Financial Statement Modeling
& Spreadsheet Engineering
“Training in spreadsheet modeling improves
both the efficiency and effectiveness with which
analysts use spreadsheets”
Steve Powell, Dartmouth College
Understand the Decision
What is the problem?
 What questions must be answered?
 What is the time horizon of the problem?
 What kind of output information is
needed?
 Who will use the information?
 What level of detail is necessary?

Structural Inputs of the Model

Define the equations and relationships that
make up the model

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What are the decision variables and what are the
linkages between the decisions and the goal of the
model?
What are the constraints?
 Definitions based on accounting rules
 Economic, industry, resource and technological
limits
What happens at the end of the planning horizon?
Data Inputs

Internal data that describes the current
state of the system
Firm’s financial statements
 Resources and capacities


External data that describes the firm’s
operating environment

Economic conditions such as interest rate,
costs, stock prices
Financial Analysis

Assess the strengths and weaknesses of
the firm’s current condition
Ratio analysis
 Break-even analysis
 Operating and financial leverage analysis


Generate pro forma financial statements
to identify strategies to improve the
condition and assess future risks
Growth and the Need for
Financing

Growth frequently associated with cash



The problem


Faster growth  more profits  more cash
This is incorrect!
Growth and profits do not equal cash flow
Growth is not an end in itself


Needs to be managed
Firms often fail because they do not plan for
growth
6
Cash Flow is Needed to Support
Sales

Cash is the life blood of organizations



Funds receivables and inventory
Buys productive assets
Pays investors fair returns
BUT
 Cash needed to support growing sales can exceed
cash flow

Firms fail when
Needs of expansion
Overwhelm
Resources for expansion
7
Flow of a Sales-Driven Model
8
Modeling Sales Forecasts
•
Simple Method: Assume average or different
growth rate for each period
•
Develop detail forecast by product, business
unit, customer or geographic market and
aggregate forecasts
•
Forecast the unit price and volume
•
Forecast size of market and estimate market
share
•
Forecast costs and apply a margin assumption
to derive sales
Financial Planning Model
Assumptions
•
Items that are functional relationships of sales
–
Percent of sales
•
•
•
Items that are functional relationships of other
financial statement items
–
•
Operating expenses
Working capital and fixed assets
Interest, depreciation, dividends, marketable
securities, cash flows
Items that involve policy decisions (e.g. longterm debt, equity, capital expenditures)
Generating the Income Statement

Expenses in period t

Related to asset and liability balances at the
end of period t – 1
Interest Expenset based on Debtt-1
 Depreciationt based on Gross Fixed Assetst-1

Or
 Related to Sales in period t

COGSt = COGS/Sales * Salest
11
Balance Sheet Sector

Track financial state of firm through time

Balance sheet equations go a long way towards
ensuring this


Results in one period (t – 1) become inputs to next
period (t)
EXAMPLE


Debtt = Debtt-1 + Debt Issuedt – Debt Repaidt
Feed into income statement

Interest Expenset = Debtt-1 * Interest Rate
12
Investment Module
Calculates Required New Investment

Compile changes in assets

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Add cost of maintaining production

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Left side of balance sheet
Current Assets
 Including Cash Balance
 Not including discretionary items (e.g. marketable
securities)
Long-term assets
 Net Fixed Assets
 Goodwill
Replacement of depreciated assets
Output information to Financing Module
13
Three Sources for Financing New
Investment

Spontaneous


Internal equity


Increase in liabilities that increase naturally
with sales
Current year's retained earnings
External capital markets

New debt or equity
14
Sustainable Growth in the Rapid
Growth Phase

The "it takes money to make money" phase
 Increased sales require more assets of all
types
 Internal sources don’t generate enough cash



Retained earnings
Increase in spontaneous liabilities
Need to raise capital externally

New question: How fast can firm grow without
altering its current capital structure?
15
The “Plug”
The balance-sheet item which will “close”
or balance the balance sheet model so
that Total Assets will always equal Total
Liabilities & Equity
 Models the assumption of how the firm
finances itself
 Examples are cash & marketable
securities, debt, debt & equity
 See Plugs.xlsx

Plan Your Layout
On paper, map out the different sections
of your model and their planned
locations within the workbook
 Consider how

readable the model layout will be for the
user
 easy it will be to modify the assumptions
 easy it will be to extend the model to include
more time periods or new products.

Modules

Data Inputs
Assumptions
 Decision Variables
 Internal Data and Data Structures

Outputs
 Pro-forma statements
 Other structural relationships
 Documentation

Layout Strategies

Modules on different worksheets
 Stair-step format in same worksheet
 For each strategy,



Consider how difficult it will be to insert or delete a
row or column
Consider how much linking needs to be done
between different modules
Consider linking a data input to the computation
area or output for later reference
Range Names

Use range names to create an overview
of a worksheet in the model layout.
Highlight the cell or range you want to
name, select Insert>Name>Define (2003)
or Formulas>Define Name (2007)
 Use View>Zoom where the Zoom factor is
set to less than 40% to see overview


To apply name to all relevant formulas in
spreadsheet, Insert>Name>Apply (2003) or
Formulas>Define Name>Apply Name (2007)
Other Layout Considerations

Gaps between logical areas improve
readability

Isolate blocks of similar formulas for safe
and convenient copying

Use styles, fonts and colors with
consistent meanings
Data Input Guidelines

Isolate constants into their own cells
Do not use constants in formulas unless it is
a number like 1 or 100 being used in
percentage calculations
 Don’t have multiple instances of a number
that is used as a decision variable or
assumption
 Organize decision variables and model
parameter/assumptions logically into separate
physical areas

To Reduce Formula Errors

Use relative and absolute cell addressing
where appropriate (Use [F4] to modify $ in
formulas!)
 Set up common structures in different parts of the
model (e.g. same row labels for different
worksheets)
 Use formulae for a cell which are consistent in their
relationship to adjacent cells

Minimize linking formulas across worksheets
 Split complex formulas into multiple
intermediary formulas
Circular References
•
•
•
•
Created when expenses in period t refer to assets
and liabilities in period t, resulting in modified
values for the plug which then impact the income
statement and the Addition to Retained Earnings
Iterative process is required to produce a
consistent and correct final set of financial
statements
To solve, use Tool Options Calculation Iteration
(2003) or MS Office Button>Excel Options>
Formulas> Iteration (2007)
Not all circularities are convergent. Make sure to
verify accuracy!
Verify Formula Reliability

Use Excel’s Auditing Toolbar
Tools>Auditing> (2003)
 Formulas>Formula Auditing (2007)

Use [Ctrl]+` to toggle between formulas
and calculations
 Use Conditional Formatting to flag
suspicious results

Format>Conditional Formatting (2003)
 Home>Conditional Formatting (2007)

Calculating a Plug with the Investment
and Financing Modules

Investment module


Required New Investment
Financing module



Required External Financing
Spontaneous Financing
Internal Equity Financing
Required External Financing  Required New Investment
 Spontaneous Financing
 Internal Equity Financing
• See Logic for Debt as Secondary Plug Excel file
26
Testing the Model

Questions:

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Extreme growth


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Does it balance under extreme conditions?
Does it make sense?
Set growth rate to -50% and 50%
Does it still balance?
Do debt or equity go negative?
What happens to excess cash flow?
High Interest

What happens when Net Income is negative?
27
Document the Spreadsheet

Use range names to make individual formulas
more readable and module layouts clearer
 Use comments to document assumptions and
modifications in a formula’s logic as well as
sources of data
 Use textboxes to describe portions of the
model’s logic and assumptions as well as
instructions for use
 Create a worksheet to describe the purpose of
the model and document changes