What is Financial Modeling?

Image what is financial modeling?

What is financial modeling? It’s a pivotal skill in today’s finance and accounting sectors, providing a glimpse into the future performance of companies. Using sophisticated software tools like Microsoft Excel, financial modeling helps analysts and finance professionals predict outcomes, analyze business strategies, and make well-informed decisions. This comprehensive guide will delve into the techniques, benefits, and courses available for mastering financial modeling. Understanding the Basics of Financial Modeling Financial modeling primarily involves creating summaries of a company’s expenses and earnings and using them to project future financial scenarios. These models are essential for decision-making in budgeting, investing, and strategic planning. For novices and seasoned professionals alike, grasping the basics through a financial modeling course is the first step toward proficiency. The Framework of Financial Modeling The foundation of any financial model is the trio of core financial statements: the income statement, the balance sheet, and the cash flow statement. Known as the “3-statement model,” this framework is crucial for anyone beginning in financial modeling. Understanding how these statements interact and reflect the business’s health is fundamental, covered comprehensively in financial modeling courses. Advanced Financial Modeling Techniques After mastering the basics, more complex scenarios come into play, such as Mergers & Acquisitions (M&A), Discounted Cash Flow (DCF) analysis, and Leveraged Buyout (LBO) models. Each of these uses the fundamental data from the 3-statement model but in ways that cater to specific financial analyses. Advanced courses can provide the specialized training needed to tackle these complex models. Software Tools for Financial Modeling While financial modeling is often synonymous with Excel, the landscape of tools available extends much further. Advanced software like MATLAB, Python, Quantrix, and Crystal Ball offer functionalities that go beyond Excel’s capabilities, especially in handling more complex mathematical models. However, for those starting out, financial modeling Excel courses provide a solid foundation and are often a prerequisite for tackling more advanced tools. Choosing the Right Financial Modeling Course With numerous online and offline courses available, choosing the right financial modeling course can be daunting. The best courses offer a mix of theoretical knowledge and practical application, using real-world data sets and scenarios. Look for courses that start with the basics and gradually introduce more complex concepts, ensuring a well-rounded learning experience. Career Opportunities in Financial Modeling Proficiency in financial modeling opens up a range of career opportunities in fields such as investment banking, corporate finance, private equity, and equity research. Each of these fields relies heavily on the ability to analyze financial data and predict future trends effectively. Financial modeling courses equip professionals with the tools to excel in these high-stakes environments. The Role of Certifications in Financial Modeling Certifications can significantly boost your credibility and career prospects in financial modeling. Well-recognized credentials, like those offered by the Financial Modeling Institute, attest to your skills and knowledge, giving you an edge in the job market. Financial Modeling Best Practices To excel in financial modeling, it’s important to adhere to industry best practices. This includes ensuring data accuracy, making logical assumptions, and maintaining a clean and organized Excel workbook. Continuous learning and application of new techniques are also crucial, as the field of financial modeling is constantly evolving. Conclusion: The Future of Financial Modeling As businesses become more data-driven, the importance of financial modeling continues to grow. It’s not only about forecasting numbers but also about understanding market trends, evaluating business strategies, and making informed strategic decisions. With the right training, tools, and approach, financial modeling can be a powerful skill set that drives business success. Key Takeaways

How to interpret the breakeven point in units?

The formula for calculating breakeven point in units is to take total fixed costs and divide by contribution margin per unit. Contribution margin per unit is calculated as revenue per unit minus variable costs per unit. The output of this formula will tell the company exactly how many units they need to sell to cover their fixed costs. If they end up selling more units, they will generate a profit, and if they sell less units, they will incur a loss. For example, if the breakeven point in units is 100 units, and the company will sell more than 100 units, they will generate a profit. If they sell less than 100 units, the company would generate a loss.

What is target costing?

Target costing is a system in which a company plans in advance the price points, product costs, and margins that it would like to use to achieve a new product. This concept will use the selling price of the product in order to determine the production of the cost that is required to enter the market. Target Costing Example: Below is an example calculation for target costing. As you can see, the company would base the selling price of a new product on existing factors in the market. Additionally, they would have to factor in a desired profit on each unit, otherwise, what is the point of selling the product, right? In our example, Sun Surf analyzes the market and determines the new surfboard will have a selling price of $450. Since they require a profit margin of 30%, that means that $135 of the $450 selling price will have to result in a profit. We’re left with a target cost of $315, which means that the company must be able to produce and sell the product for $315 per unit or less.

What is capital rationing?

Capital rationing is meant to illustrate that a company does not have unlimited capital, so they would perform analysis to determine what types of capital projects would provide the greatest benefit to the company. Every company will use different metrics to determine which projects to accept or reject based on their goals.  As it relates to your own personal situation, think about how you don’t have unlimited cash to buy whatever you want. You evaluate where you should spend your cash based on your goals or what matters most to you. That is a form of capital rationing since you are deciding where to spend or invest your cash. 

Gross Profit Method – Impact of overstating the gross profit %

A company will often use the gross profit method to estimate cost of goods sold and ending inventory during an interim period. A company would use this method if they do not have a perpetual inventory system and they only perform a physical inventory count at the end of a period. The formula for calculating cost of goods sold would just be sales x (1 – gross profit %). So what happens if the company overstates the gross profit % used in the calculation? The result would be an overstatement of ending inventory and an understatement of cost of goods sold. The example below assumes that the gross profit % used is 40%, but the correct gross profit % is actually 30%. As you can see, if we use a gross profit % of 40% on sales of $1,000, that results in cost of goods sold of $600. If the gross profit % should have been 30%, then cost of goods sold would have been $700. When we plug those figures into an inventory rollforward, we can see that ending inventory ends up being overstated when we overstate the gross profit % used.

How to calculate working capital turnover ratio?

The working capital turnover ratio is used by a company’s management team, investors, and/or creditors to determine how efficiently and effectively the company uses its assets. This is a topic that is often tested on the BEC section of the CPA exam. Candidates should understand how to calculate and interpret the working capital turnover ratio. The formula for the working capital turnover ratio is sales (net) divided by average working capital : Example Working Capital Turnover Ratio Calculation Topa Industries has the following financial information for Years 2 and 3: Year 2 Year 3 Current assets $50,000 $60,000 Current liabilities 30,000 36,000 Net working capital 20,000 24,000 Sales (net) 300,000 320,000 Cost of goods sold 150,000 160,000 What is the working capital turnover ratio for Year 3? A) 13.3 B) 14.5 C) 16.0 D) 13.6 14.5 is correct. The calculation would be sales of $320,000 divided by average working capital of $22,000, which equals a working capital turnover ratio of 14.5 times. Average working capital would be the average of $20,000 and $24,000.

How to calculate the cash conversion cycle?

The cash conversion cycle is considered a metric that expresses the length of time, in days, that is takes for a company to convert inputs into cash flows. The cash conversion cycle is computed as follow: To calculate the cash conversion cycle, you will need to calculate days in inventory (DIO), days sales in accounts receivable (DSO), and days of payables outstanding (DPO). Fortunately, we have a our mental map for the cash conversion cycle that breaks down this process into four simple and repeatable steps: Below is a description of each step that is part of the cash conversion cycle: Step 1) Days in inventory (DIO) – The days in inventory ratio indicates how long it takes a company to purchase raw materials, manufacture a product, and then sell the product to an end customer. A company would want this ratio to be as low as possible as it means they can convert their investment in raw materials into the sale of a product quickly. DIO can range widely depending on how long it takes for a company to manufacture, distribute, and sell the product to the end customer. To calculate days in inventory, you would take ending inventory and divide by daily cost of goods sold. Daily cost of goods sold would be calculated as annual cost of good sold divided by the number of days in the period. Typically, this ratio is calculated on an annual basis, so the number of days in the period would be 365 days. Step 2) Days sales in accounts receivable (DSO) – Days sales in accounts receivable is a metric that reflects the success that the firm has in collecting receivables that remain outstanding. A higher amount of days will generally indicate that the company is taking a longer amount of time to collect its receivables. A lower ratio indicates that the company can collect their receivables more quickly. The DSO for a company should align closely with the invoice terms they have for their customers. For example, if the company has invoice terms of net 30 accounts, then the DSO should be around 30 days. To calculate days sales in accounts receivable, you would take ending accounts receivable (net) and divide by daily sales. Daily sales would be calculated as annual sales divided by the number of days in the period. Typically, this ratio is calculated on an annual basis, so the number of days in the period would be 365 days. Step 3) Days of payables outstanding (DPO) – Days payables outstanding is a metric that reflects the average time (in days) that an organization will take to pay off its debt outstanding. Generally, a higher days payables outstanding ratio will indicate that it takes a company a longer amount of time to pay off its bills. The DPO for most companies is typically around 30 days as this aligns with the invoice terms a company would have with their suppliers. To calculate days of payables outstanding, you would take ending accounts payable and divide by daily cost of goods sold. Daily cost of goods sold would be calculated as annual cost of good sold divided by the number of days in the period. Typically, this ratio is calculated on an annual basis, so the number of days in the period would be 365 days. Step 4) Cash conversion cycle (CCC) – Once you have calculated the individual ratios for DIO, DSO, and DPO, you can plug them into the cash conversion cycle formula and that will give you the length of time in days it takes for a company to convert their investment into inventory back into cash. he YouTube video below will walk you through the mental map for the cash conversion cycle: Example Calculation of the Cash Conversion Cycle Prospect Technology is trying to determine their cash conversion cycle for Year 5. The company’s accounting department provided the following financial information: Period (# of days) 365 days Sales (net) $500,000 Cost of goods sold $250,000 Ending inventory $30,000 Ending accounts receivable, net $50,000 Ending accounts payable $15,000 Using the financial information above, what is the cash conversion cycle (in days) for Prospect Technology? 58.40 is the correct answer. We’ll have to go through and calculate each ratio first, and then use our formula to calculate the cash conversion cycle in days. Step 1) We’ll start by calculating the number of days in inventory. We’ll need to divide ending inventory of $30,000 by daily cost of goods sold of $685, which results in a ratio of 43.8 days. Step 2) For days sales in A/R, we’ll divide ending A/R of $50,000 by daily sales of $1,370, which results in a ratio of 36.50 days. Step 3) For days of payable outstanding, we’ll divide ending AP of $15,000 by daily cost of goods sold of $685, results in a ratio of 21.9 days. Step 4) Now that we have the individual activity ratios, we’ll take a DIO of 43.8 days, add a DSO of 36.5 days, and subtract a DPO of 21.9 days. That results in a cash conversion cycle of 58.4 days. This means it takes Prospect 58.4 days to convert its investment in inventory back into cash to use to grow the business. The YouTube video below will walk you through the example question and provide additional context for each step along the way:

Valuation Models Tested on the CPA Exam

The BEC section of the CPA Exam will test a candidates knowledge on a variety of valuation models. There are two types of valuation types that you need to be familiar with for the CPA exam. Underneath each type of valuation model, there are different methods or ratios that we need to understand for the CPA exam: Absolute Valuation Models: Absolute value focuses on intrinsic value which uses projected cash flows and other internal financial information to determine business valuation. With absolute models, we focus only on the characteristics of the company, and we will not compare against other peers or competitors in the industry. 1) Zero growth model: Perpetuities are often referred to as “zero growth stocks” and will exist when periodic cash flows that have been distributed from an annuity will last indefinitely. This essentially will occur when a company pays out the same dividend in each period and will be applied when an organization is attempting to determine its stock valuation and more specifically, its preferred stock. Perpetuities must specify dividends involved as well as its required return. Perpetuities per share valuation can be computed as follows: Below is an example of how to calculate the valuation using the zero growth model: 2) Gordon Growth Model (constant growth): This Gordon model is commonly tested on the CPA exam. The basic premise of this model assumes that dividend payments are also the cash flows that come from equity securities. Additionally, the intrinsic value of the company’s stock is considered the present value of the expected future dividends. When applying constant growth models, it should always be assumed that the dividends will be accounted for as one year subsequent to the year in which you are determining the price. Additionally, the formulas will presume that the required rate of return is greater than the dividend growth rate. Below is an example of how to calculate the valuation using the Gordon growth model: 3) Discounted cash flow (DCF) method: The discounted cash flow method can be used to calculate the intrinsic value of a stock. The DCF method calculates the present value of future cash flows for a specific period of time using a discount rate. As you can see in the visual below, we would take the business valuation from the DCF model and divide by shares outstanding to calculate the intrinsic value per share. This can be compared to the market price per share to determine if the stock is overvalued or undervalued. Below is an example of how to calculate the valuation using the DCF method: Relative Valuation and the Use of Price Multiples: Models that use the value of comparable stocks for determining the value of similar stocks are called relative valuation models. These valuation multiples are typically compared to another company to determine valuation. 1) Price-Earnings Ratio (P/E): The P/E ratio is most commonly used for the valuation of equity securities. The rationale for this is that earnings are the key driver of the investments value. The number is the market price or the stock price. The denominator uses the company’s earnings per share (EPS), which can be based on the trailing 12 months or forward looking 12 months. P/E ratio comparison: This comparison illustrates that even though the tech firm has a higher market price per share, the P/E ratio for the tech firm of 20x indicates the stock is more expensive when compared to the grocery store’s P/E ratio of 10x. However, this ratio doesn’t factor in future growth like the PEG ratio below does. 2) Price-to-Earnings Growth (PEG) Ratio: The PEG ratio measures the effect of earnings growth on a company’s price-to-equity. Stocks that contain higher PEG ratios are generally more attractive than stocks that contain lower PEG ratios. PEG ratio comparison: The market price and EPS for both companies are the same as the P/E ratio example, however, we also can factor in the growth rate. When looking at the P/E ratio, the Tech firm looks more expensive at 20x earnings vs only 10x for the grocery store. However, the after factoring in the growth rate of 20% of the tech firm, the PEG ratio is now 100x vs 250x for the grocery store. This just shows that factoring in growth rate is key when assessing valuation. Investors want the PEG ratio to be as low as possible. 3) Price-to-Sales (P/S) Ratio: The price-to-sales ratio can be used to forecast the current stock price. This rationale indicates that sales are less subjective to potential manipulation than book values or earnings. P/S ratio comparison: In the example below, we can see how the P/S ratio for the grocery store is 2x while it is 5x for the tech firm. This implies that the tech firm is more expensive as it costs more for each $1 of revenue generated by the company. In general, investors want the P/S ratio to be as low as possible as it indicates the stock is cheaper. 4) Price-to-Cash-Flow (P/CF) Ratio: The idea behind the price-to-cash-flow (P/CF) ratio is that cash flow will be harder for companies to manipulate than earnings. Generally, this is a more stable metric than price-to-earnings. Remember, cash flow adds back non-cash expenses like depreciation and amortization to net income (Cash flow doesn’t necessarily equal net income or profit). P/CF ratio comparison: In the example below, we switch to calculating in total and not on a per share basis. The result ends up being the same. Even though the tech company has a higher market value, they appear more expensive with a P/CF ratio of 2.5 as compared to 0.8 for the grocery store. 5) Price-to-Book (P/B) Ratio: The price-to-book ratio is calculated by dividing a company’s stock price by its book value per share, which is defined as the net assets of the company. This is another indicator for determining if a company is either over or under valued. The price-to-book ratio will vary by industry and should only be compared against…