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Financial
Forecasting,
Analysis, and
Modelling
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A Framework for
Long-Term Forecasting

MICHAEL SAMONAS
Financial
Forecasting,
Analysis, and
Modelling
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This edition first published 2015
© 2015 Michael Samonas

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Library of Congress Cataloging-in-Publication Data

Samonas, Michael.
Financial forecasting, analysis, and modelling : a framework for long-term forecasting / Michael Samonas.
pages cm
Includes bibliographical references and index.
ISBN 978-1-118-92108-1 (cloth)
1. Corporations–Finance–Mathematical models. 2. Corporations–Finance–Forecasting. I. Title.
HG4012.S26 2015
658.1501’12–dc23
2014040071

Cover Design: Wiley

Cover Image: Top:©iStock.com/MarsBars;
Bottom: ©iStock.com/studiocasper

Set in 10/12pt Times by Laserwords Private Limited, Chennai, India

Printed in Great Britain by TJ International Ltd, Padstow, Cornwall, UK
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ffirs.indd 12/18/2014 Page v

To Konstantinos, Eleftheria, my Mom and Dad

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Table of Contents

Preface xi

Acknowledgments xiii

About the Author xv

PART ONE
Developing Corporate Finance Models 1

Chapter 1
Introduction 3
1.1 What is Financial Modelling? 3
1.2 Defining the Inputs and the Outputs of a Simple
Financial Model 6
1.3 The Financial Modelling Process of More Complex Models 9
1.3.1 Step 1: Defining the Problem the Model Will Solve:
The Fundamental Business Question 9
1.3.2 Step 2: Specification of the Model 10
1.3.3 Step 3: Designing and Building the Model 11
1.3.4 Step 4: Checking the Model’s Output 13
1.4 Excel as a Tool of Modelling: Capabilities and Limitations 13

Chapter 2
A Short Primer in the Accounting of Financial Statements 17
2.1 The Accounting Equation 17
2.2 The Balance Sheet 20
2.3 The Income Statement 23
2.3.1 Cash Accounting Versus Accrual Accounting 26
2.4 The Cash Flow Statement 26
2.4.1 Operating Activities 27
2.4.2 Investing Activities 27

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viii TABLE OF CONTENTS

2.4.3 Financing Activities 27

2.4.4 Income Flows and Cash Flows 27
2.4.5 Preparing the Statement of Cash Flows 28
2.5 The Articulation of Income Statement, Balance
Sheet, and Cash Flow Statements 29
2.6 Financial Statement Analysis: Ratio Analysis 32
2.6.1 Profitability Ratios 35
2.6.2 Liquidity Ratios 37
2.6.3 Solvency Ratios 38
2.6.4 Other Ratios 39
2.6.5 The Limitations of Financial Ratios 40

Chapter 3
Financial Statement Modelling 43
3.1 Introduction – How Financial Models Work 43
3.2 Collecting and Analyzing Historical Data 47
3.3 Selecting the Key Forecast Drivers 53
3.4 Modelling the Income Statement 59
3.5 Modelling the Balance Sheet 63
3.6 Modelling Interest and Circular References 66
3.7 Modelling the Cash Flow Statement 69

Chapter 4
Forecasting Performance 75
4.1 Introduction: Designing a Dashboard-like Control Panel 75
4.2 Basic Statistical Methods Used for Forecasting 88
4.3 Forecasting Sales 93
4.3.1 Bottom-up Versus Top-down Forecasting 97
4.3.2 Forecasting Sales of Existing Products or Services 97
4.4 Forecasting Costs 99
4.5 Forecasting CAPEX and Depreciation 103
4.5.1 Forecasting CAPEX and Depreciation for Existing Companies 108
4.6 Forecasting Working Capital and Funding Needs 110
4.6.1 Forecasting Funding Needs 113

Chapter 5
Business Valuation 115
5.1 Valuation Approaches 115
5.2 Steps for Applying the DCF Method 120
5.3 Rewriting Financial Statements – Calculation of
Free Cash Flows 121
5.4 Calculating the Weighted Average Cost of Capital 124
5.4.1 Calculating the Weighted Average Cost of Capital of SteelCo 128
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Table of Contents ix

5.5 Estimating the Terminal Value 131

5.6 DCF Summary – Enterprise Value Adjustments 132

PART TWO
Planning for Uncertainty 137

Chapter 6
Using Sensitivity Analysis 139
6.1 Introduction 139
6.2 One-Dimensional and 2-Dimensional Sensitivity Analysis 140
6.3 Choosing the Variables to Change 145
6.4 Modelling Example 149
6.4.1 Selecting the Variables to Change 149
6.4.2 Assigning a Range of Values 149
6.4.3 Constructing the 2-dimensional Sensitivity Analysis Table 151
6.4.4 Interpreting the Results 153

Chapter 7
Using Scenarios 157
7.1 Introduction 157
7.2 Using Scenario Analysis with Excel’s Scenario Manager 158
7.2.1 Adding 2 More Scenarios 159
7.3 Alternative Ways to Create Scenarios in Excel 163
7.4 Applying Scenarios to SteelCo’s Case 167
7.4.1 Deciding on the Number of Scenarios and Input Variables
under each Scenario 167
7.4.2 Deciding on the Output Variables 168
7.4.3 Assigning Values to the Input Variables under Each Scenario 170
7.4.4 Building the Scenarios in Excel’s Scenario Manager 173
7.4.5 Interpreting the Results 176

Chapter 8
Using Monte Carlo Simulation 179
8.1 Introduction 179
8.2 Building Uncertainty Directly Into the Modelling Process 180
8.3 Probabilities, Cumulative Probabilities, and Frequency Distribution Charts 182
8.4 Modelling Example 187
8.4.1 Identifying the Key Risk Variables 188
8.4.2 Choosing a Probability Distribution for Each Input Variable 188
8.4.3 Performing the Simulation Runs 190
8.4.3.1 The Simple VBA CODE 192
8.4.4 Creating a Histogram (Frequency Distribution Chart) in Excel 195
8.4.5 Interpreting the Results 200
8.4.6 Some Issues of Concern 201
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203

203
203
204
205

207
TABLE OF CONTENTS

Walking through the Excel Model Provided with the Book

Other Excel Files Provided with the Book

(SteelCo SA 4yr Business Plan)

Structure of the Model

Introduction
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Appendix
1.

2.

Index
x
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Preface

O ver the past several years, spreadsheet models have been the dominant vehicles for finance
professionals to implement their financial knowledge. Moreover, in the aftermath of the
recent financial crisis the need for experienced Financial Modelling professionals has steadily
increased as organizations need to plan and adjust to the economic volatility and uncertainty.
The level of risk in taking certain decisions needs to be projected using proper financial
models and the alternative possible outcomes need to be analyzed. One benefit of this type
of analysis is that it helps companies to be proactive instead of reactive. They can avoid or
at least mitigate potential negative results that may stem from influences in their industry or
within the business itself.
This book provides a step-by-step guide that takes the reader through the entire process
of developing long-term projection plans using Excel. In addition, by making use of various
tools (Excel’s Scenario Manager, sensitivity analysis, and Monte Carlo simulation) it provides
practical examples on how to apply risk and uncertainty to these projection plans. Although
these projections are not guarantees they can help organizations to be better informed, and
thereby provide peace of mind.
Financial Forecasting, Analysis and Modelling: A Framework for Long-Term Forecasting
covers financial models in the area of financial statement simulation. It provides clear and con-
cise explanations in each case for the implementation of the models using Excel. It is relevant
to a variety of situations. At the most fundamental level, it can help:
▪ Project a company’s financial performance;
▪ Forecast future cash flows and perform a DCF valuation;
▪ Present the good, basic, and bad scenarios of the evolution of the company’s debt
covenants.
At a more advanced level it ensures that the financial analyst or decision-maker is properly
informed and comfortable when called to decide the following types of question:
▪ What will be the double impact on the liquidity of the organization of a simultaneous
increase of 35% in turnover and a decrease of 10 days in the credit period provided to
clients?
▪ What will be the range of the company’s net debt at a 95% confidence level based on
selected assumptions?

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Acknowledgments

I owe a debt of gratitude to many individuals who helped me with this book. Foremost is my
wife Eleftheria for the support and encouragement she provided to me. Furthermore, I would
like to thank my parents for their tireless efforts to support me in every step of my life. Their
determination and drive have been a constant inspiration. My special thanks go to Nikos Kara-
nikolas, a magnanimous reviewer, who provided detailed written suggestions in a response to
the publisher’s request for his review. Also I really appreciate the insightful comments of my
esteemed colleague Carmen Mihaela Bulau on many of my manuscripts in spite of her hectic
schedule.
Finally, I appreciate the efforts of all the people at John Wiley & Sons who have helped
make this book happen. In particular I would like to thank Werner Coetzee (Commissioning
Editor), Jennie Kitchin (Assistant Editor), Caroline Quinnell (Copy Editor), and last but not
least Kelly Cracknell and Abirami Srikandan - Hoboken (Production Editors), who guided me
through the production process.

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About the Author

ichael Samonas is a finance professional with extensive experience in Financial Planning,

M Analysis and Modelling. He is currently the Group CFO of SIDMA S.A., a member of the
Viohalco Group of companies. He has worked in the past for various multinationals including
Vodafone S.A. and the Hellenic Telecommunications Organization conducting a range of
models for business planning, valuations, mergers, projects, and data analysis. For a number
of years Michael was an instructor at the School of Business & Economics of the University
of Laverne, Athens Campus. A regular contributor to financial and business journals, Michael
has taught specialized courses in Financial Analysis & Business Modelling, Credit Analysis
& Cash Flow Forecasting, and Investment Evaluation & Appraisal.
Michael holds both MSc and PhD degrees from the Department of Physics and the Elec-
tronic & Electrical Engineering Department of University of Surrey as well as an MBA from
the University of La Verne California. He also holds a BSc degree in Applied Accounting from
University of Oxford Brookes (with honours) and is a Fellow of the Association of Chartered
Certified Accountants (ACCA).

xv