Best practices in financial modeling

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Best Practices in Financial Modeling
Webinar 1

© Pristine For Webinar-Best Practices in Financial Modeling (Confidential) 1
Agenda
 Modeling depleting items
 Consistency in the format
 Modeling the Taxes
 Modeling of Debt and Cash Balances

Key concepts
I. Scalability
II. Robustness
III. Modeling cash balance and debt
IV. Modeling Taxes
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Introduction
 Financial modeling is the building of a mathematical model that helps in financial decision-
making situations
 It is a skill widely used in the financial services
 Building a financial model is a challenging task and often simple mistakes can lead to major losses
for both the firm and their client
 In this series we take you through some of the common mistakes that are committed by analysts
when preparing financial models and the best practices to make a robust and scalable financial
model
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1. Modeling depleting items
 Depleting items (at constant rate) should be modeled with caution
 Use “min” function to cap the depletion
 For example depreciation, debt repayment should be modeled with usage of MIN function so that
the value in a year is the depletion rate or the balance amount whichever is lower
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1.1 Common mistake
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No Capex, asset is depreciated by
straight line method @
30%, depreciation formula and
linkage is correct but it has not
been capped
 On dragging to the next
column, the formula for
depreciation remains correct but
the Net Block turns negative.
 Depreciation in FY17 can’t be
greater than the residual value in
the previous year

1.2 Correct modeling technique
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Depreciation should be capped
using MIN function. It should be
the minimum of the residual value
from previous year and normal
depreciation
On dragging to the next
column, the depreciation is
now restricted to the
residual value at the end of
the previous year. Net
Block is zero now

2. Consistency in the format
 It is important to maintain the consistency in the format of modeling across all the items
• Separate headings, sub headings etc. by different font size and row colors. Maintain consistency of
formatting scheme across the model
• Report a particular year in the same column across sheets. For example, if FY17 has been reported in
Column G on P&L sheet, it should be reported in the same column across all the sheets
(assumption, balance sheet, build up, cash flow, valuation etc)
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2.1.1 Common mistakes
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P&L has been rolled out
laterally i.e. years changing
column wise debt
amortization schedule is
rolled out vertically where
years are changing across
rows

2.1.2 Common mistakes
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Since the format is
transposed, dragging the
interest expense laterally
forces Excel to pick up the
incorrect value placed
laterally adjacent to the
cell D16, while we actually
wanted the value D17

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Had the format
been kept
consistent, draggi
ng to the next
column would
have picked up
the value from the
correct cell

3. Calculating taxes
 A model is robust if it does not break down when assumptions are changed from one end of the
spectrum to another
• A frequently noticed error in this category is incorrect / inconsistent tax computation if assumptions
are changed such that PBT changes sign from positive to negative
• Another frequently noticed error is that balance sheet starts showing negative cash if capital
expenditure in a year is doubled or tripled.
 Ensure all the possible scenarios are modeled. For example, if tax is modeled simply as
• Tax = Tax Rate x PBT
• Or Tax = if (PBT <0, 0, Tax Rate x PBT)
• Your model will break down in case PBT is negative for a few years in succession. It will not return the
benefit of accumulated losses.
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3.1 Common Mistake
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Look at the formula.
The formula for taxes
and the linkage to the
cell is correct.
However the formula
does not take into
account the case of a
negative EBT
In this case our
formula handles the
condition when PBT is
negative but however
does not give us the
benefit of carrying
forward our losses

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No tax due to negative
PBT
Benefit of
accumulated
losses, only earnings in
excess of accumulated
losses (= USD 2 Mn) is
taxed
Tax = IF (PBT<0, 0, IF
(Cum PBT<0, 0, Tax rate
x MIN(PBT, Cum PBT)

4. Modeling of Debt and Cash Balances
 Another common error in modeling is not to link debt balances with cash balance
 Any drastic change in assumption may make the cash flow during the year highly negative wiping
out previous balances, the closing cash balance on the balance sheet will turn negative
 Provision for shortfall should always be incorporated in model
 Model should automatically draw more debt to make up for the shortfall and bring the cash
balance back to threshold level
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4.1.1 Common mistake
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No provision for
shortfall in cash, no
protection against cash
balance going negative
Suppose Capex in FY15 is now increased to $10 million.

4.1.2 Common Mistake
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As soon as Capex in
changed, cash balance
on the balance sheet
turns negative and our
model breaks down

4.2.1 Correct modeling technique
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Instead, model the
provision for shortfall so
that the model draws
down additional debt if
shortfall in cash is
expected

4.2.2 Correct modeling technique
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Now see the impact of
changing capex, model
automatically draws
additional debt to restore
cash balance to threshold
level – induces robustness
in model

Summary
Today we’ve learnt some common mistakes that can and should be avoided when modeling in Excel
 Model must be made scalable by protecting the formula with dollar referencing
 “MIN” function should be used to cap the depletion when depleting items like depreciation are
modeled
 It is important to maintain the consistency in the format of modeling across all the items
 A sound financial model must be able to handle all boundary conditions. For e.g. when calculating
taxes, we should check for a negative PBT and model loss carryforward in case of consecutive
years of negative PBT
 When modeling cash and debt balances, a provision for shortfall in cash should always be
incorporated in model
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Best practices in financial modeling

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