PROJECT REPORT SUBMITTED TOWARDS THE PARTIAL FULFILLMENT OF

BACHELOR OF COMMERCE (HONS.)

PROJECT REPORT

ON

FINANCIAL MODELLING
BATCH: 2016-2019

SUBMITTED BY: - PROJECT GUIDE: -

Name: - Rohit Kumar Name: - Ms. Divya Gupta

Enrollment No.: -42724088816 Designation: -Assistant Professor

TRINITY INSTITUTE OF PROFESSIONAL STUDIES

Affiliated to Guru Gobind Singh Indraprastha University, New Delhi

Batch: -2016-2019
 CERTIFICATE

TO WHOM SO EVER IT MAY CONCERN

This is to certify that the project work “FINANCIAL MODELING” made by ROHIT
KUMAR, B.COM(H), 6th semester, Enrollment no: 42724088816 is an authentic work carried
out by him/her under guidance and supervision of Ms. Divya Gupta.

The project report submitted has been found satisfactory for the partial fulfillment of the
degree of Bachelor of Commerce (Honors).

Project Supervisor

Ms. Divya Gupta

 DECLARATION

I hereby declare that the following documented project report on “Financial Modeling” is an
original and authentic work done by me for the partial fulfillment of Bachelor of Business
Administration degree program.

I hereby declare that all the Endeavour put in the fulfillment of the task and genuine and
original to the best of my knowledge & I have not submitted it earlier elsewhere.

Signature:

ROHIT KUMAR

B.COM (H)

SEMESTER- 6th Semester

SECTION- B

SHIFT- Evening Shift

 ACKNOWLEDGEMENT

It is in particular that I am acknowledging my sincere feeling towards my mentors who

graciously gave me their time and expertise.

They have provided me with the valuable guidance sustained and friendly approach it would
have been difficult to achieve the results in such a short span of time without their help.

I deem it my duty to record my gratitude towards my internal project supervisor Ms. Divya
Gupta who devoted her precious time to interact, guide and gave me the right approach to
accomplish the task and also helped me to enhance my knowledge and understanding of the
project.

ROHIT KUMAR

B.COM (H)

SEMESTER- 6th Sem

SECTION- B

SHIFT- Evening Shift

 Unit-1
EXCEL AS A TOOL IN FINANCIAL MODELING
 Cell
In Microsoft Excel, a cell is a rectangular box that occurs at the intersection of a vertical
column and a horizontal row in a worksheet. A cell can only store 1 piece of data at a time.
You can store data in a cell such as a formula, text value, numeric value, or date value.

 Row
A row is the range of cells that go across (horizontal) the spreadsheet/worksheet. Rows are
identified by numbers e.g. row 1, row 5. Example: A row might contain the headings of a
table e.g. product ID, product name, price, number sold.
 Column
A column is a vertical series of cells in a chart, table, or spreadsheet. Below is an example of
a Microsoft Excel spreadsheet with column headers (column letter) A, B, C and D.

 Range
A cell range is a collection of selected cells in a spreadsheet. In Excel, a range is defined by
the reference of the upper left cell (minimum value) of the range and the reference of the
lower right cell (maximum value) of the range.

 Active Cell
Alternatively referred to as a cell pointer, current cell, or selected cell, an active cell is a
rectangular box, highlighting the cell in a spreadsheet. An active cell helps identify what cell
is being worked with and where data will be entered.

 How to insert values

o Select a cell in which you what to insert data.
o Start typing.
o Example: Abc in a A1 Cell.

 How to delete
o Select a cell or a no. of cells which you want to delete.
o Press delete key.
 o Example: Abc from cell A1 is being depleted by pressing Delete key.

 Copy
o Select a cell or range of cells which you want to copy.
o Right click and select copy option. Or press Ctrl+C key.
o Go to the cell where you want to paste copied data.
o Right click and select paste option. Or press Ctrl+V key.
o Example: Abc from cell A1 is being copied and paste to the cell A2.

 Cut
o Select a cell or no. of cells which you want to cut.
o Right click and select cut option. Or press Ctrl+X key.
o Go to the cell where you want to paste copied data.
o Right click and select paste option. Or press Ctrl+V key.
 o Example: Abc from cell A1 is being cut and paste to the cell A2.

 Paste
Commands mostly used by the Cut and paste or copy and paste.

Short cut key of paste is Ctrl+V

 Edit
There are many ways you can edit the data in your Excel sheets. Excel provides plenty of
tools and features not only to edit your document, but also to customize the editing process.

 Resize
You can resize your text and images by clicking on it and then selecting it and then changing
the size of it from the "HOME" bar.
 Insert a comment
o Right-click the cell and then click Insert Comment (or press Shift+F2).
o Type your annotation text.
o Click outside the cell.

 Hide & unhide a comment

o Right-click the cell and then click Show/Hide Comment.
 Show Comment

 Hide Comment
 Add a sheet
In Microsoft Excel, a sheet, sheet tab, or worksheet tab is used to display the worksheet that
a user is currently editing.

o Clicking a worksheet tab (located at the bottom of the window), users may move
between the various worksheets. Every Excel file may have multiple worksheets,
but the default number is three.
o Or press Shif+F11
o Or, On the Home tab, in the Cells group, click the arrow next to Insert, and then
click Insert Sheet.

Or
 Rename
o Clicking a worksheet tab (located at the bottom of the window).
o Right-click on the tab of the worksheet you want to rename to open the context
menu.
o Click on Rename in the menu list to highlight the current worksheet name.
o Type the new name for the worksheet.
o Press the Enter key on the keyboard to complete renaming the worksheet.
o Or, on the Home tab, in the Cells group, click the arrow next to Format , and then
click Rename Sheet.

Or
 Delete
o On the Home tab, in the Cells group, click the arrow next to Delete, and then
click Delete Sheet.
o You can also right-click the sheet tab of a worksheet or a sheet tab of any
selected worksheets that you want to delete, and then click Delete Sheet.
Or

 Hide/Unhide
o On the Home tab, in the Cells group, click the arrow next to Format, and then
click Hide & Unhide Sheet.
o You can also right-click the sheet tab of a worksheet or a sheet tab of any
selected worksheets that you want to hide, and then click Hide/Unhide Sheet.
Or

 Move/Copy Sheet

o On the Home tab, in the Cells group, click the arrow next to Format, and then
click Move or Copy Sheet.
o You can also right-click the sheet tab of a worksheet or a sheet tab of any
selected worksheets that you want to Move or Copy , and then click Move or
Copy Sheet.

Or
 Wrap Text
o In a worksheet, select the cells that you want to format.
o On the Home tab, in the Alignment group, click Wrap Text . Notes: Data in the
cell wraps to fit the column width, so if you change the column width,
data wrapping adjusts automatically.
 Filtering & Sorting
The filter tool gives you the ability to filter a column of data within a table to isolate the key
components you need. The sorting tool allows you to sort by date, number, alphabetic order
and more.

Filter/Sort
 o On the Home tab, in the Cells group, click the arrow next to Sort & Filter, and
then click Filter/Sort.
o You can also right-click the sheet tab of a worksheet or a sheet tab of any
selected worksheets that you want to filter/sort, and then click what you want to
filer/sort.
o Example: I have filtered, name of the people whose birthday month is December.
I have sorted, cells which contains purple color should be on top.

OR
Sort
 Merger and Center
This document explains how to merge cells within all versions of
Microsoft Excel. Merging cells is often used when a title is to be centered over a particular
section of a spreadsheet. When a group of cells is merged, only the text in the upper-leftmost
box is preserved.

o On the Home tab, in the Cells group, click the arrow next to Merge & center,
and then click Merge& center.
 Conditional Formatting
Conditional formatting is a feature of Excel which allows you to apply a format to a cell or
a range of cells based on certain criteria. For example the following rules are used to
highlight cells in the conditional format.
o On the Home tab, in the Cells group, click the arrow next to Conditional
Formatting, and then click the format which you want to apply.
o Example: I have done conditional formatting by setting an icon, i.e. whose
percentage of attendance is less than 50% will be marked cross, more than 50%
but less than 75% will be marked as exclamation mark and more than 75% will
be marked as tick.
 What if analysis

What-If Analysis in Excel allows you to try out different values (scenarios) for formulas.

Assume you own a book store and have 100 books in storage. You sell a certain % for the
highest price of $50 and a certain % for the lower price of $20.

(i) Creating Different Scenarios

But what if you sell 70% for the highest price? And what if you sell 80% for the highest
price? Or 90%, or even 100%? Each different percentage is a different scenario. You can use
the Scenario Manager to create these scenarios.

STEPS:

1. On the Data tab, in the Forecast group, click What-If Analysis.

2. Click Scenario Manager.

3. Add a scenario by clicking on Add.

 4. Type a name (60% highest), select cell C4 (% sold for the highest price) for the
Changing cells and click on OK.

5. Enter the corresponding value 0.6 and click on OK again

6. Next, add 4 other scenarios (70%, 80%, 90% and 100%).

7. Finally, your Scenario Manager should be consistent with the picture below:

The Scenario Manager will look like the picture given below.

(ii) Scenario Summary

To easily compare the results of these scenarios, execute the following steps.

1. Click the Summary button in the Scenario Manager.

2. Next, select cell D10 (total profit) for the result cell and click on OK

Result:
Conclusion:
If you sell 70% for the highest price, you obtain a total profit of $4100, if you sell 80% for
the highest price, you obtain a total profit of $4400, etc. That's how easy what-if analysis in
Excel can be.

(iii) Goal Seek

What if you want to know how many books you need to sell for the highest price, to obtain a
total profit of exactly $4700? We use Excel's Goal Seek feature to find the answer.

1. On the Data tab, in the Forecast group, click What-If Analysis.

2. Click Goal Seek.
 3. 3. Select cell D10.

4. 4. Click in the 'To value' box and type 4700.

5. 5. Click in the 'By changing cell' box and select cell C4.

6. 6. Click OK.

RESULT:

 Macros
A macro is simply a series of instructions. After you've created a macro, Excel will execute
those instructions, step-by-step, on any data that you give it. For example, we could have
a macro that tells Excel to take a number, add two, multiply by five, and return the modulus.

o Record macro in Excel

To start automating your Excel actions with macros, you’ll need to “record” a macro.

Recording a macro is how you tell Excel which steps to take when you run the macro.

And while you can code a macro using Visual Basic for Applications (VBA), Excel also lets
you record a macro by using standard commands.
Let’s take a look at a basic example. In our spreadsheet, we have a list of names and a
corresponding list of their sales for the month:

We’ll record a macro that sorts the sales from highest to lowest, copies the information of the
most successful salesperson, and changes the formatting to make that information stand out.

To start recording a macro, just click that button.

You’ll be asked to name your macro (we’ve named ours “HighSales”), and enter a shortcut
key if you choose.

Keep in mind that there are already a lot of Ctrl-based shortcuts, so try not to overwrite any
of those that you use regularly.
And that’s all you need to do to record a macro! Just hit record, take some actions, and then
stop recording.

o View Macros

 Solver
Excel includes a tool called solver that uses techniques from the operations research to find
optimal solutions for all kind of decision problems.

To find the optimal solution, execute the following steps.

1. On the Data tab, in the Analyze group, click Solver.

Enter the solver parameters (read on). The result should be consistent with the picture below.

 Pivot table
The pivot table is one of Microsoft Excel's most powerful -- and intimidating -- functions.
Powerful because it can help you summarize and make sense of large data sets.

 Enter your data into a range of rows and columns.

 Sort your data by a specific attribute.

 Highlight your cells to create your pivot table.

 Drag and drop a field into the "Row Labels" area.

 Drag and drop a field into the "Values" area.

 Fine-tune your calculations.

 Pivot Chart
 Unit-2
FINANCIAL MODELING BASIC CONCEPT
INTRODUCTION TO EXCEL

MS-Excel is a Windows based application package. It is quite useful in entering, editing,

analysis and storing of data. Arithmetic operations with numerical data such as addition,
subtraction, multiplication and division can also be done with Excel. You can sort the
numbers/characters according to some given criteria (like ascending, descending etc.)and
solve simple financial, mathematical and statistical formulas.

Excel is a spreadsheet, a grid made from columns and rows. It is a software program that can
make number manipulation easy and somewhat painless. The nice thing about using a
computer and spreadsheet is that you can experiment with numbers without having to RE-DO
all the calculations.

EXCEL FEATURES

There are a number of features that are available in Excel to make your task easier. Some of
the main features are:

AutoFormat - lets you to choose many preset table formatting options.

1. AutoSum - helps you to add the contents of a cluster of adjacent cells.

2. List AutoFill - automatically extends cell formatting when a new item is added to the end
of a list.

3. AutoFill - feature allows you to quickly fill cells with repetitive or sequential data such as
chronological dates or numbers, and repeated text. AutoFill can also be used to copy
functions. You can also alter text and numbers with this feature.

4. AutoShapes toolbar will allow you to draw a number of geometrical shapes, arrows,
flowchart elements, stars and more. With these shapes you can draw your own graphs.

5. Wizard - guides you to work effectively while you work by displaying various helpful tips
and techniques based on what you are doing.

Drag and Drop - feature will help you to reposition the data and text by simply dragging the
data with the help of mouse.
6. Charts - features will help you in presenting a graphical representation of your data in the
form of Pie, Bar, Line charts and more.

7. PivotTable - flips and sums data in seconds and allows you to perform data analysis and
generating reports like periodic financial statements, statistical reports, etc. You can also
analyse complex data relationships graphically.

EXCEL WORKSHEET

Excel allows you to create worksheets much like paper ledgers that can perform automatic
calculations. Each Excel file is a workbook that can hold many worksheets. The worksheet is
agrid of columns (designated by letters) and rows (designated bynumbers). The letters and
numbers of the columns and rows (called labels) are displayed in gray buttons across the top
and left side of the worksheet. The intersection of a column and am row is called a cell. Each
cell on the spread sheet has a cell address that is the column letter and the row number. Cells
can contain either text, numbers, or mathematical formulas.

STEPS IN CREATING A FINANCIAL MODEL

Step 1 - Understand the expected uses of the model and the required outputs.
Step 2 - Collect historical data for the company, its industry and for its major competitors.
Step 3 - Understand the company's plan and develop a comprehensive set of modelling
assumptions.
Step 4 - Build a model and debug it.
Step 5 - Improve the model based on feedback.
Building a Template

If you create your own template, you can safely store it in the Templates folder. As a result,
you can create new workbooks based on this template without worrying that you overwrite
the original file.

To create a template, execute the following steps.

1. Create a workbook.
2. On the File tab, click Save As.
3. Click Browse.
4. Enter a file name.
5. Select Excel Template (*.xltx) from the drop-down list.
Excel automatically activates the Templates folder. Notice the location of the
Templates folder on your computer. It's usually located here:
C:\Users\<username>\Documents\Custom Office Templates.
6. Click Save.

FORECASTING FINANCIAL STATEMENTS

 1. QUANTITATIVE

a. Performa Financial Statements

In this we use sales figures and cost from previous two to three years after
excluding onetime cost. It is mainly used in case of mergers and acquisition as
well as in the case when a new company is forming and statements are needed
to collect capital from investor.

b. Time series forecasting

We try to identify the trend. To find out the trend we need data of mere
previous year. Example: 10 year or 15 year.

c. Cause effect method

Here the forecaster examines the cause and effect relationship of the variable
with other relevant variables like change in disposable income, interest rate,
GDP, unemployment etc.

1. QUALITATIVE

a. Executive Opinion
In this the expert opinion of key personnel of different departments like sales,
production, purchasing and operations are gathered to arrive at future
predictions.

b. Reference class forecasting

In this we predict the outcome of the planned action based on similar scenario
in other places or times.

c. Delphi technique
A series of questionnaires are prepared and answered by a group of expert who
are keeping separate from each other. Once the result of each questionnaire
was compiled and second questionnaire is prepared and this process continues
until a narrow shortlisted of opinions is reached.

d. Sales force polling

In this method the essentials are derived based on the average of sales force
polling.

FINANCIAL STATEMENT TECHNIQUES

1. HORIZONTAL ANALYSIS

Horizontal analysis compares financial information over time, typically from past
quarters or years. Horizontal analysis is performed by comparing financial data from a
past statement, such as the income statement. When comparing this past information
one will want to look for variations such as higher or lower earnings.

2. VERTICAL ANALYSIS

Vertical analysis is a percentage analysis of financial statements. Each line item listed
in the financial statement is listed as the percentage of another line item. For example,
on an income statement each line item will be listed as a percentage of gross sales.
This technique is also referred to as normalization or common-sizing.

3. RATIO ANALYSIS

Ratio analysis is an attempt of developing meaningful relationship between individual

items (or group of items) in the balance sheet or profit and loss account. Ratio
analysis is not only useful to internal parties of business concern but also useful to
external parties. Ratio analysis highlights the liquidity, solvency, profitability and
capital gearing.

4. TREND ANALYSIS

The ratios of different items for various periods are find out and then compared under
this analysis. The analysis of the ratios over a period of years gives an idea of whether
the business concern is trending upward or downward. This analysis is otherwise
called as Pyramid Method.

5. REGRESSION ANALYSIS
 Regression analysis is a powerful statisticalmethod that allows you to examine the
relationship between two or more variables of interest.
While there are many types of regression analysis, at their core they all examine the
influence of one or more independent variables on a dependent variable.
Financial Statement Modeling involves Three Financial Statements:

Balance Sheet

Balance Sheet is a statement of the assets, liabilities, and capital of a business or other
organization at a particular point in time, detailing the balance of income and expenditure
over the preceding period.

Cash flows

Cash flow is the net amount of cash and cash-equivalents being transferred into and out of a
business. At the most fundamental level, a company’s ability to create value for shareholders
is determined by its ability to generate positive cash flows, or more specifically, maximize
long-term free cash flow.

Income Statements

An income statement or profit and loss account is one of the financial statements of a
company and shows the company’s revenues and expenses during a particular period. It
indicates how the revenues are transformed into the net income or net profit.

Cash flows

In financial accounting, a Cash flow statement, also known as statement of cash flows, is
a financial statement that shows how changes in balance sheet accounts and income
affect cash and cash equivalents, and breaks the analysis down to operating, investing, and
financing activities. Essentially, the cash flow statement is concerned with the flow of cash in
and out of the business. The statement captures both the current operating results and the
accompanying changes in the balance sheet. As an analytical tool, the statement of cash flows
is useful in determining the short-term viability of a company, particularly its ability to pay
bills. International Accounting Standard 7 (IAS 7), is the International Accounting
Standard that deals with cash flow statements.

People and groups interested in cash flow statements include:

 Accounting personnel, who need to know whether the organization will be able to
cover payroll and other immediate expenses
 Potential lenders or creditors, who want a clear picture of a company's ability to repay

 Potential investors, who need to judge whether the company is financially sound

 Potential employees or contractors, who need to know whether the company will be
able to afford compensation

 Shareholders of the business.

Financial Ratio & Company Analysis

 ACTIVITY RATIOS
1. Inventory Turnover
Inventory turnover is calculated by dividing cost of goods sold by average inventory. A
higher turnover than the industry average means that inventory is sold at a faster rate.
Additionally, a high inventory turnover rate means less company resources are tied up in
inventory. However, there are usually two sides to the story of any ratio. An unusually high
inventory turnover rate can be a sign that a company’s inventory is too lean, and the firm may
be unable to keep up with any increased demand. Furthermore, inventory turnover is very
industry-specific. In an industry where inventory gets stale quickly, you should seek out
companies with high inventory turnover.

2. Receivables Turnover

The receivables turnover ratio is calculated by dividing net revenue by average receivables.
This ratio is a measure of how quickly and efficiently a company collects on its outstanding
bills. The receivables turnover indicates how many times per period the company collects and
turns into cash its customers’ accounts receivable. Once again, a high turnover compared to
that of peers means that cash is collected more quickly for use in the company, but be sure to
analyze the turnover ratio in relation to the firm’s competitors. A very high receivables
turnover ratio can also mean that a company’s credit policy is too stringent, causing the firm
to miss out on sales opportunities. Alternatively, a low or declining turnover can signal that
customers are struggling to pay their bills.

3. Payables Turnover
Payables turnover measures how quickly a company pays off the money owed to suppliers.
The ratio is calculated by dividing purchases (on credit) by average payables. A high number
compared to the industry average indicates that the firm is paying off creditors quickly, and
vice versa. An unusually high ratio may suggest that a firm is not utilizing the credit extended
to them, or it could be the result of the company taking advantage of early payment discounts.
A low payables turnover ratio could indicate that a company is having trouble paying off its
bills or that it is taking advantage of lenient supplier credit policies.

4. Asset Turnover
Asset turnover measures how efficiently a company uses its total assets to generate revenues.
The formula to calculate this ratio is simply net revenues divided by average total assets. A
low asset turnover ratio may mean that the firm is inefficient in its use of its assets or that it is
operating in a capital-intensive environment. Additionally, it may point to a strategic choice
by management to use a more capital-intensive (as opposed to a more labour-intensive)
approach.

 Liquidity Ratios
Liquidity ratios are some of the most widely used ratios, perhaps next to profitability ratios.
They are especially important to creditors. These ratios measure a firm’s ability to meet its
short-term obligations.

1. Current Ratio
The current ratio measures a company’s current assets against its current liabilities. The
current ratio indicates if the company can pay off its short-term liabilities in an emergency by
liquidating its current assets. Current assets are found at the top of the balance sheet and
include line items such as cash and cash equivalents, accounts receivable and inventory,
among others.

2. Quick Ratio
The quick ratio is a liquidity ratio that is more stringent than the current ratio. This ratio
compares the cash, short-term marketable securities and accounts receivable to current
liabilities. The thought behind the quick ratio is that certain line items, such as prepaid
expenses, have already been paid out for future use and cannot be quickly and easily
converted back to cash for liquidity purposes. In our example, the quick ratio of 0.45x
indicates that the company can only cover 45% of current liabilities by using all cash-on-
hand, liquidating short-term marketable securities and monetizing accounts receivable.

3. Cash Ratio
The most conservative liquidity ratio is the cash ratio, which is calculated as simply cash and
short-term marketable securities divided by current liabilities. Cash and short-term
marketable securities represent the most liquid assets of a firm. Short-term marketable
securities include short-term highly liquid assets such as publicly traded stocks, bonds and
options held for less than one year. During normal market conditions, these securities can
easily be liquidated on an exchange.

 Solvency Ratios
Solvency ratios measure a company’s ability to meet its longer-term obligations. Analysis of
solvency ratios provides insight on a company’s capital structure as well as the level of
financial leverage a firm is using.

1. Debt-To-Capital Ratio
The debt-to-capital ratio is very similar, measuring the amount of a company’s total capital
(liabilities plus equity) that is provided by debt (interesting bearing notes and short- and long-
term debt). Once again, a high ratio means high financial leverage and risk. Although
financial leverage creates additional financial risk by increased fixed interest payments, the
main benefit to using debt is that it does not dilute ownership. In theory, earnings are split
among fewer owners, creating higher earnings per share. However, the increased financial
risk of higher leverage may hold the company to stricter debt covenants. These covenants
could restrict the company’s growth opportunities and ability to pay or raise dividends.

2. Debt-To-Equity Ratio
The debt-to-equity ratio measures the amount of debt capital a firm uses compared to the
amount of equity capital it uses. A ratio of 1.00x indicates that the firm uses the same amount
of debt as equity and means that creditors have claim to all assets, leaving nothing for
shareholders in the event of a theoretical liquidation.

3. Interest Coverage Ratio

The interest coverage ratio, also known as times interest earned, measures a company’s cash
flows generated compared to its interest payments. The ratio is calculated by dividing EBIT
(earnings before interest and taxes) by interest payments.

 Profitability Ratios
Profitability ratios are arguably the most widely used ratios in investment analysis. These
ratios include the ubiquitous “margin” ratios, such as gross, operating and net profit margins.
These ratios measure the firm’s ability to earn an adequate return. When analyzing a
company’s margins, it is always prudent to compare them against those of the industry and its
close competitors.

 Gross Profit Margin

Gross profit margin is simply gross income (revenue less cost of goods sold) divided by net
revenue. The ratio reflects pricing decisions and product costs. The 50% gross margin for the
company in our example shows that 50% of revenues generated by the firm are used to pay
for the cost of goods sold.

 Operating Profit Margin

Operating profit margin is calculated by dividing operating income (gross income less
operating expenses) by net revenue. Operating margin examines the relationship between
sales and management-controlled costs. Increasing operating margin is generally seen as a
good sign, but investors should simply be looking for strong, consistent operating margins.

 Net Profit Margin

Net profit margin compares a company’s net income to its net revenue. This ratio is
calculated by dividing net income, or a company’s bottom line, by net revenue. It measures a
firm’s ability to translate sales into earnings for shareholders. Once again, investors should
look for companies with strong and consistent net profit margins.

 ROA and ROE

Two other profitability ratios are also widely used—return on assets (ROA) and return on
equity (ROE).
Return on assets is calculated as net income divided by total assets. It is a measure of how
efficiently a firm utilizes its assets. A high ratio means that the company is able to efficiently
generate earnings using its assets. As a variation, some analysts like to calculate return on
assets from pretax and pre-interest earnings using EBIT divided by total assets.

Various approaches to valuation of Business

1. Cost approach
2. Market approach
3. Discounted cash flow (intrinsic value)
When valuing a business or assets, there are three broad categories that contain their own
methods. The cost approach looks at the cost to build something and is not frequently used by
finance professionals to value a company as going concern.

Market approach - This is a form of relative valuation and frequently used in the industry. It
includes comparable analysis and prudent transactions finally.
The discounted cash flow (DCF) is a form of intrinsic valuation and the most detailed
through approach to valuation model.

Public company comparable is also known as comparable approach per group analysis.

In this we compare the current value of business to the other similar business by looking at
trading multiples like PE ratio, EV: EBITDA ratio or other ratios. If the company trades at 10
times PE ratio.
Example: If company X trades at 10 times PE ratio and another company Y that we want to
value which has same attributes as company X having earnings of Rs. 2.50 per share the the
market value of company Y stock must be 10*2.5 =25

Precedent transactions: Precedent transactions are those where you compare the company in
question to other business that have recently being sold or acquired in the industry. They are
useful for merger and acquisition transactions but can easily become stale dated and the
longer reflective of the current market prices.
DCF - It is an intrinsic value approach where an analyst forecasts the business's free cash
flow into the future and discount book to today at the firm's weighted average cost of capital
(WACC)

Sensitivity analysis
One of the major uses of financial statement forecasting models is to do sensitivity analysis.
We can see the effect of making changes in any of the input (independent) variables on the
other dependent variable by making the changes in the model. But trying these out one at a
time does not provide us a comprehensive picture. Your management wants to see how Net
Income, EPS, dividend per share, and stock price will change for 2006 for sales growth rates
from 1% to 10% per year over the years. Create a one-input data table to show this
information. Also create a two-input data table to show how EBIT for 2003 will depend on
cost of sales to sales ratio and sales growth rate in a reasonable range.

Probabilistic Analysis of the Best & Worst Case Scenario

Unit-3
CASH RATIOS &NON CASH VALUATIONS
2.1 INTRODUCTION TO EXCEL

MS-Excel is a Windows based application package. It is quite useful in entering, editing,

analysis and storing of data. Arithmetic operations with numerical data such as addition,
subtraction, multiplication and division can also be done with Excel. You can sort the
numbers/characters according to some given criteria (like ascending, descending etc.)and
solve simple financial, mathematical and statistical formulas.

Excel is a spreadsheet, a grid made from columns and rows. It is a software program that can
make number manipulation easy and somewhat painless. The nice thing about using a
computer and spreadsheet is that you can experiment with numbers without having to RE-DO
all the calculations.

2.2 EXCEL FEATURES

There are a number of features that are available in Excel to make your task easier. Some of
the main features are:
AutoFormat - lets you to choose many preset table formatting options.

1. AutoSum - helps you to add the contents of a cluster of adjacent cells.

2. List AutoFill - automatically extends cell formatting when a new item is added to the end
of a list.

3. AutoFill - feature allows you to quickly fill cells with repetitive or sequential data such as
chronological dates or numbers, and repeated text. AutoFill can also be used to copy
functions. You can also alter text and numbers with this feature.

4. AutoShapes toolbar will allow you to draw a number of geometrical shapes, arrows,
flowchart elements, stars and more. With these shapes you can draw your own graphs.

5. Wizard - guides you to work effectively while you work by displaying various helpful tips
and techniques based on what you are doing.

Drag and Drop - feature will help you to reposition the data and text by simply dragging the
data with the help of mouse.

6. Charts - features will help you in presenting a graphical representation of your data in the
form of Pie, Bar, Line charts and more.

7. PivotTable - flips and sums data in seconds and allows you to perform data analysis and
generating reports like periodic financial statements, statistical reports, etc. You can also
analyse complex data relationships graphically.

EXCEL WORKSHEET

Excel allows you to create worksheets much like paper ledgers that can perform automatic
calculations. Each Excel file is a workbook that can hold many worksheets. The worksheet is
agrid of columns (designated by letters) and rows (designated bynumbers). The letters and
numbers of the columns and rows (called labels) are displayed in gray buttons across the top
and left side of the worksheet. The intersection of a column and am row is called a cell. Each
cell on the spread sheet has a cell address that is the column letter and the row number. Cells
can contain either text, numbers, or mathematical formulas.
2.3 STEPS IN CREATING A FINANCIAL MODEL

Step 1 - Understand the expected uses of the model and the required outputs.
Step 2 - Collect historical data for the company, its industry and for its major competitors.
Step 3 - Understand the company's plan and develop a comprehensive set of modelling
assumptions.
Step 4 - Build a model and debug it.
Step 5 - Improve the model based on feedback.

2.4 Building a Template

If you create your own template, you can safely store it in the Templates folder. As a result,
you can create new workbooks based on this template without worrying that you overwrite
the original file.

To create a template, execute the following steps.

7. Create a workbook.
8. On the File tab, click Save As.
9. Click Browse.
10. Enter a file name.
11. Select Excel Template (*.xltx) from the drop-down list.
Excel automatically activates the Templates folder. Notice the location of the
Templates folder on your computer. It's usually located here:
C:\Users\<username>\Documents\Custom Office Templates.
12. Click Save.
2.5 FORECASTING FINANCIAL STATEMENTS

2. QUANTITATIVE

d. Performa Financial Statements

In this we use sales figures and cost from previous two to three years after
excluding onetime cost. It is mainly used in case of mergers and acquisition as
well as in the case when a new company is forming and statements are needed
to collect capital from investor.

e. Time series forecasting

We try to identify the trend. To find out the trend we need data of mere
previous year. Example: 10 year or 15 year.

f. Cause effect method

Here the forecaster examines the cause and effect relationship of the variable
with other relevant variables like change in disposable income, interest rate,
GDP, unemployment etc.

2. QUALITATIVE
 e. Executive Opinion
In this the expert opinion of key personnel of different departments like sales,
production, purchasing and operations are gathered to arrive at future
predictions.

f. Reference class forecasting

In this we predict the outcome of the planned action based on similar scenario
in other places or times.

g. Delphi technique
A series of questionnaires are prepared and answered by a group of expert who
are keeping separate from each other. Once the result of each questionnaire
was compiled and second questionnaire is prepared and this process continues
until a narrow shortlisted of opinions is reached.

h. Sales force polling

In this method the essentials are derived based on the average of sales force
polling.

FINANCIAL STATEMENT TECHNIQUES

6. HORIZONTAL ANALYSIS
Horizontal analysis compares financial information over time, typically from past
quarters or years. Horizontal analysis is performed by comparing financial data from a
past statement, such as the income statement. When comparing this past information
one will want to look for variations such as higher or lower earnings.

7. VERTICAL ANALYSIS
Vertical analysis is a percentage analysis of financial statements. Each line item listed
in the financial statement is listed as the percentage of another line item. For example,
on an income statement each line item will be listed as a percentage of gross sales.
This technique is also referred to as normalization or common-sizing.
8. RATIO ANALYSIS
Ratio analysis is an attempt of developing meaningful relationship between individual
items (or group of items) in the balance sheet or profit and loss account. Ratio
analysis is not only useful to internal parties of business concern but also useful to
 external parties. Ratio analysis highlights the liquidity, solvency, profitability and
capital gearing.

9. TREND ANALYSIS
The ratios of different items for various periods are find out and then compared under
this analysis. The analysis of the ratios over a period of years gives an idea of whether
the business concern is trending upward or downward. This analysis is otherwise
called as Pyramid Method.
10.REGRESSION ANALYSIS
Regression analysis is a powerful statisticalmethod that allows you to examine the
relationship between two or more variables of interest.
While there are many types of regression analysis, at their core they all examine the
influence of one or more independent variables on a dependent variable.
Financial Statement Modeling involves Three Financial Statements:

Balance Sheet

Balance Sheet is a statement of the assets, liabilities, and capital of a business or other
organization at a particular point in time, detailing the balance of income and expenditure
over the preceding period.

Cash flows

Cash flow is the net amount of cash and cash-equivalents being transferred into and out of a
business. At the most fundamental level, a company’s ability to create value for shareholders
is determined by its ability to generate positive cash flows, or more specifically, maximize
long-term free cash flow.

Income Statements

An income statement or profit and loss account is one of the financial statements of a
company and shows the company’s revenues and expenses during a particular period. It
indicates how the revenues are transformed into the net income or net profit.
2.6 Cash flows

In financial accounting, a Cash flow statement, also known as statement of cash flows, is
a financial statement that shows how changes in balance sheet accounts and income
affect cash and cash equivalents, and breaks the analysis down to operating, investing, and
financing activities. Essentially, the cash flow statement is concerned with the flow of cash in
and out of the business. The statement captures both the current operating results and the
accompanying changes in the balance sheet. As an analytical tool, the statement of cash flows
is useful in determining the short-term viability of a company, particularly its ability to pay
bills. International Accounting Standard 7 (IAS 7), is the International Accounting
Standard that deals with cash flow statements.

People and groups interested in cash flow statements include:

 Accounting personnel, who need to know whether the organization will be able to
cover payroll and other immediate expenses
 Potential lenders or creditors, who want a clear picture of a company's ability to repay

 Potential investors, who need to judge whether the company is financially sound

 Potential employees or contractors, who need to know whether the company will be
able to afford compensation

 Shareholders of the business.

2.7 Financial Ratio & Company Analysis

 ACTIVITY RATIOS

5. Inventory Turnover

Inventory turnover is calculated by dividing cost of goods sold by average inventory. A

higher turnover than the industry average means that inventory is sold at a faster rate.
Additionally, a high inventory turnover rate means less company resources are tied up in
inventory. However, there are usually two sides to the story of any ratio. An unusually high
inventory turnover rate can be a sign that a company’s inventory is too lean, and the firm may
be unable to keep up with any increased demand. Furthermore, inventory turnover is very
industry-specific. In an industry where inventory gets stale quickly, you should seek out
companies with high inventory turnover.

6. Receivables Turnover

The receivables turnover ratio is calculated by dividing net revenue by average receivables.
This ratio is a measure of how quickly and efficiently a company collects on its outstanding
bills. The receivables turnover indicates how many times per period the company collects and
turns into cash its customers’ accounts receivable. Once again, a high turnover compared to
that of peers means that cash is collected more quickly for use in the company, but be sure to
analyze the turnover ratio in relation to the firm’s competitors. A very high receivables
turnover ratio can also mean that a company’s credit policy is too stringent, causing the firm
to miss out on sales opportunities. Alternatively, a low or declining turnover can signal that
customers are struggling to pay their bills.

7. Payables Turnover
Payables turnover measures how quickly a company pays off the money owed to suppliers.
The ratio is calculated by dividing purchases (on credit) by average payables. A high number
compared to the industry average indicates that the firm is paying off creditors quickly, and
vice versa. An unusually high ratio may suggest that a firm is not utilizing the credit extended
to them, or it could be the result of the company taking advantage of early payment discounts.
A low payables turnover ratio could indicate that a company is having trouble paying off its
bills or that it is taking advantage of lenient supplier credit policies.

8. Asset Turnover
Asset turnover measures how efficiently a company uses its total assets to generate revenues.
The formula to calculate this ratio is simply net revenues divided by average total assets. A
low asset turnover ratio may mean that the firm is inefficient in its use of its assets or that it is
operating in a capital-intensive environment. Additionally, it may point to a strategic choice
by management to use a more capital-intensive (as opposed to a more labour-intensive)
approach.
  Liquidity Ratios

Liquidity ratios are some of the most widely used ratios, perhaps next to profitability ratios.
They are especially important to creditors. These ratios measure a firm’s ability to meet its
short-term obligations.

4. Current Ratio
The current ratio measures a company’s current assets against its current liabilities. The
current ratio indicates if the company can pay off its short-term liabilities in an emergency by
liquidating its current assets. Current assets are found at the top of the balance sheet and
include line items such as cash and cash equivalents, accounts receivable and inventory,
among others.

5. Quick Ratio
The quick ratio is a liquidity ratio that is more stringent than the current ratio. This ratio
compares the cash, short-term marketable securities and accounts receivable to current
liabilities. The thought behind the quick ratio is that certain line items, such as prepaid
expenses, have already been paid out for future use and cannot be quickly and easily
converted back to cash for liquidity purposes. In our example, the quick ratio of 0.45x
indicates that the company can only cover 45% of current liabilities by using all cash-on-
hand, liquidating short-term marketable securities and monetizing accounts receivable.

6. Cash Ratio
The most conservative liquidity ratio is the cash ratio, which is calculated as simply cash and
short-term marketable securities divided by current liabilities. Cash and short-term
marketable securities represent the most liquid assets of a firm. Short-term marketable
securities include short-term highly liquid assets such as publicly traded stocks, bonds and
options held for less than one year. During normal market conditions, these securities can
easily be liquidated on an exchange.
  Solvency Ratios

Solvency ratios measure a company’s ability to meet its longer-term obligations. Analysis of
solvency ratios provides insight on a company’s capital structure as well as the level of
financial leverage a firm is using.

4. Debt-To-Capital Ratio

The debt-to-capital ratio is very similar, measuring the amount of a company’s total capital
(liabilities plus equity) that is provided by debt (interesting bearing notes and short- and long-
term debt). Once again, a high ratio means high financial leverage and risk. Although
financial leverage creates additional financial risk by increased fixed interest payments, the
main benefit to using debt is that it does not dilute ownership. In theory, earnings are split
among fewer owners, creating higher earnings per share. However, the increased financial
risk of higher leverage may hold the company to stricter debt covenants. These covenants
could restrict the company’s growth opportunities and ability to pay or raise dividends.

5. Debt-To-Equity Ratio
The debt-to-equity ratio measures the amount of debt capital a firm uses compared to the
amount of equity capital it uses. A ratio of 1.00x indicates that the firm uses the same amount
of debt as equity and means that creditors have claim to all assets, leaving nothing for
shareholders in the event of a theoretical liquidation.

6. Interest Coverage Ratio

The interest coverage ratio, also known as times interest earned, measures a company’s cash
flows generated compared to its interest payments. The ratio is calculated by dividing EBIT
(earnings before interest and taxes) by interest payments.

 Profitability Ratios

Profitability ratios are arguably the most widely used ratios in investment analysis. These
ratios include the ubiquitous “margin” ratios, such as gross, operating and net profit margins.
These ratios measure the firm’s ability to earn an adequate return. When analyzing a
company’s margins, it is always prudent to compare them against those of the industry and its
close competitors.

 Gross Profit Margin

Gross profit margin is simply gross income (revenue less cost of goods sold) divided by net
revenue. The ratio reflects pricing decisions and product costs. The 50% gross margin for the
company in our example shows that 50% of revenues generated by the firm are used to pay
for the cost of goods sold.

 Operating Profit Margin

Operating profit margin is calculated by dividing operating income (gross income less
operating expenses) by net revenue. Operating margin examines the relationship between
sales and management-controlled costs. Increasing operating margin is generally seen as a
good sign, but investors should simply be looking for strong, consistent operating margins.

 Net Profit Margin

Net profit margin compares a company’s net income to its net revenue. This ratio is
calculated by dividing net income, or a company’s bottom line, by net revenue. It measures a
firm’s ability to translate sales into earnings for shareholders. Once again, investors should
look for companies with strong and consistent net profit margins.

 ROA and ROE

Two other profitability ratios are also widely used—return on assets (ROA) and return on
equity (ROE).
Return on assets is calculated as net income divided by total assets. It is a measure of how
efficiently a firm utilizes its assets. A high ratio means that the company is able to efficiently
generate earnings using its assets. As a variation, some analysts like to calculate return on
assets from pretax and pre-interest earnings using EBIT divided by total assets.

2.8 Various approaches to valuation of Business

1. Cost approach
2. Market approach
3. Discounted cash flow (intrinsic value)

When valuing a business or assets, there are three broad categories that contain their own
methods. The cost approach looks at the cost to build something and is not frequently used by
finance professionals to value a company as going concern.

Market approach - This is a form of relative valuation and frequently used in the industry. It
includes comparable analysis and prudent transactions finally.
The discounted cash flow (DCF) is a form of intrinsic valuation and the most detailed
through approach to valuation model.

Public company comparable is also known as comparable approach per group analysis.

In this we compare the current value of business to the other similar business by looking at
trading multiples like PE ratio, EV: EBITDA ratio or other ratios. If the company trades at 10
times PE ratio.
Example: If company X trades at 10 times PE ratio and another company Y that we want to
value which has same attributes as company X having earnings of Rs. 2.50 per share the the
market value of company Y stock must be 10*2.5 =25

Precedent transactions: Precedent transactions are those where you compare the company in
question to other business that have recently being sold or acquired in the industry. They are
useful for merger and acquisition transactions but can easily become stale dated and the
longer reflective of the current market prices.
DCF - It is an intrinsic value approach where an analyst forecasts the business's free cash
flow into the future and discount book to today at the firm's weighted average cost of capital
(WACC)

2.9 Sensitivity analysis

One of the major uses of financial statement forecasting models is to do sensitivity analysis.
We can see the effect of making changes in any of the input (independent) variables on the
other dependent variable by making the changes in the model. But trying these out one at a
time does not provide us a comprehensive picture. Your management wants to see how Net
Income, EPS, dividend per share, and stock price will change for 2006 for sales growth rates
from 1% to 10% per year over the years. Create a one-input data table to show this
information. Also create a two-input data table to show how EBIT for 2003 will depend on
cost of sales to sales ratio and sales growth rate in a reasonable range.

2.10 Probabilistic Analysis of the Best & Worst Case Scenario

With risky assets, the actual cash flows can be very different from expectations.
At the minimum, we can estimate the cash flows if everything works to perfection – a best
case scenario – and if nothing does – a worse case scenario. In practice, this analysis can be
structured in two ways. In the first, each input into asset value is set to its best (or worst)
possible outcome and the cash flows estimated with those values. Thus, when valuing a firm,
you may set the revenue growth rate and operating margin at the highest possible level while
setting the discount rate at its lowest level, and compute the value as the best-case scenario.
The problem with this approach is that it may not be feasible; after all, to get the high revenue
growth, the firm may have to lower prices and accept lower margins. In the second, the best
possible scenario is defined in terms of what is feasible while allowing for the relationship
between the inputs. Thus, instead of assuming that revenue growth and margins will both be
maximized, we will choose that combination of growth and margin that is feasible and yields
the maximum value. While
this approach is more realistic, it does require more work to put into practice. There are two
ways in which the results from this analysis can be useful to decision makers. First, the
difference between the best case and worst case values can be used as a measure of risk on an
asset; the range in value (scaled to size) should be higher for riskier investments. Second,
firms that are concerned about the potential spill over effects on their operations of an
investment going bad may be able to gauge the effects by looking at the worst case outcome.
Thus, a firm that has significant debt obligations may use the worst case outcome to make a
judgment as to whether an investment has the potential to push them into default.
The Steps involved in analyzing the probabilistic analysis are as follows:
1. Identify the factors based on which the model will be built.
2. Ascertain the number of situations that needs to be analysed.
3. Arrive at the cash flows from each situation.
4. Assign probabilities to each of the scenarios.
For example: in the shipping industry, say a company has manufactures ships and income is
from selling these ships to the customers. This company is planning to introduce another ship
based on the seating capacity. Currently, say the ship offers only 1000 seats, the company due
to demand is planning to offer a ship that can hold 1500 passengers. The uncertainties are the
demand, the customer preferences, growth in the market, acceptance of the design from the
prospective buyers etc. we can consider three scenarios for the demand/sales factor, i.e,
growth rate, moderate growth rate and low growth rate. High growth rate say 10%, moderate
growth rate 5%-10%. So in these situations, the sales numbers projected will differ as shown
below:
10% growth rate 5%-10% growth rate Below 5% rate

Sales 150 100 50

Hence the projections, the cash flows and the valuation will vary in each situation. The
difficulty is in ascertaining the numbers of sales and assigning the probabilities. This can be
done by persons who have a strong understanding of the industry.
The management can assign the probability, based on the likely hood of the event, say the
worst (lowest demand, i.e below 5%) situation is given a probability of 0.15, ie there are only
15% chances of salesfalling below 5% rate, and most likely 5%-10% is 0.6, i.e., 60% and
optimistic situation is say 0.25, i.e 25%. These probabilities have to be assigned carefully as
they will have an impact on decision-making.
 Unit-3

CASH RATIOS &NON CASH VALUATIONS

3.1 STRUCTURED MODEL WITH A MENU & ACCOUNTING
STATEMENTS
A structured model links the income statement, balance sheet, and cash flow statement into
one dynamically connected model. Accounting statement models are the foundation on
which more advanced financial models are built such as discounted cash flow DCF models,
mergers models, leveraged buyout LBO models, and various other types of financial models.

There are several steps required to build an accounting statement model, including:

 Input the historical financial information into Excel

 Determine the assumptions that will drive the forecast

 Forecast the income statement

 Forecast capital assets

 Forecast financing activity

 Forecast the balance sheet

 Complete the cash flow statement

A structured model with a menu and accounting statements can be shown as:

1) Table of Contents
2) Revenue, cost and expense projections
3) Income statement
4) Balance Sheet statement
5) Cash Flow statement

3.2 TIME VALUE OF MONEY

When money is invested today, after a year, it will give us a rate of return. This return
enhances the value of money. Hence, what value of money is today, will not be the same after
a period of time. For example, if A invests Rs.1000 today at 8% interest per annum, the
amount he will get is Rs.1080/-. Whether A gets Rs.1000 today, or Rs.1080 after a year, the
value is the same. This is called time value of money. These values of the business have to be
ascertained based on the money that the business generates. The value of money generated by
the business tomorrow is not equal to what it is today. The interest rate/investment rate has to
be ascertained in every business. This rate is what is called the discount rate.

COST OF CAPITAL

Ascertaining the discount rate is crucial to valuation and it plays a vital role in valuation. To
ascertain the discounting factor, either cost of capital can be used or weighted average cost of
capital can be used for arriving at the rate at which the present value of future cash flow can
be ascertained.

The most commonly used model is the capital asset pricing model (CAPM) which arrives at
the rate of return of an asset. The formula for cost of equity is

Cost of equity = Risk free rate + Beta*market premium

Where, the market premium is the difference between the market rate of return for a security
less the risk free rate.

After arriving at the discounting factor, the same is used for finding out the present value of
future cash flows.

Example:

Particulars Rs. Cost

Equity Capital 200000 15%
Preference Capital 500000 12%
Debentures 3000000 6%
Weights of equity, preference, and debentures are 36%, 9%, and 55% respectively. Calculate
cost of capital
3.3 CAPITAL BUDEGTING MODELS

3.3.1 NPV Function

Aim: Returns the net present value of an investment based on a series of periodic cash flows
and a discount rate.

Syntax: =NPV(rate, values)-initial_investment

Result:
3.3.2 IRR Function

Aim: IRR (Internal Rate of Return) returns the internal rate of return for a series of cash
flows. It is used when a firm wants to understand whether to accept or reject a proposal based
on whether it is profitable or not.

Acceptance Rule:

IRR > Hurdle Rate ------ (Accept the Proposal)

IRR < Hurdle Rate ------ (Reject the Proposal)

IRR = Hurdle Rate ------ (May Accept/Reject)

Syntax: =IRR(values, [guess])

Result:
3.3.3 MIRR Function

Aim: MIRR(Modified Internal Rate of Return) Returns the internal rate of return where
positive and negative cash flows are financed at different rates.

Syntax: =MIRR(values, finance_rate, reinvest_rate)

Finance Rate is that rate at which capital is introduced.

Reinvest Rate is that rate at which fresh capital is introduced.

Result:
3.4 Dividend Discount Model

It is a way of valuing a company based on the theory that is the stock is worth the dscounted
sum of all ts future dividend payments in other words it is used to evaluate the stocks based
on net present value of the future dividends.

Formula

Intrinsic value = Sum of Present Value of Dividends + Present Value of Stock Sale Price.

Types of Dividend Discount Model

Zero growth Dividend discount model

This model is used that all the dividends that are paid by the stock remains one and same
forever until infinite.

Constant Growth model

This model assumes that dividends grow at a fixed % annually . They are nt variable and are
constant throughout.

Variable growth or non constant growth

Assumes that this model will divide the growth into 2 or 3 phases 1st will be a fast initial
phase, then a slower transition phase ultimatley ends with a lower rate for the infinite period.
Result:

Zero Growth Rate Model

The Annual Dividend is given as Rs. 1.8 having 8% required rate of return. Calculate the
Intrinsic Value of the Stock.
3.5 MARKET BASED METHODS

When an investor invests, the first thing that he does, is that he enquires if there has been
similar transactions that have happened in the same industry to see at what was it acquired.
Valuation is not only numbers, but can also denoted as 2X, or 5X of some variable. This
variable can be the revenue, EBITDA or the PAT. These have a bearing in the valuation.
The steps involved in the market based approach is as follows:
 Ascertain the peer group. The companies in the same industry, that are into the same
kind of business, is called the peer group.
 The peer group companies must be comparable in size and nature to the company that
is being valued.
 The peer group companies must be listed in the market, i.e., the stocks of which trade
in the listed stock exchange.
 Once, the peer group is identified, the valuation can be either revenue based or
EBITDA based, or PAT based.

Revenue of each companies is taken and the revenue multiple is ascertained. The revenue
multiple is calculated using the following formula:

Aggregate EV of all the companies / aggregate revenue of all the companies

EV is enterprise value. The enterprise value is defined as the market capitalization less the
debt and cash is added. Market capitalization shows the market value of the firm and it
computed by multiplying the number of shares and the current quoted market price. The
quoted market price has to be taken as on the valuation date. The enterprise value is the
market capital + debt – cash. Debt is added as any investor, who is going to acquire the
company or invest in the company has to repay the debt and the cash is subtracted as any
investor who takes over has that amount of cash to repay the debt. In case the company has
preference capital and minority interest, then the formula is as follows:

Market capitalization + Preference capital + minority interest + debt – cash and cash
equivalents.

Preference capital, minority interest, associate company value, debt, all have to be taken at
market value. Basically, enterprise value depicts the market value of the firm. Preference
capital is added as market capitalization only considers the outstanding equity shares.
Minority interest is that part that is not held by the holding company, but it is the claim of the
minority share holders, and has an impact during consolidation.
Significance of EV/ EBITDA

Enterprise values the businesses based on their market capitalization. For listed companies,
the market capitalization is the total shares multiplied by the share price as on a given date.
However, EV is not deal only with the market. The stock prices always don not reflect the
true value of the company. Sometimes, a good asset backed stock may also fall below its
book value, due to external factors like government regulations, global recession etc.
EV/EBITDA gives the operating profit multiple as a times of the enterprise value. It is an
important tool to compare different companies of different countries as it ignores the taxation
effect. Also, this helps in comparisons of companies, which have a different capital structure.
EV is better than Market capitalization as it assumes the debt. Hence, this multiple considers
the liability that the company has to assume in case of acquisition or merger. Lower the EV,
better is the position for the acquirer.

Significance of EV/Sales
This ratio signifies the value of the company in terms of its sales. This multiple, shows how
many times the sales is the EV. This is beneficial as the acquirer/purchaser will know how
much it costs to buy the sales of the company. This is better than the price to sales valuation
as the price to sales value takes the market price, whereas this takes into account the debt and
takes a more realistic picture.