When it comes to financial modelling, first impressions count

23 June 2021

When a financial model is provided for the first time it conveys a myriad of information. However, not all of it is necessarily positive.

A well-prepared financial model helps to build trust in the project, the business and the team behind them. A poor financial model creates doubt, increases perceived risks, and can lead to significant issues and inaccurate decision making such as:

  • Mis-priced transaction negotiations.
  • Budgeting and capital allocation errors.
  • Finance that is more expensive
  • A project to be denied funding.

At its very core, applying the theory of “Inputs - Processes - Outputs” to an excel spreadsheet to prepare the three key financial statements (arguably all integrated to hold the basic accounting equation “Assets = Equity + Liabilities”) is what financials models for corporate financiers are all about. This results in a huge range of applications and, depending on the purpose for which a particular model may be used, its structure, outputs, flexibility, etc. will be customised.

Ideally, developed models should be customised to reflect each business, industry and transaction rather than trying to fit the unique business and transaction into a standard template. Although some standardisation warrants efficiency, each model should represent a unique story, adhere to best practice modelling procedures and should be planned and coded as a tool to show the unique identity of each business.

For example, a project finance model will usually have, among others:

  • Monthly and quarterly resolution (as opposed to yearly).
  • Extensive details on financing such as coding a logic for exhausting equity before debt.
  • Flexibility for project start dates flowing all the way through other time flags for construction.
  • Use of funds.
  • Commencement of operations.

Project finance models help financiers work through various scenarios and assess whether enough cash flows will be available to repay the debt and meet their investment requirements. This feeds into the covenants in financing agreements and reflects in the interest rates. Projects with risky cash flows or tight cash flows will usually have higher interest rates and requirements for things like collaterals and re-routing of cash flows.

A financial model developed to give an indicative value of a potential target company based on just its financial statements for the past three years and no other information, will usually have high level growth estimates for earnings and cash flows to project the financial statements and cash flows.

Compared to a project finance model, financial models developed on limited information to assess an indicative preliminary valuation will be significantly less robust, have less visibility on the relationship between operations, value drivers, cash flows and ultimately the valuation. This is purely because at this stage, detailed information to create such a sophisticated model and resulting cash flows is not available. Once a non-binding indicative offer or Heads of Agreement has been signed, such a financial model is generally replaced with a more detailed and robust financial model post.

A detailed model should be dynamic and able to:

  • Present viable scenarios.
  • Handle sensitivity analysis.
  • Flex on the value drivers.
  • Adjust for any findings in the Due Diligence process.
  • Reflect strategic options available to the acquirer resulting in a range of valuations.

Ideally, the financial model should also have a clear dashboard to present the model outcomes in a transparent and user-friendly manner. Such a model should not only be able help the acquirer in finalising the offer price but may also reflect their post-acquisition strategy and the impact on shareholders’ wealth as a result of the acquisition and implementation of the post-acquisition strategy. This should also feed into budgets, capital allocation processes and the budgetary monitoring process to investigate any negative variances against the plan when the decision to acquire was made.

Understanding the purpose of the model is key to its structure, detail, and the focus of outputs required to be analysed. Proficient Excel skills are a pre-requisite for financial modelling and with more advanced Excel skills, financial models should become simpler, flexible, and more robust. However, a good financial model for business decision making should reflect up to date knowledge of accounting standards, valuation theory, and sound understanding of the business (business processes) and the environment in which the business operates (economic, commercial/competitive, political, etc.).

Depending on the purpose of the model, a financial model developer should be able to decide the most appropriate skills to focus on and when to focus on them. Furthermore, the model developer should be able to decide on the sources of information, who to involve, and when to leverage the knowledge of others involved in the process.

Below are some examples of the purposes financial models are developed for and the usual stages of the business cycle they are used in.

Purpose

Usual business cycle*

Pre-feasibility stage

Idea conception

Feasibility stage

Investment decision firmed, early stages of sourcing financing

Bankable feasibility

Approaching financial institutions to source financing.

Raising early growth/sustaining capital (VC funding)

Early stage

Raising expansion capital

Growth, mature

Listing (exit and capital raise)

Early stage, growth, mature

Bid support

Not applicable

Public Private Partnerships

Not applicable

Valuations for various purposes

All stages

Budgeting

Early stage, growth, mature

Working capital financing and decisions

Early stage, growth, mature

Debt restructuring

Not applicable

Strategic options analysis (LBO, expansion, divestment, product pricing, operational and capital restructuring).

All stages

*Business cycle is only a broad guideline

Financial models prepared for some purposes require more flexibility, and involvement of technical and commercial experts. For example, feasibility stage models are more detailed and technical experts are involved to provide technical information. This includes commercial due diligence or market research to help determine the market size, pricing, sales volume forecasting, competition in the market, possible reactions of competitors and impact on the business/project.

At this stage, the achievability risk in forecasts is high, so discount rates used to determine the net present value are high, and financiers would want to flex the model to ascertain the impact of quantifiable risks on cash flows. Therefore, the financial models prepared require relatively more flexibility. Furthermore, feasibility study models presented to financiers are preferably prepared on a monthly basis to analyse the monthly cash position and any breach of debt covenants. A financial model prepared to value a mature, stable business may be prepared on an annual basis (depending on the industry) and will focus more on cash flows.

Forecast pricing, sales volumes and cost structures can be substantiated with historical data points, and not much flexibility may be required because it is business as usual. Other than analysing the key business drivers and incorporating sensitivity analysis, the model built may require more focus on identifying and presenting value drivers, incorporating valuation parameters, and creating output which enables a model user to easily identify trends and any anomalies as opposed to flexing timelines and funding structures.

Simplicity is the key! At times, complicated coding and complex structures are mistaken for a well-developed financial model. However, simplifying and breaking the logic into understandable parts is a better practice which not only increases the flexibility, ability to understand and ease of use but also allows for better model reviews resulting in error identification and correction at the testing stage.

Avoiding coding practices which result in “black box” financial models should be the objective at all stages of developing a robust financial model and should also form part of the feedback from model reviewers at testing stage.

Financial models are tools used to assist in some key and very important decisions and such decisions require huge capital outlays. Given its importance as a tool, involving financial modelling professionals is a good governance practice in the corporate decision-making process and helps to ensure that correct decisions based on sound logic are made, reported, implemented and monitored.

The Findex Corporate Finance team has extensive experience in reviewing and building numerous business and financial models for a diverse range of purposes and sectors, that have helped our clients successfully close transactions. If your business requires assistance with Valuations and Financial Modelling, Debt Advisory, Mergers & Acquisition or Equity Capital Markets, get in touch with us today.