tax rate. Companies’ income is subject to various taxes imposed by the govern-ment on their net profits. The effective tax rate is the net rate a company pays on its net income that includes all forms of taxes.
▪Information about the investment plans, if any, of the company.
▪Any macroeconomic indicators such as Gross Domestic Product (GDP) and inflation rate forecasts respectively.
In the specification part of the modelling process we discussed the single sheet on which we collect all the assumptions that we will use in the model. This sheet will resemble Exhibit 3.2 with the information the FP&A has gathered up to this point.
Note that there is a separate column presenting the Unit of Measure (UOM) of each relevant piece of information. Units are usually very obvious to the modeller, but this does not apply to everyone who sees the model over its lifetime. The model user should be able to understand the unit of measure for every input assumption.
Then the FP&A needs to transform the income statement, balance sheet, and statement of cash flows to the right level of detail. This level of detail will apply to both historical and forecast financial statements. While he needs to forecast many significant income statement, balance sheet, and cash flow statement accounts, as we discussed at the problem definition stage, to keep the model as simple as possible some other accounts need to be grouped together.
The first line of the income statement is the revenue line. Revenues are a product of units sold times price per unit. Since there are 2 product lines, flat and long products, the FP&A needs to monitor the units sold for both lines and their relevant prices. The rate of change for the revenue line is also calculated and will be used as a proxy of the evolution of sales in the forecast period.
After the revenue line he monitors the gross margin. The gross margin percentage is calculated as a percentage of sales. Again this figure will be used to forecast the gross margin. Following this are the other operating income, the operating expenses, and the other operating expenses.
Normally other operating expenses include a provision for bad debts. This provision refers to credit losses that pertain to the period of the income statement. A provision is a double entry that debits (increases) an expense account of the income statement and credits (decreases) a balance sheet asset account. The balance sheet account is the accounts receivable and is reduced by the amount about which there are doubts as to whether it will be collected (that is the allowance for bad debts).
Next come the Earnings Before Interest Tax Depreciation and Amortization or EBITDA figure. EBITDA is used to indicate the ability of a company to service its debt and allows us to analyze the performance of its operations while eliminating all operating and non-recurring items such as depreciation, interest, taxes, and one-time charges such as professional fees, or other non-recurring costs. Next is the EBITDA margin which is the EBITDA as a percentage of sales. The EBITDA margin is helpful when analyzing the growth of a company year over year because it reflects whether this growth was profitable and to what extent.
Growth is good, provided that the new businesses added in are as profitable as the existing one.
Then the net interest is recorded. That is interest expense minus interest income. In case there is no explicit information about the cost of funds in the company financial statements, the FP&A can get an estimate of the average cost of debt by dividing interest expense by the aver-age level of debt between 2 consecutive balance sheets. Then the depreciation is recorded and the profits before tax calculated after subtracting depreciation and interest expenses respec-tively from EBITDA. In case of profits the tax expense, let us say to the federal government, is reported and finally the profits after taxes. This final figure feeds directly into the balance sheet account of retained earnings if no dividends are given back to shareholders.
EXHIBIT 3.2 “Assumptions” worksheet
It is considered best practice in financial modelling to record the income accounts in black and the expense accounts in red. Similarly, to record profits in black and losses in red.
Exhibit 3.3 presents the historic income statement of SteelCo for the past 3 fiscal years 2011 to 2013 as they have been recorded by the FP&A.
Having finished with the Income statement, the FP&A reports the balance sheet in the following way.
Assets are broken down into current assets and non-current assets. Non-current assets are divided into net fixed assets, that is:
Fixed asset purchase price (Gross Fixed Assets) + Subsequent additions to existing assets
− Accumulated depreciation
and other non-current assets which include intangible assets and investments in subsidiaries, joint ventures, and associates. Current assets include the receivables from the credit sales to customers, inventory, cash and other assets. The inventory is the value of materials and EXHIBIT 3.3 Historical income statements of SteelCo
goods held by the company to support its sales and is divided into merchandise, finished goods, and spare parts. Inventory is a large item in the current assets and must be accurately counted and valued at the end of each accounting period in order to determine a company’s profit or loss. Other assets include all the other categories of assets not described explicitly above. On the equity and liabilities side, owner’s equity is grouped into share capital and retained earnings or losses, that is the accumulated earnings and losses over the years of operation of the company. Finally the liabilities part of the balance sheet is divided into long-term debt, short-long-term debt, payable to suppliers, and other liabilities. IASB dictates that we distinguish between short-term and long-term since only the short-term element participates in current liabilities which in turn participates in the current ratio. Other liabilities include all the other categories of liabilities not described explicitly above.
Exhibit 3.4 presents the historic balance sheets of SteelCo for the past 3 fiscal years 2011 to 2013 as they have been recorded by the FP&A.
Notice that at the end of the balance sheet there is a built-in check figure that should always equal zero. This figure simply entails a subtraction between total assets and owner’s equity & liabilities and a result equal to zero ensures that the basic accounting equation holds.
EXHIBIT 3.4 Historical balance sheets of SteelCo
Finally the statements of cash flow for the last 3 fiscal years is recorded at a certain level of detail. The adjustment for tax, depreciation, and the changes in working capital are recorded from the operating activities. The investing and financing activities are recorded at the minimum level of detail as shown in Exhibit 3.5.
EXHIBIT 3.5 Historical statements of cash flow of SteelCo
Notice that in the cash flow statement the cash and cash equivalents at the beginning of a period should be equal to the cash and cash equivalents at the end of the previous period.
Moreover the cash and cash equivalents at the end of a period should be the same as the cash account of the balance sheet of that period.
Now that the FP&A has collected the historical financial statement of the last 3 fiscal years, he needs to do some analysis and compute the key forecast drivers of interest. That is, for each line item in the financial statements, he will have to build historical ratios, as well as forecasts of future ratios. These ratios will form the basis for the forecast financial statements.