What’s the most important thing in a financial model?

I recently had the opportunity to share one of my passions with more than 100 interested parties.

I was asked to present “Ratio Analysis and related issues” by CPD Campus. Apparently my presentation was well received, which of course made me quite happy.

It also caused me to reflect on how we use ratios and related issues in the models we build – and a question frequently posed by people interested in financial modelling.

“ What’s the most important thing in a financial model?”

The glib answer of course is –“all of it” – but in reality it is the integrity of the results – which in turn are dependent on the process and analysis detailed below.

And the truth about being a financial modeller, is that it carries a heavy responsibility, given the fact that the model will be used to make some serious and significant decisions.

As any competent financial modeller will tell you, there are two aspects to a model, namely:

a. the build and

b. the analysis

When considering the first – the build – the following issues need to be addressed:

a. Understanding the business case – a fundamental issue in modelling.

Let’s be frank, if you don’t fully comprehend the business case – and I don’t mean superficially – then any attempt to build an effective model is doomed!

This initial step is pre-eminent and depending on the circumstances, can require significant research and often Socratic discussion with senior management to elicit detailed operational information.

b. This process leads us to the model drivers – the key assumptions which create the output. The de facto model bible.

c. Having determined the key drivers, what follows is the model build including the sequence , structure and the application of best practice modelling methodology.

d. All of the above, of course, are incorporated in the formulas – the model engine – that are used to produce a set of financial statements, culminating in the process of balancing the balance sheet which proves the accounting validity of the model.

And then, we get to the analysis – and the application of the various key ratios applicable to the output of the model – the key insights provided by of the model.

Typically ratios are divided into 5 categories:

1. Profitability
2. Balance Sheet (Activity)
3. Liquidity
4. Gearing
5. Returns

Of course, not all ratios are applicable to every model and typical ratio usage may include:

a. Profitability

i. Contribution (also called Variable Profit) which allows calculation of the level of revenue in order to breakeven

ii. EBITDA – not a ratio but often used as the start point of the cash flow statement – and used (misused) as a “valuation” method

iii. PBIT – operating profit – the first key operating driver of corporate performance and used in conjunction with balance sheet utilisation (Activity) to calculate RONA – a pre-interest, pre-tax
return on Net Assets

iv. PAT – Profits after tax – also described as “profits available for dividends” – and used to calculate the dividend cover ratio – the relationship between profits after tax and dividends

b. Balance sheet

i. Activity – a key measure of asset utilisation and the second key operating driver of corporate performance (see PBIT above). PBIT X Activity = RONA %

ii. Working Capital days – a key ratio for businesses where levels of inventory, debtors and creditors have a significant effect on cash flow.

c. Liquidity

i. Free Cash flow – a key output used to calculate a number of key performance indicators including IRR, NPV, DSCR (debt service cover), Project Life cover, Loan Life Cover, Equity IRR. Tax in this calculation is based on PBIT (excluding interest)

ii. Net cash Flow to both total and interest-bearing debt – a measure of risk and insolvency

iii. DSCR – Debt Service Cover – used to calculate the relationship between free cash flow and debt repayments (normally a requirement of the senior debt provider)

d. Gearing

i. Debt – both total and interest-bearing – in relation to shareholders equity.

ii. Equity to total Capital Employed – used to calculate Leverage (Gearing) and a key factor in improving shareholder returns (ROE). Typically used when RONA % exceeds the cost of debt
(interest rate%)

iii. Interest bearing debt to Net Assets (Capital Employed)

iv. Interest Cover – relationship between PBIT and interest payments

e. Returns

i. RONA – (see PBIT above) – RONA is the operating return ratio of a business.

ii. ROE – returns before dividends based on Opening Shareholders Equity – the bottom line

iii. Equity IRR – IRR % based on cash flows attributable to shareholders

iv. Dividend IRR – IRR% based on equity investment and dividends declared

v. Project IRR – applicable to project models – IRR calculated on Project Free cash Flows. A key ratio and compared to the WACC% – weighted average cost of capital

If you are interested in attending one of our financial modelling courses, or obtaining more information, please send an email to: colin@goalfix.co.za

Colin Human CA(SA)

Goalfix Financial Modellers