My Quick Summary of Finance (including Ratio Analysis & Modeling)

As I alluded to, an MBA classmate and I are working on launching a video course covering the basics of accounting and finance.

You can sign-up for our pre-launch list here: https://www.businessbasicsessentials.com/

Our goal with the video course is to help pass along the most valuable knowledge we have regarding business, so that you don’t have to go through all the years and spend all the money we did.

In the process of making this video course, I've created some rough information covering the basics of financial accounting, managerial accounting, corporate finance, financial statement analysis, and financial modeling. I'm not going to post all of that here (because it would be way too long), but here are my quick notes regarding corporate finance, financial statement analysis, and financial modeling.

Consider this a "free taste" of what the video course will be covering:

There are a lot of types of finance out in the world. Personal finance is all about building your budget, savings, and paying off debt. Investment finance is all about deciding what to invest into and how much, but corporate finance is what we’re going to talk about today.

You see, corporate finance helps business owners and managers maximize the value of their business by balancing risk and return. Corporate finance is useful for small and big businesses in every industry. We are going to teach you what kind of projects and opportunities to invest into, how to best fund these investments, when to pay off business debt, when NOT to pay off business debt, and how to determine when to give money back to investors.

In a quick summary, corporate finance deals with the tools and analysis of finding and using outside debt and investments.

Time Value of Money

What would you rather have: $100 today or $100 in 10 years from now? The vast majority of us would pick $100 today. Why?

For one, we may not even be around in 10 years from now. For two, the person paying us may not be around in 10 years from now. A lot can happen in 10 years.

Congratulations, you just understood the single most important financial concept in the world: time value of money. You see, money today is worth more than money tomorrow. Why? Because of risk.

If you give me money today, I can use it or invest it immediately, gaining value right now.

If you give me money tomorrow, I have to wait to use it or invest it, postponing the value the money represents to me till late. Between now and tomorrow, a lot can happen. I may miss out on a big investment opportunity, I may get hurt and have to borrow money to pay for my bills, and life just happens.

Time value of money is also related to inflation. I’m sure you know that $100 in the 1950s is different from $100 today.

You see, inflation just means money loses its ability to purchase the same goods or services overtime. That’s why your grandparent’s story of buying a coke for 10 cents is so crazy to think about now that we are paying $2 for a bottle.

It is due to inflation and risk that money tomorrow is worth less than money today.

Sooo, if I was to offer you $100 today and $110 a year from now, would you take that deal? That is a much different question, one of which we are going to solve with something called the Present-Value of money.

You see, we can figure out how much future money is worth to us today through a simple equation.

The Present Value of Money is equal to the Future Value of Money divided by (1+ interest rate )^number of years.

So let’s get back to our $110 a year from now. In order to bring that value back to today’s dollars (aka present value) we have to discount it using our interest rate. Discounting a future cash payment is just a fancy way of saying “bring it into today’s dollars”.

Our interest rate is how much return we would expect to make if we invested today. For simplicities sake, let’s say we would expect to make 5% on any investment we make today. So our interest rate we use to discount this cash payment would be 5% (sometimes this is called the discount rate, but it just depends on who you are talking to).

So: $110/(1+5%)^1 year

This is equal to $104.76 in today’s dollars.

So what’s a better deal, $100 in today's dollars or $104.76 in today’s dollars?

Well, $104.76 is better. So, you should prefer the $110 a year from now since its present value is worth more.

That’s how the time-value of money works. For now, remember that $1 today is worth more than $1 tomorrow because you the opportunity to invest it or avoid future risk by getting it today.

Capital Budgeting

Investing and capital budgeting is all about planning where to put a company’s money in order to boost profits. The main activity is deciding what growth and investment opportunities are worth pursuing and which are not. This is done through several different analysis tips and techniques, but they all leverage various accounting ideas.

Companies are constantly looking to invest in two different ways:

1. Through CapEx (short for capital expenditures) which is money used to acquire, maintain, or improve buildings, machines, and technology. This is traditionally seen as maintenance-focused, not growth-focused.
2. Through acquiring new companies or capabilities. This could be acquiring a company or new revenue-generating property.

A great way to view the differences in these two investments is that CapEx allows you to continue to do what you have always done and Acquisitions allows you to make more sales than you would’ve in the past.

For our concerns, we are going to focus on the acquisition-focused investments and how to determine if new sales opportunities are worth investing into.

There are two techniques to valuing a future investment opportunity:

1. Net Present Value (called NPV)
2. Internal Rate of Return (IRR)

Both of these topics leverage the idea of time value of money in order to determine the value of an opportunity. Net Present Value is all about discounting future cash flows to the present using an agreed-upon interest rate.

The NPV formula is just multiple present value formulas added together. Remember, the present value of money is just the future value divided by 1 + the interest rate to the number of years between the future payment and today. The main use of NPV is through a financial modeling technique called Discount Cash Flow (sometimes known as DCF). 

Let’s run through an example of doing NPV.

Let’s say I run a hotel company and there is a possibility of buying a new hotel property for $300. This hotel makes around $100 per year. My plan would be to operate the hotel for 5 years and then sell it for whatever I buy it for.

Should I buy this hotel?

NPV will help us determine the answer.

The first step to every NPV calculation is to create a timeline of inflows and outflows of cash. Every timeline starts at time Zero. 

Time zero is when you pay for the new investment

Time 1 is after owning/using the investment for one time period. In this case, it would be running the hotel for 1 year and getting our first $100

So, let’s look at our full timeline.

-$300 in Time 0 (aka right now we sent our $300)

+$100 in Time 1,2,3, and 4

+$400 in Time 5

In order to discount these payments back to Time 0 (aka today) we need to figure out what interest rate to use. 

In the real world, you would calculate your cost of capital. Since this a hypothetical situation, we are just going to say it is 10%.

We only need to discount future cash flows, not cash flows at Time 0 (aka today), so we need to discount the $100 cash flows during times 1,2,3,4 and the $400 cash flow in time 5. I could talk over all this math, but let’s just show you what it looks like.

For time 1, $100/(1+10%) or $91

For time 2, $100/(1+10%)^2 or $83

For time 3, $100/(1+10%)^3 or $75

For time 4, $100/(1+10%)^4 or $68

And then for time 5, $400/(1+10%)^5 or $248

Now, all our cash flows are in the same time period (time 0, aka now). So all we have to do is add them together. All our inflows add up to $565. Our outflow is $300 (our initial purchase price). So 565-300 is $265.

According to net present value ideas, any project with a positive NPV is a good project. So, this hotel is a good investment according to NPV analysis.

Boom. NPV is finished, so what’s IRR?

Internal Rate of Return, IRR, is the discount rate that makes the NPV of a project zero.

It is typically compared to the company’s cost of capital. If the IRR is greater than the cost of capital (aka the interest rate the company has to pay to borrow the money) then it is a good investment.

In order to calculate IRR, you need to use excel. You can do it by hand, but it takes forever. Using either the IRR or XIRR function of excel is much much easier.

To do IRR in excel, you just put the list of positive cash inflows and negative cash outflows in excel.

Doing this for our hotel example gives us an IRR of 33%. This means we should do the hotel deal as long as our cost of getting the $300 to invest in the deal doesn’t have a 33% interest rate or higher. This 33% can also be seen as the expected return from this investment. For example, if we could invest more than $300 in this deal, we should because 33% return is a great deal.

IRR is also a great way to compare projects of different sizes. NPV varies by the size of the deal. Bigger deals have a bigger NPV. However, the best deals have the best IRRs. Therefore, if you are comparing deals of different sizes (such as millions v thousands of dollars invested) IRR is a better tool than NPV.

However, IRR does have one main limitation. IRR assumes all positive cash flows are REINVESTED at the same rate as the project. So that $100 I get from Year 1 of running the hotel is assumed to be reinvested at 33% along the life of the hotel project. This isn’t usually the case, so IRR may be a bit off. Not a ton, but just a bit.

This was a lot, but hopefully, you learned some helpful tools to evaluate business opportunities.

For both NPV and IRR, you need to determine the timeline of cash payments from and to the project. NPV gives you a hard dollar amount while IRR gives you an expected % return. Both are beneficial for a few reasons, and good business owners and managers should do both analyses before deciding whether to pursue an opportunity or not.

Capital Financing

Other than deciding where to invest, corporate finance helps businesses figure out where to find the money to invest. Specifically, how much debt vs equity a company should use.

Remember, debt is money borrowed and must be repaid to the lender. Like a loan.

Equity is money given to you from outside investors in return for a part of the company, or possibly project.

Balancing debt & equity is a core duty of corporate finance. Too much debt, and the risk of bankruptcy increases. Too much equity, and you may not have any of the company left for yourself! Balancing these aspects is called a company’s capital structure. You do this by evaluating a company's weighted average cost of capital. Weighted Average Cost of Capital is a fancy business topic everyone should know about.

Weighted Average Cost of Capital, also known as WACC, is simply the blended cost of the company’s equity & debt. The goal is to have a low WACC. That means you can find money cheaply.

There are two portions of WACC you need to understand: the cost of equity and the cost of debt.

Let’s attack the cost of equity first.

The cost of equity is determined by using what is called the Capital Asset Pricing Model (aka CAPM).

CAPM helps people understand the risk-reward ratio of a company. According to CAPM, the cost of equity is equal to the risk-free rate plus Beta*market risk premium.

That’s a lot of vocabulary words, so let’s take it piece by piece.

The risk-free rate is the interest rate that is closest to “risk-free”. Usually, companies use the 10-year treasury bond yield. To find this number, all you have to do is google “What is the 10-year US treasury bond yield”, for right now, it’s only 0.72%. However, the long-term average is 4.5%.

Beta is a fancy way of saying, “how risky is this company relative to the rest of the market”. Unlike treasury yields, beta is a bit harder to find. If a stock is riskier than the overall market, it will have a Beta higher than 1. One way to estimate Beta is to take an industry’s Beta and then adjust for “leverage”. NYU, the school, has a database of various industry’s Beta’s. Just Google, “Beta by industry” and it is the first result. To adjust for leverage, which is just whether a company has more or less debt that the rest of the industry, all you have to do is multiple the beta for the industry by (1+(1-tax rate)*(Debt/Equity)).

Remember, Debt/Equity is an equation we learned in financial accounting. It is a way to measure the leverage of a company. The (1-tax rate) is a way to take the “tax shield” of debt into consideration.

Wait, what’s a tax shield? You see, the interest you pay on debt is tax-deductible. It reduces how much in taxes you have to pay. It is a shield to protect your profits from taxes.

Soooo, to make sure Beta takes into account how much, or little, debt a company has, you have to take the industry beta and multiple it by the (1+the tax shield*the leverage ratio) aka (1+(1-tax rate)*(debt/equity).

Market-Risk Premium is technically defined as the return of the stock market – the risk-free return. The easiest way to find this is to google “Ibbotson risk premium”. Ibbotson is a third-party research firm that studies this exact topic. However, to get the real research from Ibbotson, it will cost you some money, but to get close, you just need to look at some of the other Google results. A few of them will have some estimates for you to use. The long-term average is around 3.5%.

That was all just to understand the CAPM equation which just allows us to figure out the cost of equity, the first half of the WACC equation.

Now, let’s turn our attention to the debt side of the equation.

Luckily, this is the easier part. The cost of debt is simply the yield to maturity on the firm’s debt. Yield to maturity is just the interest rate you are paying on your debt. Technically, it gets a bit more complicated, but for our case, this will work just fine.

Once you have the cost of equity and debt, you just need to figure out how much each represents as a percent of total value. Pretty much, what % of debt and what % of equity do you have?

Equity % is just All Equity / All Debt + All Equity

Debt is just the opposite. All Debt / All Debt + All Equity

Ok, so let’s run with an example.

Let’s say we are going to calculate WACC for an entertainment company with $4 Million debt and $5 million in equity. They pay $400,000 in interest every year. Their tax rate is 30%. What’s their WACC?

Our first step is to turn to CAPM.

CAPM is the Risk-Free Rate + Beta*Market-Risk Premium.

Risk-Free rate for right now is .72%

Beta for an entertainment company, according to NYU is 1.33. To make this custom for our company, we have to take our leverage and tax-shield into consideration. So 1+(.7*.8) = 1.56. 1.33 *1.56 is pretty close to 2.

Market-Risk Premium is right around 4.5% right now

So, .72%+(2 *4.5%) gives us 9.7%. That’s our cost of equity.

Our cost of debt is calculated by dividing our interest payments over our total debt, so 400,000/4,000,000. Which is 10%

Now how much is debt and how much is equity

Debt is 4/9 which is 44%

Equity is 5/9 or 56%

So let’s put this into our WACC equation.

WACC = (Cost of Equity * % of Company which is Equity) + (Cost of Debt * % of Company which is Debt)*(Tax Shield)

Equity portion is 9.7%*56% or 5.4%

Debt is 10%*44%*(1-30%) or 3.1%

Add these together and we get a total WACC of 8.5%.

Is this good? It isn’t bad. AS we’ve seen, WACC changes with the overall economics of the world, the company’s decision to add more debt or more equity, and the tax rate the company faces.

WACC is an extremely helpful equation and process to understand as a business owner and manager. Remember, a lower WACC is always better!

A company’s capital structure is crucial to maximizing the value of a business.

A combination of long-term and short-term debt plus equity impacts how a company uses profits now and tomorrow. Too much debt, and a company can’t make their interest payment if a recession happens, then it goes bankrupt. Too little debt, and a company isn’t growing as fast as competitors.

Companies have to evaluate their funding options, including interest rates, their cost of capital, and their expectations of the future.

Looking at competitors and industry averages will allow business owners and managers to know whether they are more or less aggressive than the rest of their market. As long as they have a reason to be more or less aggressive, they are probably making the right decision.

What would be wrong is not doing the math and not having a reason behind their capital structure. Once we get into financial modeling, we’ll show you how to create a financial model to determine your optimal allocation using a few assumptions.

However, setting the capital structure is just half the battle. Getting to and managing your optimal capital structure is a job by itself.

What To Do With Profits

Remember Retained Earnings?

Retained Earnings is the profit a company makes and keeps. It is the link between the net profit on the income statement and the equity section of the balance sheet. A positive net profit increases retained earnings.

Every company can do a few things with Retained Earnings:

• They can invest it back into the company
• Give it to investors in the form of dividends or share buybacks
• Use it pay off debt

Corporate finance helps companies determine which of these options is the best for them given the circumstances they are in.

A rough rule of thumb many corporate finance people follow is that if a company can earn a rate of return greater than the company’s cost of capital, they should pursue it. If not, they should return excess profits to shareholders.

So knowing WACC and the IRR of your potential investment opportunities are key to knowing if you should give out a dividend, pay off debt, or re-invest your retained earnings.

Ratio Analysis

Ratio analysis allows us to compare the financial performance of different companies and industries.

Have you ever wondered whether Grocery Stores are a better performing industry than Pharmacies? Ratio Analysis has you covered. Have you ever wondered if Pepsi or Coke has a better performing stock? Ratio analysis to the rescue.

Ratio analysis is how most professional investors determine which stocks they are going to invest into and which they are going to avoid. While these videos of ratio analysis are going to cover the essentials, it won’t cover everything.

Don’t expect to be a professional investor after just a few videos here. However, you will have a good idea of what to look at when comparing companies, which can eventually lead you to better understand investments.

You’ll know more than 80% of people who are making stock picks though, but those people are idiots, which is why most people treat the stock market like a more sophisticated version of Vegas.

I digress.

We need ratio analysis to compare similar and different companies and industries. That’s the bottom line.

What you use this comparison for, is up to you.

There are five main “buckets” of ratios we’re going to be using: Activity ratios, liquidity ratios, solvency ratios, profitability ratios, and valuation ratios. Each bucket has a few different ratios inside of it and some ratios fall under multiple buckets.

I personally also believe there are two key ratios which I think go above and beyond these ratios: ROE Dupont Analysis and CROIC minus WACC

All of these ratios and equations use the financial statements in one way or another. So the first step to any kind of ratio analysis is to get our financial statements into a common-style and format.

As we’ve seen, each company has a slightly different way of expressing their performance on the financial statements. We could spend an entire course on just how to combine different financial statements into a universal style. Luckily, we don’t have to.

There are a lot of websites that have consolidated and created a common-form financial statement for all the publicly traded companies out there. Yahoo Finance, Zacks, Morningstar, Factset, S&P Cap IQ, Bloomberg, and Macrotrends are all examples.

My favorite? Macrotrends. It’s free, easy to understand, and updated frequently.

Now that we know where we are going to get our data, it’s time to start making some ratios and analyzing companies.

Activity Ratios

Activity ratios measure how productive or efficient a company is in using its assets. They are sometimes known as operating efficiency ratios or asset utilization ratios. What you’ll tend to find with activity ratios is an income statement line item divided by a balance sheet line item (or reverse).

The income statement value can be pulled straight from the most recent income statement, but the balance sheet value ahs to be averaged. It has to be the last period’s value plus the current period’s value divided by two. Why? Because the income statement tracks changes over time while the balance sheet gives you a simple snapshot of what a company owns right now.

The most common activity ratios are receivables turnover, inventory turnover, payables turnover, working capital turnover, and total asset turnover.

Receivables Turnover is simply Total Annual Sales/Average Accounts Receivables

Inventory Turnover is Total Annual COGS/ Average Inventory

Payables Turnover is Total Annual COGS/Average Accounts Payables

These three make look familiar because we talked about then in the Cash Conversion Cycle. Remember, the Cash Conversion Cycle is Days Inventory Outstanding + Days Sales Outstanding – Days Payable Outstanding.

Days Inventory Outstanding is simply 365/Inventory Turnover

Days Sales Outstanding is simply 365/Receivables Turnover

Days Payable Outstanding is 365/Payables Turnover

That was a lot of numbers, but hopefully, some of it was a recap of what we talked about before.

All in all, turnover is best when it is high which means the cash conversion cycle is best when it is low.

Last, but certainly not least is Total Asset Turnover. Total Asset Turnover is Total Revenue/Average Total Assets. It’s a key ratio to see about how efficient a company is on using their assets.

Certain industries will have extremely high turnover ratios while other industries will have low turnover ratios. This is all just a difference in business models. Businesses with low assets will have high turnover while businesses with high assets will have low turnover.

Turnover ratios and the cash conversion cycle is best used to compare the efficiency of companies in the same industry or with the same business model. Compared CVS to Kroger will be much more beneficial than comparing Coke to Facebook.

Liquidity Ratios

Liquidity ratios measure a firm’s ability to meet its short-term obligations. This could be mean debts or unfulfilled jobs (unearned revenue).

There are three ratios which all deal with about the same thing: Current Ratio, Quick Ratio, and Cash Ratio. Each ratio looks at different sets of current assets divided by current liabilities.

• Current ratio looks at all Current Assets divided by Current Liabilities
• Quick ratio looks at Cash & Receivables divided by Current Liabilities
• And, as you can guess, Cash Ratio is Cash divided by Current Liabilities

The last liquidity ratio is called the Defensive Interval Ratio. The Defensive Interval Ratio looks at the Cash & Receivables of a company divided by the Average Daily Expenditures. Average Daily Expenditures comes from the income statement and cash flow statement. It is all “cash” expenditures for the year divided by 365.

For example, it would include all operating expenses minus depreciation & amortization. So COGS + R&D + SG&A + Other Expenses – D&A. Then you divide this number by 365.

The goal of the Defensive Interval Ratio is to tell you how many days of normal operations the company has on hand in liquid assets. The more days, the more liquid the company.

Liquidity is a bit of a double-edged sword. Too little liquidity and your company seems risky. Too much liquidity and your company isn’t investing in growth. No one invests in a company just so that company can put that money into cash. A company is best when it is investing in projects and products that create more money than they cost. If a company is just holding cash, they aren’t investing and therefore aren’t growing profits or sales.

Liquidity is just one portion of the riskiness of a company. The other portion is long-term solvency.

Solvency Ratios

Solvency ratios measure a company’s ability to meet long-term obligations. They provide information relating to the relative amount of debt in a company’s capital structure and the adequacy of earnings and cash flow to cover interest expenses and other fixed charges as they fall due. There are two main types of Solvency ratios: debt & coverage.

Debt ratios measure the amount of debt to assets & equity. This is sometimes called leverage.

For example, Total Debt/Total Assets tells you what % of assets was financed with debt. Total Assets/Total Equity is called financial leverage. Leverage is another double-edged sword. Too much leverage and it affects your coverage ratios, which we’ll cover in a second. Not enough leverage, and you aren’t buying or investing as fast as your competitors, so you eventually lose market share. We talked a bit about this when we went over capital structure and whether debt was good or bad.

Coverage ratios help you understand how long you can pay the interest on your debt. The most common is Interest Coverage which is simply EBIT/Interest Expense. A higher ratio indicates you are stronger than a lower ratio.

Overall, your leverage can be high as long as your coverage ratio is ok. Once again, comparing companies from the same industry will help you determine which is more or less solvent. Certain industries will go through phases of super solvency and others phases of bankruptcy, oil and gas is a great example of this. Comparing different industries’ solvency levels may help you better understand the risks each industry is facing.

Profitability Ratios

Profitability ratios measure a company’s ability to generate profits from its assets, either as a return-on-sales or return-on-investment point of view.

We have already covered a lot of the return-on-sales ratios such as gross margin, operating margin, and net margin. In case you forgot, margin ratios are just calculated by dividing the associated profit by total sales. So gross margin would be gross profit divided by total sales.

Return-on-investment ratios include things like Return-on-Assets and Return-on-Equity. What you are doing here is dividing a profit (usually net profit) by an average total account from the balance sheet.

ROA, Return on Assets is just Net Profit divided by Average Total Assets.

ROE, Return on Equity is just Net Profit divided by Average Total Equity.

You can get as complicated or uncomplicated as you want with these kinds of ratios. I’ll dive in a bit more into how to customize these.

Overall, more profitability is always better.

Valuation Ratios

Valuation ratios help you understand how much you are paying, as an investor, for something else. For example, Price To Earnings (P/E) is the Current Price Per Share divided by the Earnings Per Share. This tells you how much you pay by buying a share of this company for $1 of earnings allocated to that share. In layman’s terms, P/E is how much investors are paying for $1 of profit.

You can do the exact same thing for Price per Free Cash Flow or Price per Sales. All you have to remember is to divided total Free Cash Flow or Total Sales by the total number of shares outstanding to determine Cash Flow Per Share or Sales Per Share.

You can do this same process for any kind of income statement or cash flow item. You an even do it with average balance sheet items. For example, you can divided Price Per Share by The Average Total Asset Per Share to determine Price Per Asset, aka how much investors are paying for $1 in assets.

Overall, you want companies that have low valuations. Those are seen as “deals” in the stock market.

Layton’s Two Favorite Analysis Ratios

Here are two main ideas you won’t get anywhere else.

There’s an analysis called Dupont ROE Analysis. ROE is just Return on Sales, the Dupont Analysis portion is how you go about analyzing ROE. You can look at the DuPont analysis on ROE and instantly gain insight in their capital structure, profitability, and efficiency. It’s kind of like popping the hood of a car.

When running the DuPont analysis you look at three unique ratios: Net Profit Margin, Asset Turnover, & Leverage.

• Net Profit Margin is just Net Profit / Total Sales. It is a profitability ratio, which we’ve covered earlier.
• Asset Turnover is just Total Sales / Average Total Assets. It is an efficiency ratio and tells you how efficient in creating sales a company is.
• Leverage is just Average Total Assets / Average Total Equity. It is a solvency ratio as it shows how leveraged a company is, aka how much debt they’ve used to buy assets.

When these three ratios are multiplied together, you get Return-on-Equity. This works because denominators and nominators cross themselves out along this path.

The ultimate Nominator is Net Profit because Total Sales is canceled out and so is Average Total Assets. The ultimate Denominator is Average Total Equity because Total Sales & Total Assets are canceled out.

Now here comes the fun part. For various reasons, such as the manipulation of accounting and the unreliable nature of net profits, a lot of investors tend to view Cash From Operations or Free Cash Flow as a true measure of a company’s profits.

At the same time, total equity isn’t the best way to gauge how well a company is doing with the money they have taken from outsiders. Invested Capital is a concept a lot of investors use to overcome this issue. Invested Capital is Total Equity + Short & Long Term Debt. In theory, this is all the money the company has gained from outsiders.

Using the idea that Free Cash Flow is better then Net Profits and Invested Capital is better than Total Equity, we have a new DuPont Model.

• Free Cash Flow / Total Sales
• Total Sales / Average Total Assets
• Average Total Assets / Invested Capital

Ultimately when multiplied together, these give you Cash Return on Invested Capital (sometimes called CROIC). CROIC tells you how much free cash flow the business generates from a dollar of capital given to it.

CROIC, by itself, is a great way to evaluate the overall company. High CROIC means a good company.

However, we must also take into account how much it costs to gain capital. Do you remember, WACC? Weighted-Average-Cost-of-Capital? WACC told us how much it costs to get their capital (aka the debt and equity). Remember it was made up of the cost of debt (aka interest rates and tax shield) and the cost of equity (remember that CAPM formula?).

If CROIC tells you how much cash flow a company makes per dollar of capital and WACC tells you how much that dollar of capital costs, if CROIC is greater than WACC, the company is investing wisely. If CROIC is less than WACC, the company is investing poorly.

Therefore, the ultimate analysis of a company is CROIC – WACC.

To the extent a company achieves rates of return above WACC they are “creating value”. If they are earning a rate of return below WACC, then they are “destroying value”.

Financial Modeling

A financial model is simply a tool that allows investors and managers of companies to make decisions based on their assumptions. It helps us understand the financial impact of two different courses of actions or strategies.

Most of the time financial models are built-in Excel and are typically based on the company’s historical performance, assumptions about the future, and require preparing an income statement, balance sheet, and cash flow statement (known as a 3-statement model).

From there, more advanced types of models can be built such as discounted cash flow analysis (DCF model), leveraged-buyout (LBO), mergers and acquisitions (M&A), and sensitivity analysis.

All of these models help people make smarter decisions, which is the end goal of all financial models.

The main sections to include in a financial model (from top to bottom) are:

• Assumptions and drivers
• Income statement
• Balance sheet
• Cash flow statement
• Supporting schedules
• Valuation
• Sensitivity analysis
• Charts and graphs.

Financial modeling is an iterative process. You have to chip away at different sections until you’re finally able to tie it all together.

Every financial model starts by uploading the company’s historical results. You should begin building the model by pulling at least three years of financial statements and inputting them into Excel. Just like with ratio analysis, you can use websites like Macro Trends that help you consolidate and standardize historical statements. Your level of granularity and customization of the model is determined by how accurate your results need to be.

If you need extremely accurate results, you will have to create a very custom financial model. If instead, you just want to know if one strategy is better than another, that can be done with a relatively broad and less detailed model.

Either way, you start by looking at the company’s most recent past.

Once you have your historical data inputted, you need to start setting up some assumptions about the future.

Assumptions tend to either be inline with the past or change. For example, you may think the company will grow at around the same pace as it always has, or you may think the company will see significantly faster or slower growth. Either way, most assumptions fall into these two camps: the same as it has always been or different.

The things you need to make assumptions about are things like revenue growth rate, gross margins, variable costs, fixed costs, AR days, inventory days, and AP days, to name a few. 

For example, you may think that gross margins will stay the same, which means if Sales grows then so do the COGS. If instead, you think Gross Margins will get bigger, then Sales will grow faster than COGS.

This kind of decision will have a huge impact on your financial model and shouldn’t be made lightly. Be sure you aren’t just guessing and you are backing your thoughts on data, whether that’s looking at historical growth rates for the company or overall expert forecasts for the industry or company.

Sales, and therefore profits, are typically forecasted based on two main categories: growth-based and driver-based.

A growth-based forecast is simpler and makes sense for stable, mature businesses, where a basic year-over-year growth rate can be used. For simpler models, this will work. Assuming sales will grow at the same rate they have in the past five years or at 10% for the next five years is fine and both are based on growth-rates.

On the other hand, looking at the underlying drivers of sales is much harder, but much more accurate. It requires separating sales into various drivers, such as price, volume, products, customers, market share, and external factors. Regression analysis is often used as part of a driver-based forecast to determine the relationship between underlying drivers and top-line revenue growth. Obviously, this isn’t easy and most people will never have to do this. Just understanding this is a possibility in financial modeling puts you above most.

After Sales, the rest falls in-line. After Sales is properly forecasted, expenses are relatively easy to understand.

Certain expenses, such as COGS, are variable costs. They will grow as sales grow. You will be able to “link” these kinds of variable expenses to sales.

Other expenses, such as R&D and SG&A, are fixed costs. They will not grow as sales grow and instead have to have their own assumptions regarding their future growth or decline.

An easy way to determine if an expense is by looking at historical common-size income statements. A common-size income statement is just all the income statement divided by Total Sales. It will give you a % for everything on the income statement.

A variable costs % relative to total sales will be about the same over the past few years. It may change a bit, but not a lot.

A fixed cost % relative to total sales will change year over year. When sales are high, fixed costs as a % of sales should be low. When Sales are low, the opposite is true.

This way of analyzing costs can help you determine which costs should be tied to sales and which costs shouldn’t.

Once costs are built out, you can calculate the various profits pretty easily. The only problem is, Depreciation & Amortization.

Once most of the income statement is in place, then it’s time to forecast the balance sheet, including capital assets. Begin by calculating accounts receivable and inventory, which are both functions of revenue and COGS, as well as the AR days and inventory days, which you can find by looking at historical ratios and making your own assumptions. Next, fill in accounts payable, which is a function of COGS and AP days.

PP&E is often the largest balance sheet item, and capital expenditures (CapEx), as well as depreciation, need to be modeled in a separate area. You have to create a model for capital assets like Property, Plant & Equipment (PP&E), as well as for debt and interest. The PP&E schedule will pull from the historical period and add capital expenditures and subtract depreciation.

The most detailed approach is to have a separate model for each of the major capital assets, and then consolidate them into a total schedule. That’s a lot of work because each capital asset schedule will have several lines: opening balance, CapEx (aka increases), depreciation (aka decreases), and closing balance.

Most models won’t need such a detailed model. Instead, you can estimate CAPEX and depreciation and amortization as a set rate of total capital assets. Just divide depreciation and amortization by total PP&E to estimate about what the depreciation rate is for this company.

The debt schedule will also pull from the historical period and add increases in debt and subtract repayments. Interest will be based on the average debt balance and the historical interest rate (unless you think that’s going to change).

On the income statement, link depreciation to the PP&E schedule and interest to the debt schedule. From there, you can calculate earnings before tax, taxes, and net income. On the balance sheet, link the closing PP&E balance and closing debt balance from the schedules. Shareholder’s equity can be completed by pulling forward last year’s closing balance, adding net income and capital raised, and subtracting dividends or shares repurchased.

With the income statement and balance sheet complete, you can build the cash flow statement with the reconciliation method. Start with net income, add back depreciation, and adjust for changes in non-cash working capital, which results in cash from operations. Cash used in investing is a function of capital expenditures in the PP&E schedule, and cash from financing is a function of the assumptions that were laid out about raising debt and equity.

When the 3 statement model is completed, it’s time to calculate free cash flow and perform the business valuation. The free cash flow of the business is discounted back to today at the firm’s cost of capital (its opportunity cost or required rate of return). Free Cash Flow is simply Cash From Operations – Capital Expenditures.

Free Cash Flow shows you how much money a company has after operating and maintaining the business of the company.

The Three Statement Model is complete

With an operating income statement, balance sheet, and cash flow statement, you three statement model is complete. All you have to do is make sure your balance sheet balances as you create your forecasts.

This probably won’t happen right off the bat. Some assumptions will clash with other assumptions and it require a bit of cleaning. No worries! That’s what we have best practices for.

It’s important to clearly distinguish between inputs (assumptions) in a financial model, and output (calculations). This is typically achieved through formatting conventions, such as making inputs blue and formulas black. You can also use other conventions like shading cells or using borders.

It’s critical to structure a financial model in a logical and easy to follow design. This typically means building the whole model on one worksheet and using grouping to create different sections. This way it’s easy to expand or contract the model and move around it easily.

Discount Cash Flow Model 101

With a three-statement model now completed, and hopefully working as you forecast into the future, you are now ready to create a discount cash flow model.

A discount cash flow model is just a fancy way of saying net present value. All you are doing is taking the free cash flow from your forecasted years and discounting them back to today for a final value of the company based on your forecasts.

Most DCF models have five or so years forecasted out and then they have a “terminal value” for any time period after that. The terminal value is a very important part of a DCF model. It often makes up more than 50% of the net present value of the business.

There are two ways to calculate the terminal value:

1. The perpetual growth rate approach
2. The exit multiple approach

The perpetual growth rate approach assumes that the cash flow generated at the end of the forecast period grows at a constant rate forever. So, for example, the cash flow of the business is $10 million and grows at 2% forever, with a cost of capital of 15%. The terminal value is $10 million / (15% – 2%) = $77 million. This is super simple and easy to understand and forecast.

With the exit multiple approach, the business is assumed to be sold for what a “reasonable buyer” would pay for it. This typically means an EV/EBITDA or P/E multiple at or near current trading values for comparable companies. For example, if the business has $6.3 million of EBITDA and similar companies are trading at 8x then the terminal value is $6.3 million x 8 = $50 million.

Either way, your terminal value is then discounted back to the present to get the NPV of the terminal value. XNPV and XIRR are easy ways to be very specific with the timing of cash flows when building a DCF model. Best practice is to always use these over the regular Excel NPV formula and IRR Excel functions.

Your forecasted free cash flow for each of the future years will need to be discounted back to today. Remember, we use WACC as the discount rate for these future cash flows.

We use Free Cash Flow is used because it represents economic value, while accounting metrics like net income do not. A company may have positive net income but negative cash flow, which would undermine the economics of the business. Cash is what investors really value at the end of the day, not accounting profit.

If you’re looking for the equity value of the business, you take the net present value (NPV) of the unlevered free cash flow and adjust it for cash and equivalents, debt, and any minority interest. This will give you the equity value, which you can divide by the number of shares and arrive at the share price.

Sensitivity Analysis

Let’s say some of your assumptions were more guesses than really expert forecasts. That’s ok. Sensitivity analysis allows us to understand what assumptions have the largest impact on our final valuation.

This is useful for assessing the risk of an investment or for business planning purposes (e.g., does the company need to raise money if sales volume drops by x percent?).

You can evaluate the sensitivity of assumptions by using Data Tables and the CHOOSE function in excel.

At the end of a day, each financial model will be unique, but they all operate on these same core ideas: building a three-statement model, forecasting into the future, discounting the values back, and testing your assumptions through sensitivity analysis.

If you made it all the way here, congrats!

I hope you appreciated my short-hand version of MBA-level finance. Hopefully, you learned something here and there. Our actual video course will go into more depth with more examples and repetition!

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