What is the primary objective of financial modelling?
To project the future and capture expectations about income statements, balance sheets, and cash flows
Financial modelling aims to provide realistic expectations of future financial performance.
What should expectations in financial modelling reflect?
- The economics of the industry
- The competitive advantages and risks of the firm’s strategies
- The drivers of the firm’s profitability and risk
What are the key principles of forecasting in financial modelling?
- Project future operating, investing, and financing activities
- Produce realistic expectations of future earnings, cash flows, and dividends
- Avoid wishful thinking
- Ensure financial statements are comprehensive
defining a clear objective, gathering and analyzing relevant historical data, selecting appropriate quantitative and qualitative methods, documenting assumptions and decisions, projecting future financial statements like the income statement, balance sheet, and cash flow statement, and continually monitoring and evaluating forecast performance against actual outcomes
True or False: Financial statement forecasts must have external validity.
True
What is the first step in projecting an income statement?
Start with projecting revenues
What two factors determine revenues in financial modelling?
- Sales (volume)
- Price
What is a challenge in projecting revenues for cyclical firms?
There is an extra layer of difficulty due to economic fluctuations
What are the two common methods of the top-down approach in forecasting?
- Growth relative to GDP approach
- Market growth and market share
What does the growth relative to GDP approach involve?
Forecasting GDP and estimating growth based on GDP
What does bottom-up forecasting start with?
The different product lines of a company
What is a hybrid approach in forecasting?
Combines elements of both top-down and bottom-up approaches
What is the assumption about operating costs in financial modelling?
Operating costs are normally assumed to grow at the rate of sales
What should be looked for in a company’s footnotes regarding costs?
Evidence of hedging strategies
What are the two types of capital expenditures?
- Maintenance
- Growth
What is the purpose of smoothing forecasts?
To expect random fluctuations around a generally smooth average of growth over time
What indicates a need for a company to raise additional capital?
If assets > liabilities
What reflects changes in the balance sheet in the statement of cash flows?
Increases/decreases in assets and liabilities
What is a company’s primary task regarding cash flows?
To generate cash flows at rates of return on invested capital greater than its cost of capital
What does ROIC stand for?
Return on Invested Capital
What does NOPLAT represent?
Net operating profit less adjusted taxes
What factors can lead to a higher ROIC?
- Charging a price premium
- Producing more efficiently
What is the impact of input cost increases on pricing?
They are likely to cause higher prices for end users
What are factors that enhance a company’s pricing power?
- Few substitutes with high switching costs
- Unique product offerings
- Low rivalry among competitors
- Low supplier bargaining power
- High barriers to entry
What does Porter describe regarding pricing premiums?
Achieved through innovative products, quality differences, and customer lock-in
