BIBLIOGRAPHY AND REFERENCES
3. Owner’s equity (the difference between assets and liabilities)
3.1 INTRODUCTION – HOW FINANCIAL MODELS WORK
In Chapter 1 we examined the financial modelling process in terms of the definition of the problem we are trying to solve and the specifications of the model under discussion. In this chapter we will apply the third step of the process described in Chapter 1, which is to build the model, and the 4th step of the process, that is checking that the model produces rational results. In order to build a real life model we need first to address a real-life problem that we will solve using the proposed model.
Let us describe the following situation. Steel Corporation SA, or SteelCo, is a long-established company in the steel sector but has been severely hit by the economic downturn which followed the 2008 financial crisis. The steel sector is a capital-intensive sector, both in terms of production facilities and working capital needs. The industry standard for leverage, as expressed by the total liabilities to equity ratio, is higher than 3. SteelCo expanded into new production facilities just before the onset of the crisis. The funding of the project was done by a syndication of banks and the following terms and conditions were agreed on the bond loan provided in June 2008 (see Exhibit 3.1):
CHAPTER 3
Financial Statement Modelling
The tenor of the loan represents the period for which the loan was granted and is usually expressed in years. The spread is used to calculate the amount of interest the borrower pays the bank for using the loan. The interest is calculated on a daily basis by applying the spread on the existing amount of the balance, divided by a 360-day year, and multiplied by the num-ber of days being calculated from one due date to another. The repayment term refers to the amount of payment at the end of the term and anticipates that the loan will be refinanced in order to meet the payment obligation. Finally, before agreeing to a loan, lenders often require borrows to agree to abide by restrictive covenants. Covenants are the provisions banks attach to long-term debt that trigger technical default when violated by the borrowing company. For example, SteelCo’s bank required that it keep its current ratio above 1.0, its leverage below 5 and its interest cover above 1.5. Breaking a covenant “triggers” a default and the lender’s right to call the loan. Although banks pull the “trigger”, they seldom call the loan. Doing so often results in bankruptcy for the company, bad publicity for the bank, and costly legal bills.
However, the trigger forces the borrower to return to the bargaining table where the lender can demand a plan for corrective action, a higher interest rate, more collateral, and/or extra covenants. This is the case of SteelCo. The company breached the interest cover at the end of fiscal year 2013.
Unfortunately after the onset of the crisis, steel consumption plummeted and the com-pany had to bear severe losses which in turn affected its equity adversely. Moreover, the cost of funding increased dramatically making things even worse. The company started funding its losses with debt and thus its liabilities started increasing year on year as well. The Chief Executive Officer of the company is worried about the fact that during the last quarter of fiscal year 2013 the third covenant of the loan was breached. The Financial Planning and Analysis manager (FP&A) of the company was assigned by the CEO the task of advising the Board of Directors about the possibility that SteelCo might breach the other covenants before the end of the loan should the economy remain stalled at current levels of consumption.
In seeking to respond to the CEO’s request and to be able to monitor the possible range of the loan covenants, the FP&A needs to build a complete financial model of the company, forecast its future performance, and thus the values of the requested ratios.
In other words he needs to create the so-called Proforma Financial Statements. Proforma balance sheets are created by forecasting individual account balances at a future date and
Term Value
Tenor (years) 9
Spread 2.50%
Repayment 61% at the Ninth year
Amount (€ mio) € 70 m
Covenants Acceptable range
Current Assets / Current Liabilities >1.0 Leverage (Total Liabilities/Shareholders Equity) < 5 Interest cover (EBITDA / Interest Expense) > 1.5
BOND LOAN TERMSHEET
EXHIBIT 3.1 SteelCo’s bond loan term sheet
then aggregating them into a financial statement format. Account balances are forecast by identifying the forces that influence them and projecting how the accounts will be influenced in the future by such forces. Sales, company credit and payments policy, and cost structure are often significant forces. Proforma financial statements are a forecasting method that uses sales figures and costs from the previous 2 to 3 years to create financial statements into the future.
At this point, somebody could ask why the FP&A needs a complete, fully operational financial model for just 3 ratios. Let us see why. Let us break down the problem as we said in Chapter 1. The first ratio is the quick ratio we referred to in Chapter 2 and it is a measure of liquidity. For this ratio the FP&A needs to forecast 2 balance sheet accounts, that is current assets and current liabilities. If we recall from Chapter 2 how these accounts are broken down then we see that for current assets we need to forecast trade receivables and inventory and for the current liabilities trade payables and short-term debt respectively. That is, in order to forecast just the first ratio, the FP&A needs to understand and model the whole operating cycle of the company. He needs to forecast the working capital needs and the funds required to support those needs.
The other 2 ratios are measures of solvency. Again let us break them down further.
To forecast both total liabilities and equity requires a complete balance sheet plus an income statement. Remember that the equity at the year-end depends on the net income or net loss of the income statement. Total liabilities include, as well as the current liabilities, the long-term liabilities. Long-term liabilities normally include the portion of debt that has been used to finance long-lived assets such as heavy machinery and production machinery. So in order to forecast long-term liabilities the FP&A needs to understand the future strategic investment plan of the company. Moreover, the third ratio contains 2 income statement accounts, that is, EBITDA (operating profits) and interest expense. In turn, interest expense depends on the level of debt the company needs to operate. But the level of debt depends on the profits or losses of the year which, in turn, include interest expense. This is called a circular reference and we will deal with it in the last section of this chapter. Other information the FP&A needs to collect in order to complete the task includes the following:
▪ Projected sales growth rates for the period under analysis, i.e. up to 2017;
▪ Projected profit margins;
▪ Projected operating expenses;
▪ The breakdown of the company’s debt and the cost of this debt;
▪ Any investment plans;
▪ Depreciation information.
The FP&A has now finished with the definition of the problem as described in Chapter 1.
He has broken down the task into smaller parts and are ready to give the specifications of the model, i.e. its structure, before he starts forecasting. It is clear so far that he will have to model the standard financial statements, including the income statement (profit & loss), bal-ance sheet, and statement of cash flow. The time frame of the forecast is dictated by the tenor (lifetime) of the long-term loan. The loan expires in 2017 so he will need to forecast up to 2017 on a yearly basis. Operating expenses will be grouped in one category, Selling General
& Administrative (SG&A) as they do not need much detail about them. The Key Performance Indicators (KPI) that will be forecast in order to address the problem in question are the
3 covenants: the quick ratio, the leverage, and the interest cover. Neither sensitivity analysis nor a control panel was required for the time being.
Now that he has specified the structure of the model he is ready to proceed to step 3 of Chapter 1. He will build the model. What needs to be done is: