CHAPTER THREE

EXCEL IN ACCOUNTING:
Microsoft Office Excel was designed to support accounting functions such as budgeting,
preparing financial statements and creating balance sheets. It comes with basic spreadsheet
functionality and many functions for performing complex mathematical calculations. It also
supports many add-ons for activities such as modeling and financial forecasting, and seamlessly
integrates with external data to allow you to import and export banking information and financial
data to and from other accounting software platforms.
Budgeting and Statements
Microsoft Office Excel ships with templates for creating budgets, cash-flow statements and
profit-and-loss statements, which are some of the most basic documents used in accounting. In
addition, you can download more complex budgeting and statement templates from the Office
website, or purchase specialized templates from third-party vendors and install these in the
application. If you need to create complex or custom budgets or financial statements, you can
either customize an existing template and re-use its elements, or create one from scratch using
the functionality built into Excel.
Spreadsheets
Performing line calculations is a basic accounting task, and Excel spreadsheets are designed to
contain data in a tabular format that supports both in-line and summation calculations, replacing
the need for ticker tape and special accounting calculators. The data in the spreadsheet is
reusable and storable, making Excel more flexible than an accounting calculator for performing
simple calculations and summations. Additionally, you can create charts and graphs from the
spreadsheet data, creating a media-rich user experience and different views of the same data.
You can also use add-ons to mine the data and create models and financial forecasts.
External Data
You can import data from many different data sources into Excel. This is especially useful for
accounting as you can pull sales data, banking data and invoices from many sources into one
central workbook to support your accounting activities. The data can be stored in different
databases and file formats prior to importing, allowing you to access data from many different
areas of your business without having to do additional data entry
Integration
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Excel integrates with many popular accounting software applications. For example, you can use
the wizards that ship with your preferred accounting software package to map Excel spreadsheets
to your accounting data so you can perform push and pull data operations from both Excel and
your accounting package on demand.
PREPARING COMMON SIZE STATEMENTS DIRECTLY FROM TRIAL BALANCE:
What the Common-Size Reveals?
The biggest benefit of a common-size analysis is that it can let an investor identify large or
drastic changes in a firm’s financials. Rapid increases or decreases will be readily observable,
such as a rapid drop in reported profits during one quarter or year.
In IBM's case, its results overall have been relatively steady. One item of note is the Treasury
stock in the balance sheet, which has grown to more than a negative 100% of total assets. But
rather than alarm investors, it indicates the company has been hugely successful in generating
cash to buy back shares, which far exceeds what it has retained on its balance sheet.
A common-size analysis can also give insight into the different strategies that companies pursue.
For instance, one company may be willing to sacrifice margins for market share, which would
tend to make overall sales larger at the expense of gross, operating or net profit margins. Ideally
the company that pursues lower margins will grow faster. While we looked at IBM on a stand-
alone basis, like the R&D analysis, IBM should also be analyzed by comparing it to key rivals.
Common size statements directly from trial balance:
A common-size financial statement is displays line items as a percentage of one selected or
common figure. Creating common-size financial statements makes it easier to analyze a
company over time and compare it with its peers. Using common-size financial statements helps
investors spot trends that a raw financial statement may not uncover.
All three of the primary financial statements can be put into a common-size format. Financial
statements in dollar amounts can easily be converted to common-size statements using a
spreadsheet, or they can be obtained from online resources like Mergent Online. Below is an
overview of each statement and a more detailed summary of the benefits, as well as drawbacks,
that such an analysis can provide investors.

Balance Sheet Analysis:

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The common figure for a common-size balance sheet analysis is total assets. Based on the
accounting equation, this also equals total liabilities and shareholders’ equity, making either term
interchangeable in the analysis. It is also possible to use total liabilities to indicate where a
company’s obligations lie and whether it is being conservative or risky in managing its debts.
The common-size strategy from a balance sheet perspective lends insight into a firm’s capital
structure and how it compares to rivals. An investor can also look to determine an optimal capital
structure for an industry and compare it to the firm being analyzed. Then he or she can conclude
whether debt is too high, excess cash is being retained on the balance sheet, or inventories are
growing too high. The goodwill level on a balance sheet also helps indicate the extent to which a
company has relied on acquisitions for growth.
It is important to add short-term and long-term debt together and compare this amount to total
cash on hand in the current assets section. It lets the investor know how much of a cash cushion
is available or if a firm is dependent on the markets to refinance debt when it comes due.

Analyzing the Income Statement

The common figure for an income statement is total top-line sales. This is actually the same
analysis as calculating a company's margins. For instance, a net profit margin is simply net
income divided by sales, which also happens to be a common-size analysis. The same goes for
calculating gross and operating margins. The common-size method is appealing for research-
intensive companies, for example, because they tend to focus on research and development
(R&D) and what it represents as a percent of total sales.
Below is a common-size income statement for IBM. We will cover it in more detail below, but
notice the R&D expense that averages close to 6% of revenues. Looking at the peer group and
companies overall, according to a Booz & Co. analysis, this puts IBM in the top five among tech
giants and the top 20 firms in the world (2013) in terms of total R&D spending as a percent of
total sales.

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Common Size and Cash Flow:
In similar fashion to an income statement analysis, many items in the cash flow statement can be
stated as a percent of total sales. This can give insight on a number of cash flow items, including
capital expenditures (capex) as a percent of revenue. Share repurchase activity can also be put
into context as a percent of the total top line. Debt issuance is another important figure in
proportion to the amount of annual sales it helps generate. Because these items are calculated as
a percent of sales, they help indicate the extent to which they are being utilized to generate
overall revenue.
FORECASTING FINANCIAL STATEMENTS USING EXCEL:
KEY PRINCIPLES

 Good forecasts must be consistent with historical performance and the current industry
outlook.
 Look at historical numbers in relationship to others and use these ratios, particularly the
operating ratios, to make your projections.
 All forecasts are estimates and approximations. Spend the time thinking and developing
your ideas about the big picture, not the third decimal place.
 If the forecast looks too good to be true, it probably is.
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  Re-examine your assumptions.

INCOME STATEMENT ACCOUNTS

Revenues
For industrial/manufacturing types of companies, revenues drive the other numbers in the model.
Here are things to think about as you make your forecast:
Revenues are the result of three main components: price, industry growth, and market share.
Isolating the price growth from inflation will give you the measure for volume growth.
Understand that in the context of the economic cycle, and then concentrate on what the drivers
for future industry growth and market share might be.
Add back the inflation component (typically very low at 1–2 percent in the United States) to get
the full estimate of future revenues growth.
Unless you are looking at new industries (new drugs, new telecommunications), most businesses
are mature and should grow at around the growth of the economy. Gross domestic product
(GDP) growth rates would be a good proxy. Your particular company’s sales growth will also be
affected at different points of the product cycle by new entrants and competing new
technologies. Remember also that fast-growing businesses have very dramatic price and volume
falls as the demand reaches a certain point. If your company does not have a position of
advantage, it will lose market share, and your volume estimates must reflect that.
If your company has product lines that have very different characteristics, it would be
worthwhile to forecast the individual product lines. Where they are similar enough, it is better to
think in broad aggregate terms and forecast only one revenue line. There is no need to get super
precise price and volume numbers for the forecast years.
Take into account the characteristics of the industry your company is in. Some industries have
price controls or restrictions, which would limit your own forecasts.
Margin Assumptions
 Analyze the trends in the historical accounts, such as cost of goods sold as percentage of
sales, SG&A (sales, general & administrative) as percentage of sales, etc. Your forecasts

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 should be consistent with these trends, while taking into account what you know of any
improvements or changes in the company’s operating systems.

 If there have been striking changes in the margins, you should try to understand the
reason.

 Look at the trends in the context of the economic and product cycles.

Depreciation
 Although it can be convenient to forecast depreciation as a percentage of sales, the
relationship to sales is indirect.

 Depreciation is determined by net PPE (plant, property, and equipment), which, in turn, is
affected by capital expenditures. Capex typically vary with sales.

 If some precision is required, the best way to model depreciation is to lay out the
depreciation that is associated with each year’s new capital investments.

 Depreciation for tax purposes and for book purposes can be different. This will lead to
the creation of deferred taxes.

BALANCE SHEET
Cash
There are two kinds of cash account in the model. One is the cash that the company needs to
have on hand to handle day-to-day expenses. We can think of this as ‘‘minimum cash.’’ You can
attach an interest rate to this, but more likely than not, this cash is not kept in the bank and so it is
not earning interest. Because this cash also reflects operational needs, it makes sense to forecast
this as a percentage of sales.
The other is the cash that is automatically produced by the model when liabilities and equity
exceed assets the Surplus funds row. You do not forecast this account directly. Rather, is a result
of the forecast assumptions you make for other parts of the balance sheet and indeed the income
statement, too. (It may be that your assumptions will create a need for additional debt, in which
case you would not see the Surplus funds line.) To the extent that you will have Surplus funds,
make sure that you enter an interest rate.

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Short-Term Investments
If your company has this account, you may want to forecast the same level going forward,
without any growth. By holding it steady, you will be able to see more clearly the rate of buildup
in Surplus funds or Necessary to finance.
Operating Assets and Liabilities
A large part of the balance sheet is there to support sales. As sales grow, these operating assets
and operating liabilities must also grow by a more-or-less proportionate rate. As a result, you can
forecast them based on a relationship to revenues in the income statement.
 The operating assets are:

 Accounts receivable

 Inventory

 Other current assets

 Net PPE

Other assets. You should check if these are related to operations or investments; if the latter, they
should be forecast at some growth rate, not as a percentage of sales.
 The operating liabilities are:
 Accounts payable
 Other current liabilities
You can project these items on the basis of the last historical year, but you should take into
account any variations from trends that are booming or reversing. Any unusual or extreme
change is a call for delving further into the information to find out what the reasons may be.
ANALYZING FINANCIAL STATEMENTS BY USING SPREADSHEET MODEL:
Spreadsheets provide a roadmap of analysis. The maps present the big picture and delineate the
“territories,” i.e., the major components of analysis. These maps help users keep the big picture
in mind as they work through the details. The spreadsheets provide a template that can be filled
in with real data for hands-on illustrations. The power of spreadsheets becomes apparent when
one compares them to the traditional sequence of text narratives, algebraic derivations, numerical
examples, and computations of metrics for real cases. Spreadsheets condense this teaching
material by an order of magnitude and enable what-if analyses. In addition to condensing the

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material and presenting it using spreadsheets, our materials also clean up the terminology and
provide a logical sequence of otherwise disparate topics. They show how valuation drives FSA.
As to the use of the materials for actual investment analysis, these spreadsheets have three
distinct uses. First, they provide three new metrics namely long-run return on book equity
(ROBE), adjusted cash earnings (ACE), and excess implied return (EIR). Second, they
summarize otherwise detailed models. Investment managers often face models that are too
detailed and overwhelming. By bolting our summary spreadsheets and metrics as “dashboards”
on top of these detailed models, the investment managers can internalize the key drivers of these
models. Third, the spreadsheets show the equivalence of various valuation approaches used in
practice. This helps investment managers reconcile apparent differences between various
approaches. There are four spreadsheets on FSA and four on valuation.

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