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Financial Planning Models in Excel

Walter Schuster

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Art. No 40024 ISBN 978-91-44-12766-8 First edition 1:1 © The author and Studentlitteratur 2019 studentlitteratur.se Studentlitteratur AB, Lund Cover design: Jens Martin/Signalera Cover illustration: Helga Kor/Shutterstock och Zmicier Kavabata/Shutterstock Printed by Dimograf, Poland 2019

TABLE OF CONTENTS

Preface 7

Reading guide 8 Financial planning in Excel 11

Part I FINANCIAL STATEMENTS-BASED MODELS

1 Problem-oriented models 15 1.1 The challenges of Re:Tailor 15 1.2 The financial modelling concept 17 1.3 Some specific issues 19 Key concepts in this chapter 21 Literature 21 2 The model logic 23 2.1 The starting statements of income and financial position 25 2.2 The budgeted statement of income 32 2.3 The budgeted statement of financial position 33 2.4 The budgeted statement of cash flows 37 2.5 Residual items 41 2.6 Totalling the statement of financial position 45 Key concepts in this chapter 46

Table of contents

3 Estimates 47 3.1 Drivers and estimates 47 3.2 The choice of user-determined input variables 51 Key concepts in this chapter 54 4 Converting the model to the spreadsheet program 55 4.1 The worksheet 55 4.2 General relationships 57 4.3 Conditional relationships 58 4.4 Organisation of worksheets 60 4.5 A stepwise approach to model-building 66 4.6 Error detection and correction 66 Key concepts in this chapter 70

Part II FURTHER DEVELOPMENT

5 A sales module 73 5.1 Forecasts starting in the firm 73 5.2 Forecasts based on the development of the total market 76 Key concepts in this chapter 78 6 An expense module 79 6.1 Classification of expenses 79 6.2 The link between sales relationships and expenses relationships 82 6.3 Variable and fixed costs 84 Key concepts in this chapter 86 Literature 86 7 An investment module 87 7.1

Treatment of investment, depreciation and asset values 87

Table of contents

7.2 A different tax base 94 Key concepts in this chapter 98 8 A research and development module 99 8.1 Treatment of R&D costs, capitalisation and amortisation 99 Key concepts in this chapter 104 9 A loan module 105 9.1 The link between loans, repayments and interest expense 105 9.2 Calculating interest expense 112 Key concepts in this chapter 114 10 An equity module 115 10.1 New issues of shares 115 10.2 Dividends 117 10.3 New issues and dividends as residuals 119 Key concepts in this chapter 120 11 A tax module 121 11.1 Tax loss carryforwards 121 11.2 Tax credits 127 Key concepts in this chapter 128 12 A financial ratios module 129 12.1 A systematic analysis based on financial ratios 129 12.2 Another check of consistent definitions 133 12.3 Industry- and firm-specific financial ratios 137 Key concepts in this chapter 138 Literature 138

Table of contents

13 A valuation module 139 13.1 The valuation model 139 13.2 Converting the valuation model to the spreadsheet program 141 13.3 Further sensitivity analysis 144 13.4 A scenario for Re:Tailor 148 Key concepts in this chapter 150

Part III USING THE MODEL

14 Using models 153 14.1 14.2 14.3 14.4

Evaluating strategies 153 Interpreting the model output 154 Differences when the user is not the model-builder 155 Differences when the model is built and used by an outside party 157 Key concepts in this chapter 158 Literature 158 Index 159

PREFACE

I wrote my first textbook on computer-supported financial planning models in the early 1990s. I was right in the middle of very quick developments at the Stockholm School of Economics (SSE). Almost thirty years later, it is clear to me that introducing these kinds of models in teaching has had a substantial and lasting impact. There are two related, yet distinct areas where computer-supported financial planning models are useful. The primary area is as a tool for strategy development and evaluation. The secondary is as a tool for learning accounting. From different points of departure, these two areas converge. In relation to the primary purpose, there has been a shift from detailed plans to gaining a deeper understanding of how different factors interact in terms of shaping the financial outcome of a firm. There is a shift in emphasis from product to process. In relation to the secondary purpose, there has been a shift from a learning tool in accounting to a learning tool in general management. When we launched the Advanced Management Program (AMP) at SSE, aimed at top executives in listed firms, the participants spent two whole course days building computer-supported financial planning models and evaluating their own business strategies. From a strategic perspective, the main advantage of a computer-supported financial planning model based on financial statements is the discipline imposed by the accounting system. Success implies growth, which, in turn, presents operating and financial restrictions. From the perspective of learning, what is particularly fruitful is the instant feed-back provided by the accounting system. Going from an imbalance to a balance is a very rewarding feeling. The trigger for me to write this textbook so many years after I wrote the first one was the internationalisation of SSE. We have seen that computerÂŠ â&#x20AC;&#x2030;T h e au th o r and S t u d e ntlitt e rat u r

Preface

supported financial planning models still represent a very useful tool for learning, not least for students of accounting and finance from other parts of the world. Naturally, there are differences in relation to model-building, depending on whether the emphasis is on strategy development and evaluation or on learning accounting, and the models tend to be more detailed in the latter case. In this book, a stepwise approach to model-building is proposed. One fundamental learning point is that a simple but complete model often does the job. The benefits frequently appear already at the early stages. When the emphasis is on learning accounting, developing the model further is more frequently justified. A particular point emphasized in the first book all those years ago was the need to put financial planning first, not the computer, which is nothing but a tool. This was asserted by the argument that the financial planning model should be computer-supported, not computer-controlled. The fascination with the new tool tended to divert attention away from financial planning. Since then, the increase in technological maturity has resulted in this becoming much less of a concern. A great number of people have given valuable comments on manuscripts to my previous Swedish textbooks. An even greater number have contributed to the development of my teaching in this area, both at the undergraduate level and in executive education programs at SSE, and as teachers as well as students/participants, thus indirectly contributing to this textbook. I am deeply grateful to all of you. For this edition, I would like to thank Niclas Hellman, Florian Eugster, Kai Krauss and Johan Graaf for their comments. Of course, as usual, the remaining mistakes are my own.

Reading guide This book is based on over two decades of experiences from teaching in the area of financial planning models. The approach is well-tried â&#x20AC;&#x201C; over the years, a picture of the problems typically appearing and how they are best solved has gradually emerged. A number of main problems could be identified. Furthermore, these main problems could, somewhat arbitrarily, be ranked by relative importance. The aim is to begin with the most important issue, then precede to the second most important and so on. 8

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Preface

The book consists of three parts. Part I begins with perhaps the most important issue of all: when to build a financial planning model. It moves on to financial planning issues that, in principle, would be the same if the financial planning process was carried out using pen, paper and a pocket calculator, and it concludes with how such a financial planning model is best converted into a spreadsheet program. Part II concerns the further development of a number of issues related to the areas of operations, finance and tax. This part may be read in two different ways, either reading the chapters in the order in which they are presented or moving directly to the chapter of primary interest (i.e., using the book as a cookery book). Part III concerns using the model. Financial planning requires two kinds of skills: model skill and forecast skill. Model skill is the ability to identify the relevant factors and the relevant relationships between these, to then formalise these in a model. Forecast skill is the ability to see trends and anticipate changes. This book primarily concerns model skill, as this type of skill is possible to learn in this way. Forecast skill, on the other hand, takes experience to acquire. Although there is a good reason for this, there is a risk that forecast problems are underestimated. Each chapter ends with a list of key concepts. In some cases, further reading in the area is also presented at the end of the chapter.

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FINANCIAL PLANNING IN EXCEL

Part I of this book concerns the costs and benefits of building a financial planning model in a spreadsheet program. To illustrate this, we will discuss the operating and financial challenges of an individual firm and outline the construction of a basic, but complete, model we may use as a tool when addressing these challenges. Part II of the book concerns the further development of the model in the areas of operations, finance and tax. Related to operations, we will discuss disaggregation of revenues and expenses respectively, as well as more comprehensive treatments of investment in property, plant and equipment and research and development costs. Related to finance, we cover more comprehensive treatments of long-term financing by liabilities and equity. There is also a further development in the model related to tax. Part II ends with two chapters focusing on support modules for calculating financial ratios and valuation. Part III deals with how to use the model. A basic notion is that the model is used for calculating the financial consequences of a firm’s strategy and make an assessment of whether the financial consequences imply a creation of value; if not, the strategy presumably needs to be revised. Besides general issues related to using the model, we also discuss the specific cases when the user is not the model-builder and when a firm’s model is built and used by an outside party.

PA R T I

FINANCIAL STATEMENTSBASED MODELS

In Part I of this book, we will discuss some fundamental aspects in relation to constructing a financial planning model in a spreadsheet program. First, we will discuss the operating and financial challenges of an individual firm and the desired characteristics of a model aiming to address these challenges (Chapter 1). We will then deal with the construction of a basic but complete model to use as a tool (Chapter 2). In connection to this, we elaborate upon the relationships in the model comprising estimates (ChapterÂ 3). This model could basically be constructed and used with a pen and paper. However, there are substantial advantages in constructing and using it in a spreadsheet program. We will discuss what a spreadsheet program is and the best way of converting the model to the spreadsheet program, thereby becoming a computersupported financial planning model (Chapter 4).

CHAPTER 1

Problem-oriented models

A financial planning model in Excel might be a useful tool when a firm’s management makes strategic and financial decisions. In this chapter, we look at when and how such a model could be used. We start by outlining the strategic and financial position of the firm Re:Tailor, which we are going to use as an illustration (see section 1.1). We will then take a closer look at what a financial planning model in a spreadsheet program actually is (see section 1.2). After that, we identify some reasons why Re:Tailor would benefit from constructing such a model and list some issues related to model-building that need to be addressed (see section 1.3). 1.1

The challenges of Re:Tailor

Re:Tailor is a European business-to-consumer (B2C) e-commerce firm selling clothes online. Although still a young firm, it has made an impact on the market and sales have grown rapidly in the last five years. However, profitability has been poor and the financial position is strained. The firm has suffered losses and it has required capital contributions from its owner in order to survive. The firm’s strengths include its effective marketing and a high level of customer awareness with regard to its brands. There are clearly opportunities to exploit. B2C e-commerce in general is steadily growing, and for the clothes segment, which so far has made a relatively low share of its sales online, there is a potential for continued rapid growth. Furthermore, the clothes segment traditionally enjoys relatively high margins. Re:Tailor is still quite small, however, and the business sector in which it operates is characterised by large economies of scale. © T h e au th o r and S t u d e ntlitt e rat u r

PART I FINANCIAL STATEMENTS-BASED MODELS

Furthermore, even if Re:Tailor were to succeed in implementing its operating strategy, financing will be a challenge. The firm faces large investments – in relation to marketing, its web platform and equipment for fulfilling orders. These large investments, together with an increase in working capital driven by the high expected sales growth, will almost certainly exceed the generation of operating cash flow before the change in working capital. The firm is currently owned by a venture capital firm. One exit strategy for the owner is to sell the shares at an initial public offering in the stock market. To succeed with this, the investors need to be convinced that there will be a certain level of stability in Re:Tailor’s future performance. The future development of B2C e-commerce in the clothes market is quite difficult to predict. Re:Tailor purchases market data from international marketing firms, which sell information derived from both primary and secondary research. These purchased market data provide information on markets in relation to both product segments and regions. An important dimension is the proportion of total customer purchases made online. Although the clothes segment has experienced a relatively low share of sales online, the segment leads products purchased online in Europe and is purchased by more than half of online shoppers. A rising disposable income level, an increasing middle-class population and increasing internet and smartphone penetration represent factors likely to have a positive effect on future market demand. Increasing customer acceptance of technology allows the e-commerce sector to be more efficient and reachable. There has been a price pressure on clothes. A strong growth in volume contributes to these depressed prices. Consumers have become more pricesensitive and many compare prices online before making a purchase. The fact that online sales growth surpasses growth rates for total retail sales has forced traditional retailers to look towards e-commerce for future growth. Among the major European online sellers of clothes, we find store-based clothing retailers as well as firms only selling their products online. Traditional retailers are also increasing their online offerings, encouraging behaviours such as seeing a product in-store before making an online purchase or researching online before making a purchase in-store. Competition is further reinforced by customers increasingly trusting 16

1 Problem-oriented models

websites in other countries, often with nationally tailored content and local logistics centres. The market is very volatile and participants experience a fierce competition. The industry is going through a consolidation phase with many mergers and acquisitions. The chief financial officer (CFO) of Re:Tailor, Evelyn, considers what to do. On the one hand, Evelyn has seen a large number of strategic analyses. These are usually based on customer demand and the firm’s ability to fulfil this demand, which is obviously a fundamental aspect. However, a weakness of some strategic analyses is that the financial consequences of a strategy are not clearly spelled out. On the other hand, the CFO has also seen a lot of financial analyses presenting the financial consequences of different scenarios. These analyses frequently contain multiple scenarios, but it is not always clear which strategy each of these represents. An ideal solution, in the mind of the CFO, would be to combine the strategic and financial analyses. 1.2

The financial modelling concept

The view of a financial planning model in a spreadsheet program we adopt could be explained further by looking at the different components of the concept in more detail. The first component – financial planning – is seen quite broadly. Consistent with the view presented in Johansson & Runsten (2014), a firm is viewed as a “financial system with an emphasis upon the relationship between, on the one hand, the generation and acquisition of financial resources and, on the other hand, the capital needs required of the ongoing production, product and market development, investment etc.” In other words, financing is not an activity independent of the firm’s operations, but it is closely linked to these operations. Financial planning is concerned with the interplay between operating and financial activities and aims to evaluate the expected consequences from different alternative actions. Furthermore, financial planning is carried out in terms of the primary financial statements (i.e., using accounting measures). Plans for purchasing, manufacturing, sales, human resources, investments, financing, etc. are evaluated in relation to their expected impact on the firm’s statements of income, cash flow and financial position. The second component – model – emphasises that the model is made up © T h e au th o r and S t u d e ntlitt e rat u r

PART I FINANCIAL STATEMENTS-BASED MODELS

of a selection of factors and the relationships between these. It is simplified by design and could thus make it easier to see the big picture. The selection of variables is critical. There are two different kinds of potential errors. The first is to leave out important variables, which means that the value of the output will be diminished. The other error is to include variables that are not particularly important, which means that there is a risk that signals from important variables will pass by unnoticed due to the noise from less important variables. Model-builders are in general less aware of the second problem and tend to include too much in the model. Just because it is simple does not mean that there is anything wrong with a model. The third and final component – Excel (or another spreadsheet program) – is subordinate to the other components. The primary focus is on the financial planning model and the spreadsheet only serves as a means for implementing the model. It is certainly possible to use a pen, paper and a pocket calculator to construct a financial planning model of the kind we will look at in the next chapter. The use of a spreadsheet should not lead the process of building a model. In the case of Re:Tailor, it would be possible to use a financial planning model for evaluating different strategies and scenarios without the support of a computer-based spreadsheet program. However, the support from a spreadsheet program will provide substantial advantages. It facilitates building a more comprehensive model of the firm in terms of the primary financial statements with a clear structure with regard to input and output data and a general formulation of relationships between variables, allowing for systematic sensitivity analyses. Computers and software for supporting financial planning models have existed for decades, while the ways in which this support is applied have changed over the years. A crucial factor was the breakthrough of easily accessible spreadsheet programs. Illustration 1.1 presents some important developments in model-building. The time required for building a financial planning model has become much shorter and the cost is substantially lower. This has played a role in terms of when a model is built, what kind of model is built and who builds the model. Models are more frequently tailor-made and used for analysing a specific problem. The ones who are closest to the problem and will make the business decisions build the model. The general development towards more situation-specific models is also 18

1 Problem-oriented models

Relatively long

Required time/cost to build?

When is a model built?

In predetermined cycles

What kind of model is built?

Standard applications

Relatively short When there is a problem Model is adapted to specific purpose

Who build the model?

Planners

Decision-makers

Purpose of the model?

Detailed forecasts

Gaining insights regarding important relationships

Illustration 1.1 Important developments in model-building.

explained by an increased awareness regarding the difficulty of making a detailed forecast of the future. Frequently, one of the greatest advantages of building and using a model is that the decision-maker gets a deeper insight into the relationship between a certain strategy and its financial consequences. The usefulness of financial planning in an environment characterised by fast changes is sometimes questioned, and it is even argued that working with a model might be harmful, since it could lead firms to hold on to obsolete plans when conditions change. However, the greater and faster the expected changes, the greater the benefits of a financial planning model, especially when the purpose of the model is to gain more insight into the factors determining the firm’s future performance and position rather than presenting a detailed forecast. 1.3

Some specific issues

Let us return to Re:Tailor. The firm faces both strategic and financial challenges. The future expansion and its financing have to be carefully analysed. The insight into different interacting factors that together shape © T h e au th o r and S t u d e ntlitt e rat u r

PART I FINANCIAL STATEMENTS-BASED MODELS

the outcome of the business would be furthered by a financial planning model in Excel. Re:Tailor expects to evaluate several alternatives and the time spent on building such a model would be justified. However, before starting building the model, there are additional issues to address. These are common in most model-building situations and fall into different areas. There will be issues related to: • • • • • •

selection and presentation of financial statements selection of model variables estimates and user input reliability of output process of constructing the model conversion of model to spreadsheet

Examples of issues related to the selection and presentation of financial statements include whether just the annual capital requirements should be calculated or whether a complete statement of financial position should be derived, how deficits and surpluses should be treated and whether the presentation should include a statement of cash flow. Examples of issues related to the selection of model variables include whether the statements presented should be as similar as possible to actual financial statements or designed more freely as well as which items should be left out or combined. An issue related to estimates and user input concerns whether there should be many or few user input variables. An issue related to the reliability of the model concerns specifying the model logic in order to make the output as reliable as possible. An issue related to the process of building the model concerns whether the different parts of the model should be developed separately and then integrated or whether the point of departure should be the model as a whole, which is then broken down into different parts. Examples of issues related to converting the model to a spreadsheet in order to extract the full potential of the program include what the outline of the model in the worksheet should look like, how the individual relationships should be expressed in order to make the model more general and whether the first forecast year should be completed before continuing with the rest 20

1 Problem-oriented models

of the forecast period or whether the whole interval should be covered from the outset. We will address these issues in the following three chapters making up the remainder of Part I.

Key concepts in this chapter • • • •

Problem-oriented model Financial statements-based model Financial planning Spreadsheet program

Literature Johansson, Sven-Erik& Runsten, Mikael: The profitability, financing and growth of the firm. Goals, relationships and measurement methods. Studentlitteratur. 2014.

Walter Schuster is a professor of accounting and managerial finance at the Stockholm School of Economics (SSE). He has taught in the areas of financial planning and computer-supported planning models for many years, both in undergraduate programs at SSE and in executive education programs.

Financial Planning Models IN EXCEL This book presents the construction of a basic but complete financial planning model that may be used as a tool when addressing the strategic and financial challenges of a firm. Financial Planning Models in Excel introduces a model that, in addition to having budgeted statements of income and financial position as output, presents a budgeted cash flow statement. The advantage is that the cash flow consequences of different scenarios are presented in more detail and structured by operating, investing and financing cash flows. Most importantly, this approach provides a check of the model relationships, thus ensuring the reliability of the model. The book presents solutions to the most common problems in relation to model-building and there are specific chapters on developing support modules for revenues, expenses, investments, research and development, liabilities, equity and tax. Focusing on the interpretation of the models, there are also chapters on support modules for calculating financial ratios and company valuation. Although Excel is not the primary focus of the book, there are guidelines on how to construct the model in order to maximise the computer support and instructions for specific issues such as the use of logical tests. Financial Planning Models in Excel is intended for university students in accounting and finance. These types of models constitute useful tools for strategy development and evaluation, as well as for learning accounting. Art.nr 40024

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