CHAPTER 1

Introduction to Financial Modelling

1.1 – Unusual approach
We are all living in a very uncertain and unprecedented time. Covid 2nd wave has been
brutally devastating and has caused a lot of pain and misery to humanity. I hope you are
your family are staying safe. Please double mask if you really have to step out. I hope
humanity does not have to face this situation ever again, and we get out of this situation
as quickly as possible.

Let me start this module on Financial Modelling with an apology. I know this module was
due for a while now. I know, I’ve taken a lot of time to get started on this. There were

😊
multiple reasons for the delay, but that’s all behind now. Here we are, all set. I’m super
excited to deliver this module, and I hope you are excited as well

But there are a few things to note before we get started –

Financial modelling as a subject is taught either in the classroom or in a video format.

There is a reason for this – while teaching this subject, at any given point, we tend to
open up multiple threads and then tie it all together in the end. So in a sense, there are
hops, jumps, crisscrossing, and a bit of number juggling. Given the nature of this
subject, it makes sense to teach this online or via a physical classroom setup.

Think of it as producing a movie. I’m sure you understand that a movie is not shot scene
after scene in a sequential manner. Different scenes are shot, songs are recorded,
action scenes are shot, edited, and then patched together and eventually made to look
like the entire movie was show scene after scene.
In a sense, financial modelling is very similar. You will understand this better as we dig
deeper.

I don’t know if financial modelling is taught in the classic article format. I could make a
huge mistake attempting this task, but I think it is worth the shot.

As I just hinted above, the learning won’t be sequential. We will have multiple threads
open; numbers will crisscross and move from one sheet to another, adding to the
non-sequential learning format. But that’s the way this will go, so please be prepared for
it.

As we progress through, you will realise that Financial Modelling is more of an art form
than financial science. We throw in a ton of assumptions while building any financial
model. The assumptions may vary from person to person based on the individual’s
experience.

However, the good part is that the model we create will very easily accommodate
changes and updates; this flexibility makes financial modelling a beautiful endeavour.
1.2 – What are you learning and why?
Perhaps an essential question – what is ‘Integrated Financial Modelling’, and why do we
need to learn this?

Think about a typical company; as you can imagine, the company can have several
moving parts. For example, a manufacturing company can have a team procuring raw
materials, workforce to manufacture goods, admin team, finance team, regulators,
compliance, marketing, supply chain, distribution, R&D, and whatnot.

Given the enormity, how do you break a company down into smaller parts and gain
meaningful insights into its functioning? How do we gauge its efficiency?

Well, this is where financial modelling comes into play. Eventually, whatever the
company does, it all boils down to numbers and metrics.

For example, successful operations lead to revenue generation, successful cost

management leads to operating profits. Good financial practice leads to manageable
debt levels; good supply chain management leads to better inventory management.
Good dividend policy strikes a balance between a company’s growth and shareholder
value. So on and so forth.

So the approach we take here is that if we can systematically analyze the numbers
presented in the financial statements, perhaps it opens up a window to understand the
company better.

When I talk about understanding financial statements, I’m talking about getting into
granular details; we go line by line. Many often assume that a series of simple financial
ratio analysis results in great insights into the company. Yes, to some extent, it does, but
we can do a lot more to better understand the company.

Better understanding leads us to a better insightful investment decision.

Think about Financial modelling as a systematic way to understand the company. Here
is what the name, ‘Integrated Financial Modelling’, means –

Financial = Indicates that we are working with the company’s financial statements

Modelling = Indicates that we are laying down a company’s financials systematically,

connecting these financial statements and subjecting the same to a bunch of equations.
The entire thing tied together is called a model, a model with specific input (financial
statements) and a specific output (valuations).
Integrated = Implies that all the numbers are interconnected, and no part of the financial
model is isolated. You will understand this better as we progress through building the
financial model.

The end objective of any financial model is to help you build a perspective of valuation.
The final output of the financial models is the company’s share price after factoring in
everything that matters. You take the share price from the model, compare the share
price against the market share price, and figure if the stock is fairly valued, undervalued,
or overvalued.

😊
The ultimate satisfaction is when you know that the stock is undervalued and available
for a throwaway price in the market, trust me on that

1.3 – Tools of the craft

Let me break the ‘not so good news’ first – to learn, build, and benefit from a financial
model; it is mandatory to have some background knowledge about the following –

○​ How to read an annual report

○​ How to read the financial statements of the company – Balance Sheet,
P&L, Cash Flow
○​ It would be best if you were comfortable working with MS Excel or any
other software similar to MS Excel

The good part is that you can learn how to read the annual report, Balance sheet, P&L,
and Cash flow in the fundamental analysis module.

Unfortunately, we don’t have a module on MS Excel, so please try and self-study MS

Excel. If you are uncomfortable with any of the three topics mentioned above, please
stop right now and learn these things before learning Financial Modelling.

Please do note, when I say you need to know how to read financial statements, I only
mean that you need to know this from a user’s perspective. As long as you know the
basics, that is good enough.

The same goes with Excel. It would help if you were good enough with essential
functions and formats. I don’t expect you to have the knowledge required to build a
complicated dashboard on excel.
The good news is that when I decided to learn Financial Modelling, I had no clue about
the three things I mentioned above. I had to learn these things first and then get back to
financial modelling. If a person like me can do this, then I’m confident anyone can.

By the way, financial modelling as a concept can be applied to any part of market
finance, be it investing or derivatives trading. Financial modelling is nothing but a
structured way of thinking through a complex problem; some even call this ‘Design
thinking’ of sorts.

If you are a regular reader of Varsity, we have dabbled with Financial Modelling in the
module related to Risk management and in the Trading systems module. It’s just that
we never called it ‘Financial Modelling’.

This module, however, will be focused on Fundamentals and Financial Modelling for
investments.

1.4 – The steps involved

At this point, I’d like to share with you a brief overview of the steps involved in creating
an integrated financial model. These steps only give you a sense of direction. We will
dig deeper into each of these steps as we proceed.

These are the steps involved in building a financial model –

Set up a layout – Perhaps the most crucial aspect of financial modelling. I foresee
myself stressing on this several times throughout this module, so bear with me. A
typical Financial model will have multiple excel sheets within a single workbook. We
need to ensure our Excel workbook is appropriately indexed and formatted and the
format stays consistent across the entire model.

For example, if I’m dealing with 2018 data in column ‘E’ of my excel sheet, I’ll ensure
that column E across all the other sheets will always deal with 2018 data. Or here is
another example of the layout, column A and B will be shrunk to ensure easy indexation
across all the sheets.

At this point, this may come across as a bunch of vague statements, but you will
appreciate these points as we progress along.

Historical Data – A rather painful task, but this need to be done. We need to download
the Annual report of the company we are dealing with, preferably for the last five years.
We need to extract the balance sheet and P&L data from the annual report and input
this in our excel sheet. Of course, we will be dealing with consolidated numbers here
and not standalone data.

Most importantly, please use the annual report as your primary data source and not any
other 3rd party data vendors.

Assumption Sheet – Remember I spoke about financial modelling as an art form rather
than financial science? Well, we create an assumption sheet and dump all our
assumptions in one sheet here. We assume things about the company should be close
to reality; the further we go from reality, the more distorted our model gets. Let me give
you an example.

Suppose a company’s revenue is growing at 7% year on year for the last five years;
what do you think will be the growth rate for the 6th year? If we have to assume
something, it has to be in the region of 7%, unless you foresee a significant change.
Anything higher or lower will distort the P&L from reality.

Asset and other schedules –Throughout the model, we create something called a
‘schedule’. We create a schedule with oversized line items. For example, the asset
schedule deals with plants, machinery, and all the company’s fixed assets. We lay down
the numbers in a systematic way and deal with them. For example, we extract the gross
block number, depreciation, netblock, and even the CAPEX figures in the asset
schedule.

So a single schedule gives us insights into multiple aspects of the company.

Like the asset schedule, we create other schedules such as – reserves schedule and
the debt schedule.

Projections – Once the assumptions are complete and the schedules, we project the
balance sheet and P&L for either 3 or 5 years forward. This is one of the crucial steps
while building the model.

Cashflow derivation – Again, a very crucial step in financial modelling. In this step, we
derive the cash flow statement using the P&L and Balance sheet data, called the
‘indirect method’, of cash flow preparation. Note, unlike the Balance sheet and P&L
data, historical data of cash flow is not extracted from the annual report but instead
derived. This step can be tricky; it sometimes works and sometimes does not work due
to its complexity.

Hence we will also look at alternatives here.

Ratios – Once all the data is in place, we can quickly draw up ratios and charts for our
model. The ratio sheet will include things like liquidity, solvency, profitability ratios etc.
Valuations – In the valuation sheet, we deploy the discounted cash flow method of
valuation and finally value the company. Think of this step as including a model within a
model. Of course, we will have sufficient checks and balances in places to ensure we
are not going way off the mark, and even if we do, the sensitivity tables that we develop
should help us get back on track.

These are roughly the steps involved in developing a full-fledged integrated financial
model. While it makes it seem simple, trust me, it is not.

I’m excited to dig deeper. I hope you are too, so buckle up for the ride 😊
Key takeaways from this chapter
○​ A financial model takes in inputs in the form of financial statements and
gives us an output mainly in terms of valuations
○​ Financial modelling involves a non-sequential learning path
○​ Multiple discussion threads open up while building a financial model
○​ Basic working knowledge of MS Excel, Balance Sheet, P&L, cashflow is
mandatory before venturing into financial modelling
○​ There are 7-8 steps to follow while building a financial model
○​ The model that we build has to be flexible to accommodate changes and
updates.
 CHAPTER 2

Excel Workbook Setup

2.1 – Selecting a company
I never expected such a tremendously positive response for the previous chapter. I’m a
bit overwhelmed, and I also get a sense that there are many expectations from this
module. I hope I won’t disappoint you all, and this module lives up to its expectation. I’ll
give it my best shot to explain what I know about financial modelling.

At this point, I’d like to spend some time to help you understand the kind of companies
to pick when building a financial model for the very first time.

A common mistake a newbie financial modeller makes is picking a complicated

company to build the first financial model.

When I was trying to learn financial modelling, I picked a company called ‘Hanung Toys’,
and as the name suggests, the company made toys!

The company had no other line of business apart from making toys; it had a simple
P&L, simple balance sheet, no complicated company structure, no complicated financial
structure. If you read the annual report once, you’d get a quick hang of what the
company does and the factors that influenced its growth.

I’m so glad that I picked ‘Hanung Toys’ as my first company to model. It was easy to
build a model due to the lack of complexities involved.

At the same time, a friend of mine picked Hindalco as his first company to model.
Everything about Hindalco was intimidating – the annual report ran into several pages.
The company manufactured Copper and Aluminium, captive power units, complex debt
structure, complex financial statements, cyclicality in earnings; commodity prices were
dependent on international markets, and whatnot.

Eventually, my friend lost interest to learn financial modelling, and he never really got
back to it. So don’t let this happen to you.

Here is a suggestion, please model the same company that we would model in this
module. Replicate what we discuss here by yourself and post that you can try to model
a company independently.

😊
By the way, just to let you know, an experienced financial modeller would love to model
a company like Hindalco for the same reasons I mentioned above

Please note that I may not be able to help each one of you with the model you’d build.
I’ll attempt to teach you a framework in this module; you will have to build on it. I hope

😊
you understand the difficulty of looking at 100’s of different models by the many readers
here. It would be impossible for me
So if you are the first-timer, then keep these points in mind –

1.​ Pick a company that is simple to understand. For example, don’t straight
away pick Reliance Industries. It is complex to model for a first-timer (for
an experienced person too)
2.​ Between a manufacturing and service-oriented company, pick
manufacturing. It is easier to understand manufacturing concepts, i.e.
number of units produced, raw material, inventory, etc. Services can be a
bit vague.
3.​ The company should have 1 or 2 products that contribute to the revenue.
The higher the number of products, the higher the complexity involved.
Think of an FMCG company; they have 100s of products, which means
100s of dependencies, making it tough to model such companies.
4.​ Pick a company that gives out as much information as possible in its
annual report. Just to let you know, Infosys is one of the best companies in
terms of information provided in the annual report. The more information
the company provides, the fewer assumptions you have to make in your
model, and that’s good news.
5.​ Ensure the company you pick is consistent in its annual report. Let me
explain this. Assume, I pick a company which manufactures and sells
mobiles phone. The company operates in India and Sri Lanka. The
company states how many units sold in India and Sri Lanka in its first-year
annual report. The company also reports the revenue generated in both
these countries. In the 2nd year annual report, the company chooses to
disclose only the revenue generated from both the countries but decides
not to give the data on the number of units sold. This is an inconsistency
in reporting, and such inconsistencies make it difficult to move ahead with
the model
6.​ Avoid banks, financial services, and NBFCs. They are just too complex
and have a ton of regulatory issues. The model we are about to learn may
not work for the BFSI sector, so please be aware of that.

Keep these few points in perspective before you pick a company to model. However, as
your first model, I hope you will consider my suggestion and replicate the model we use
in this module on your own.

Throughout this module, we will have one ‘Main model’ running and few helper models.
I want you to understand the context in which I will use these different models –
 ○​ The main model – In the main model, we will start with a blank excel
workbook and build our model step by step. We will pick a company and
stay with it throughout.
○​ Helper model – I’ll probably use 1 or 2 different companies to help different
sections of the main model slightly more detailed. The objective of the
helper model is to help you understand concepts better.

Think about it as learning how to become a master chef. While the end goal is to create
magic with your cooking, but along the way, you also need to practise your knife silks to
cut veggies efficiently.

By the way, I’d like to thank my ex-student and now a good friend Vishal Vindoorty, for
helping me with this module. Many years ago, I taught him financial modelling and
today; he teaches me.

So I guess life has come a full circle 😊

With that in place, let’s start by taking a baby step in this chapter.

2. Excel workbook setup

2.2 – Reimagine data presentation

Like I mentioned in the previous chapter, the very first step in building a financial model
is to refer to the annual report, extract the balance sheet and P&L data and input the
same in the excel sheet.

Of course, this is a time-consuming task, but a super important task as the data that you
copy from the annual report acts as the key input to the entire model. So please do this
task with at most devotion. At any cost, resist your temptation to copy-paste numbers
from 3rd party sources.

Different people have a different opinion on how many years of historical data to
consider. A common preference is to either take the last seven years or the last five
years of data. I belong to the five-year camp.

When I usually discuss the first step of financial modelling, i.e. copy the last five-year
historical balance sheet and P&L data from the annual report to an excel sheet, people
imagine something like this –
You see above is the usual way people copy the balance sheet data from the AR to their
excel sheet. The image below shows how historical P&L gets copied –
Well, yes, what you see above is technically correct. One has indeed copied the data
from the annual report to an excel sheet, but if you do it this way, as shown above, it’s
called a ‘model suicide.

The data is presented in a very unsystematic manner. So if you had imagined

something like this, then it’s time to let go of that and reimagine how data is presented
in a model friendly way.

2.3 – Set up your excel sheet

One has to set up the excel worksheet in a systematic way. The format should be
consistent across all the other sheets within the workbook.

Here are a series of steps to follow, even before we start copying the historical data
from the annual report. Think of this as a sub-step to step 1.

Open a blank excel sheet and save it with whatever name you’d like –
Index Column A and Columb B, expand Column C, and Index column D. ‘Index’ in this
context means just to shrink the column. Here is how my excel looks after indexing the
columns –
One of the things I like to do is to get rid of the gridlines in excel. The gridlines in a
financial model can be pretty distracting, especially when you have so many numbers
and formulas to manage.

So get rid of it if you can. After getting rid of the gridlines, I’d also like to freeze panes by
keeping my cursor on cell D3.

Here is how my excel looks now –

I hope you are aware of how to get rid of gridlines and freeze panes. These are basic
excel skills. If you are struggling at this point, please stop, maybe refresh your excel
skills, and get back to this later.

We now enter the years from E2 to I2 to indicate the year’s we are interested in. My
excel now looks like this –
We now label this sheet as the P&L statement (in cell A1) as shown below –
I like to keep ‘Profit and Loss statement’, in bold, font size 14. You can see below the
line that I’ve added another line that says that all the numbers stated in this sheet are in
INR Crores unless specified.

So if you see a number like 14.2, then it means that the number is 14.2 Crores Rupees
and not just 14.2. I’ve italicized the line and reduced the font size to make it look better.

What you see above is a basic skeleton of the model. We need a few similar-looking
sheets within the workbook. Remember, we will have other data sheets to include the
Balance sheet, assumption sheet, cash flow sheet, etc. So it’s a good practice to set up
multiple sheets with similar structure in one shot. You can do this in the following way.

Press the Control button in your system, and click on few sheets. By doing so, you’d be
selecting a few sheets in 1 go. When you select multiple sheets, whatever changes you
do in one sheet will replicate in the other sheets as well.

Here is how my sheet looks before I press control and select the other sheets.
As you can see, all the sheets except Sheet 1 are selected. I’ve not selected Sheet 1
since the sheet is already set up, and I don’t want to mess with it.

Now, in sheet 2, I do all the above steps that we discussed, except –

○​ Freezing panes, because freeze panes do not work when you have
selected multiple steps (or at least I don’t know how to do it)
○​ Title the sheet (like Profit and Loss statement) because each sheet will be
called something different.
After setting up sheet 2 –
Please note, all the sheets continue to be selected. I’ve executed all the steps, except
for the ones I mentioned above. Now excel will deselect the selected sheets the
moment you click on a different (non selected) sheet. So go ahead and click on Sheet 1
to deselect.

Now check sheet 3,4, and 5. These sheets should look precisely similar to Sheet2. In
each sheet, go to cell D3 and free panes.

While at this point I don’t know what I’ll do with Sheet 3, 4, and 5, I do know that Sheet 2
is for the Balance sheet. So I’ll title it as ‘balance sheet’ (cell A1).
By the way, do notice that I’ve renamed Sheet 1 and 2 as Profit & Loss and Balance
sheet, respectively. You can do this by keeping your cursor on the sheet and
right-clicking your mouse.

I’d like you to take a minute to relook at what you’ve done so far.

In fact, this is a big step in your financial modelling journey. What you’ve done so far is
to ensure that you set up your excel in a very systematic way. You have five sheets
open, and all five sheets have a similar structure.

I now know that Column E represents FY16 data, F to FY17, E to FY18, and so forth
across the entire model.

The structure won’t change, and it’s a huge deal. It’s called the ‘ Hygiene factor’ in a
model, and that, in my view, is a super important aspect.

With this note, I’ll end this chapter. In the next chapter, we will copy the data from the
annual report to our excel sheet.

You can download the excel sheet for this chapter from here, and by the way,
congratulations for successfully executing (well, almost) the very first step of financial
modelling.

PS: Are you curious to know what happened after I built the financial model for Hanung
Toys? The model suggested that the company was way overvalued, and hence I never
invested in it.

I’m so glad I dint.

Key takeaways from this chapter
○​ Pick a company that is easy to model (at least in your initial days of
financial modelling)
○​ The manufacturing sector is slightly better to model compared to the
services sector
○​ Look for reporting consistency in the annual report
○​ Do not blindly copy data from the annual report onto the excel sheet
○​ Set up your excel sheet before you can copy the data
○​ Ensure your excel sheet is consistent
 CHAPTER 3

Historical Data
3.1 – Annual Report recce
Picking up from the previous chapter, now that we have our excel sheet set up, we will
extract the data from the annual report to our blank excel sheet. The excel sheet at this
stage should look like this –

And a similar page set up for the profit and loss statement.

Now, before we start extracting the financial statements data from the annual report to
the excel sheet, we need to conduct a simple survey of the annual report. Remember,
for our financial model; we need the historical financial data from the last five years. We
will use the data of the last five years as the primary input for the model.

It is essential to ensure that the last five years data is consistent and there no missing
items in the statements. Let us understand this with a quick example.
Assume this is the revenue section of the P&L for an imaginary company –

Year 1 –

○​ Gross Income
○​ Duties
○​ Net Income
○​ Other income

Year 2

○​ Net income
○​ Other income

The company states the Gross income and duties paid in year one, but in year 2, the
company states the net income directly. Inconsistencies like this can be a problem while
modelling since it creates multiple gaps in the model. For this reason, even before we
start copying the data from the annual report to the excel sheet, we need to first look at
the last five years annual report and ensure that the statements are consistent over the
years we are interested.

Let us go ahead do this now.

In the previous chapter, we discussed the ‘main model’ and the ‘helper model’. The
main model is the one in which we will build a financial model end to end, and the
helper model will help us understand concepts related to the financial model.

So I guess it’s time to introduce the company which will act as the first ‘Helper Model’.

We would be dealing with Relaxo Footwear. Relaxo is one of the largest manufacturers
of footware in the country.

As a first step, I download the company’s last five years’ annual report and put these in
a single folder. Usually, a listed company puts up the annual report in the ‘Investors’
section of the website. I’d suggest you download the same from Relaxo’s website.

My folder with the annual reports looks like this (I know this is basic stuff, but I’m posting
an image just for clarification) –
I’ve even renamed these reports in a format that I like. I now go ahead and open all
these annual reports side by side.

Please note, we deal only with the consolidated financial statements and not the
standalone statements.

I’ll start by reviewing the consolidated balance sheet of the company. At the very first
inspection, I can see that company changed the accounting format in 2018. How did I
figure this? Well, take a look at the below screenshots.

Balance sheet as stated in March 2016 –

Balance sheet as stated in March 2017 –
You’d probably know that in every annual report, the company states the numbers for
the financial statements for the year in review and the previous Financial year. This is
the case in the above two snapshots. However, for the Financial Year 2018-19 –

The company has restated the Balance sheet for FY 2016, 2017, and 2018. So as a
financial modeller, I’d ignore the financial statement from the 2016, 2017 Annual report
and take the numbers for FY 2016, 2017, and 2018 from the 2018 Annual report.

Next, when replicating the Balance sheet on excel, I’d take the line items as per the
latest financial year. Let me explain why; here is the balance sheet snapshot as per the
2020 Annual Report –
Under current liabilities, there is a line item called ‘Lease Liabilities’, but this was
missing in 2018 and 2019. But because it is present in the 2020 balance sheet, I will
have to consider this line item and include it in my excel sheet; of course, the value
against this line item will be 0 from 2016 to 2019, and INR 27.61 Cr in 2020.
I’m trying to suggest that if you take the line items as stated in the latest year annual
report, chances are you’d have covered almost all the line items. But this is just a hack;
it may not work all the time.

3.2 – Data extraction

Alright, with that in place, let’s start extracting the data from the Annual report to the
excel sheet we set up in the previous chapter. Of course, this is a lot of manual work,
but there is no other way around this. Remember, we start with a blank excel sheet;
we’ve only set up the skeleton for now. My sheet looks like this –

To start with, on the left-hand side of the excel sheet, I type down the line items of the
balance sheet. The order in which these line items are listed is the same order in which
the balance sheet is reported. Please take a look at the snapshot below; I’ve typed out
the assets side of the balance sheet.
Notice a few things here; I’ve used column A and B as an Index. I’ve typed out the
heading and subheadings in these columns. I’ve highlighted what I mean by main and
subheading here –
In column C, I’ve mentioned the actual description of the line item. There are two main
reasons to do this –

○​ Indexing and segregation of heading and subheading is an excellent way

to present financial statements. It not just looks easy on the eye but also
captures more information
○​ Navigation becomes easy

What do I mean by navigation? When you have a lot of data to deal with, you need a
quick way to navigate through it, and excel allows you to do that. I want you to do a
small exercise to appreciate the ease of navigation.

By the way, I’m assuming that at this stage, you’d have entered the asset side of the
balance sheet in your respective excel sheet, in the same way as I’ve done. If not, I’d
suggest you do that quickly before reading further.

Now place your cursor in cell B5, where we’ve typed ‘Non – Current Assets’. Now, press
the control key + the down arrow on your keyboard. The cursor should directly jump to
the next indexed cell, i.e. ‘Financial Assets’.

This quick jump helps you navigate faster and focus on the primary data chunks.
I’ll proceed to set up the liabilities side of the balance sheet as well. So at this point, my
balance sheet sans the values is set up. Here is the snapshot, but please excuse the
compressed image; this is the only way I can present the entire balance sheet in the
following image –
Once you’ve reached this stage, the next step is to copy the data from the annual report
to the excel sheet. Please do recollect; I’m looking at the 2018 balance sheet to copy
the data for 2016, 2017, and 2018.

Let’s deal with the ‘Non – Current Assets’ first. Here is the snapshot from the annual
report –

I’ll go ahead and copy the same onto my excel sheet –

So far, so good, I suppose.

3.3 – Assumptions, facts, and format
In the image above, I’ve deliberately placed my cursor in cell E6 so that you can see
that the number, 462.30, is copied from the balance sheet and not a calculated number.
In a sense, this number is hardcoded.

In the financial modelling world –

○​ The hardcoded number is considered as a fact because we are directly

copying the number from the annual report
○​ A calculated number is considered an assumption since we apply a
mathematical operation to arrive at the number.

Given this, it is essential to distinguish between the facts and assumptions in a financial
model so that the user of the model can quickly identify which numbers are flowing
directly from AR and the calculated numbers. Also, you will know where to look in case
of an error in your model.

I’ll explain how this can be done, but before that, let’s add up the total non-current
assets.
I’ve used the ‘=sum()’ function in excel to calculate the total non-current asset. The
calculated number is treated as an assumption since I’ve calculated this on my own.
The easiest way to distinguish assumptions and facts is to colour code the numbers.

You can easily colour code this by selecting all the hardcoded numbers in one go. Click
the function + F5’ keys on your keyboard; you should get the following pop up –

Now click on special, and select only constants and numbers like shown below –
After you click ok, excel will highlight the hardcoded numbers or the facts.
Now without deselecting the numbers, select a colour of your choice. I prefer light blue
for this, but you can pick whatever you like –

After you select the colour of your choice, you can keep the total non-current assets in
bold.
If you have managed to follow the above step, then the rest of it is pretty
straightforward. All you need to do is extract the numbers from the balance sheet and
P&L and put them on your excel sheet.

3.4 – Other things to note

Some of you may wonder about the necessity to add up the numbers and colour code
them. For example, one can copy the total non-current asset as well; why calculate it
separately?
We need to calculate these numbers because going further in the model, we will project
each line item in the balance sheet for future years. The total is calculated anyway.
Therefore, calculating it now will maintain consistency in the model.

Before we conclude this chapter, few formatting tips –

○​ Keep the numbers right-aligned

○​ Extend the decimal points up to two digits
○​ Keep all the heavy numbers in bold; these are usually the subtotal and
main total numbers
○​ Use double borders for cells wherever necessary

I’ve completed filling up the balance sheet. I want you to pay attention to few last things
–
I’ve calculated the total assets on the asset side by adding up the two subtotals, i.e.
total non-current assets and total current assets. I’ve taken a similar approach on the
liabilities side as well –
Lastly, to ensure my balance sheet is balanced, I run a ‘True’ and ‘False’ check.
Remember, if assets = liabilities, that means the balance sheet is balanced.
Since it’s true, the total assets are equal to total liabilities. Hence my balance sheet is
balanced. I’m not going to explain the data extraction method for P&L. It is a similar
process. Do let me know if you get stuck on any of the steps; I’ll be happy to explain.
But I do hope your P&L would look like this –
If you are attempting the P&L, you will notice that the ‘other expense’ in the expenses
section is expanded. I’ve done this deliberately to showcase that when you have a
heavy line item in the P&L, then it probably is not a bad idea to break down its
constituents. The reason for doing this is that we can model these lines items at a more
granular level, thus ensuring our model is realistic.

Remember, Relaxo is the helper model, and this won’t be our main model. We used this
to help us understand how data can be copied from the financial statements to excel.
We will move on to the main model in the next chapter.

By the way, ‘Historical data’ was supposed to be the first step of financial modelling, but
I hope you realise that many tiny little steps are hidden within the main step. You can
expect the same for all the other steps.
As an assignment, I’d suggest you replicate the balance sheet and P&L on your own.
I’m sure the learnings from this exercise will be exciting.

Download the excel sheet used in this chapter here.

Key takeaways from this chapter

○​ Perform an annual report recce before setting up the excel sheet

○​ It makes sense to take the latest year’s financial statement for the format;
the chances are that you will cover all the line items. But this is only a
hack
○​ Indexing helps in quick navigation
○​ Differentiate between fact and assumption data points. You can do this by
colour coding
○​ Maintain format hygiene across the sheet
○​ If need be, breakdown the heavy line to get a better granular view
 CHAPTER 4

Assumptions (Part 1)
4.1 – Model integrity
I want to start this chapter by talking about a super important concept. I may have
touched upon this topic earlier, but I would like to discuss it again with snapshots to
emphasise its importance.

In the previous chapter, we set up the balance sheet and P&L for the helper model.
Here is the snapshot of the same –

P&L –

And the balance sheet –

The model design ensures column E represent FY16 data, column F to FY17 so on and
so forth. We do this to ensure that the numbers get identified quickly and linkages
between cells are accurate.
For example, imagine a scenario wherein I want to calculate the ratio of Property, plant,
and equipment to the Total revenue for FY18. If you realize, to calculate this, I need to
divide a balance sheet item with a P&L item, which means I will have to crisscross
between sheets to do the math. This further means that I can easily link the wrong cells
without evening noticing it.

Anyway, let us go ahead and do this. I can easily calculate by linking the cells of
Column G in the formula bar –

Now consider a situation where you’ve linked the wrong years while calculating this
ratio. You can spot the wrong linkage easily –

In this case, I know column G in the balance sheet should be linked with column G of
P&L. The moment I see the G and F combination, I know something is wrong.

I’ve quoted a relatively simple example here. But as the model grows and gets more
complex, you’ll understand and appreciate the need to maintain the model integrity.

4.2 – Main model

It’s time to introduce you to the primary model. I’m sure many of you here would expect

😊
me to name the company we’d work on and also name the years under consideration.
But I have different plans

I’d rather keep the name and years under consideration unknown. I’m doing this for two
reasons –

●​ By not naming the company, I’ll hopefully eliminate biases one may have. For
example, if I use a footwear manufacturing company’s data, some may feel that it
may not apply to an auto component company. So I think it is better to keep it
generic to establish the fact that this model template applies to all companies
(except banking and NBFC)
●​ Hopefully, by not quoting years, someone reading this module five years later will
also understand that the overall structure of a financial model remains the same,
no matter when you decide to learn financial modelling.

But for the sake of your understanding, assume that we are dealing with a simple
manufacturing company’s data.
I’ve used the exact steps detailed in the previous chapter and set up the Balance Sheet
and P&L data. Here is the snapshot of the same –

Balance sheet –

I’ve shrunk my excel sheet to 70% to ensure I capture both sides of the balance sheet;
hence the numbers and format look a little different.

Here is the snapshot of the P&L –

A couple of things here –

○​ The years in consideration is Year 1, Year 2, Year 3 up to year 5 etc. It

means the latest 5 years of data. So even if you read this 10 years later, it
won’t matter.
 ○​ The data is from the Annual Report, as of March 31st,e. the financial
year-end
○​ Year 1A means Year 1 actual data. Year 6P means the year 6 data
projected. The projected data is also as per March 31st. In a sense, this is
our vision of how the financial statement will look like future annual reports

You can download the excel sheet from the end of this chapter. In the excel sheet, you’ll
find the raw P&L and Balance sheet data; I’d suggest you use that data and lay it down
in the format we’ve discussed. It will be good practice for you.

4.3 – Assumptions and Projections

Remember, in the first chapter; I mentioned that financial modelling is a bit of art and
financial science?

The art part starts now 😊

The idea behind a financial model, quite obviously, is to analyse the historical financial
statements and project them forward. The common practice is to project the number to
either three or five years forward. In this model, we will try and deal with five years
projections.

To get an initial understanding of this, I’ll post a set of questions and answers –

>>>> How will you project the financial statements for the future years?

>>>> Well, you can project the financial statements by making a set of assumptions.

>>>> How will you assume these things to help you make the necessary projections?

>>>> We can assume the future trends based on historical trends.

>>>> How will you measure historical trends?

>>>>> The measurement of historical trends happens based on individual line items in
the balance sheet and P&L. In most cases; we measure by taking a simple ratio of one
line item over another. At times, we can consider the year on year growth rate as well.

We will discuss this in greater detail later in this chapter.

>>>> After measuring the historical trend, how will you project the future trend?
>>>> There are two ways to make future projections – historical average or an
intelligent guess.

At this point, I just want you to read the above and keep this in the back of your mind.
Some parts may be clear, and some parts may sound confusing, but I hope by the end
of this chapter, you’ll get a clear understanding of this topic.

With that in mind, let us go ahead and make our first assumption for the financial model,
but before that, let’s set up our assumption sheet.

To set up the assumption sheet, please go to a new sheet in the workbook and rename
the sheet to ‘Assumption’ at the bottom.

Now, we do the usual, i.e. –

1.​ Index column A and B

2.​ Expand column C
3.​ Index column D
4.​ Cells E2 to I2 will be Year 1 to Year 5
5.​ Cells J2 to N2 will be Year 5P to tear 10P

I’ve followed the same steps, and here is how my excel sheet now looks.
The idea with the assumption sheet is to lay down each of the financial statements line
items and project it based on our assumptions. So let us go ahead and lay down these
line items. Let me start with the Balance sheet; take a look at these two lines in the
balance sheet, i.e. liabilities and provisions under the current liabilities section –

Now, recollect this part from the QnA we had earlier –

To measure historical trends, we usually take the line item as a ratio of another line
item. For the balance sheet, usually, the ratio is measured by keeping the ‘Gross Block’
as the denominator. Gross block, because the gross block is one of the most oversized
balance sheet items, also sucks up the company’s CAPEX.

So, if you were to look at ‘Year 2’, liabilities as a percentage of Gross block,

Liabilities as a % of Gross Block (Y2) = 102.74/310.58

= 33.08%

Of course, we can do this in excel directly –

Notice, I’m dealing with Year 2 data. Hence in the balance sheet, I divide F6 over F34.
You may wonder why I’ve done this for Year 2 and not for Year 1. This is because there
will be instances where we’d need to calculate the year-on-year growth rate, which
means our starting point will be year 2. Hence, for this reason, we ignore Year 1 and
directly deal with year 2. You will notice this pattern in several places throughout this
module.

Alright, now that we have calculated Liabilities as a % of Gross Block, we can drag the
formula across Y3, Y4, and Y5.

As you can see, liabilities as a percentage of gross blow hovers between 27% and 35%
consistently. So, if I were to figure out what this ratio would be for Year 6, I can just take
the historical average and get a perspective.

Let me do the same –

Congratulations! With this, we have projected the very first line item of our balance
sheet. Few things to note here –

○​ I’ve used the simple average function here

○​ The first average, i.e. for the year 6, is the average of Year 2 to Year 5
○​ The 2nd average, i.e. for year 7, the average is between Year 3 and Year 6
○​ We are calculating the rolling average here, so at any point, we consider
the latest four years data
○​ The average which we have calculated hovers within the expected range,
i.e. between 27% and 35%, so this is ok.
Whenever you calculate such ratios, it is best if the variance range is narrow. The
narrower the range, the more consistent is the average calculation. The more consistent
the average, the tighter is your model.

I’m not too happy with a range, i.e. 27% to 35%; it could have been better. If you are not
too happy with it, you can try exploring other ratios like ‘labilities as a percentage of total
assets or as a percentage of netblock or something like that.

Wait! So what should you consider? Liabilities as a % of the gross block, or netblock, or
total assets?

Well, this is where the art form kicks in. There is no guiding principle here. There is no
rule which says you have to consider the denominator as gross block only. I’ve taken it
because I’m comfortable with it.

The end objective here is to ensure the calculated numbers are as consistent as
possible. Also, don’t stress too much on this; after all, this is a financial model based on
excel. We can change things at any point during this journey.

I’ll now go to the next line item, i.e. the Provisions under the current liabilities. Again, I’ll
calculate provisions as a percentage of the gross block.

Hopefully, you get the drift by now.

Let us go back to the balance sheet for a bit –

Under the liabilities side, we have projected Provisions and Liabilities. What’s next is
shareholders funds and non-current liabilities. Usually, big-ticket items like these in the
balance sheet should be dealt with separately in the financial model. We deal with it by
creating something called a ‘Schedule’. Of course, we will talk more about schedules
later in the module, but for now, think about schedules as a separate dedicated sheet
within the financial model.

So all the things marked is treated in the schedule, where we will also make future
projections. That leaves us with just the deferred tax liabilities on the liabilities side of
the balance sheet.

For the deferred tax liabilities, I’ll consider the year on year growth rate. If you look at Y1
and Y2 numbers, it’s at 13.61 Cr and 16.95Cr. To calculate the year on year growth rate
–

(16.95/13.61) – 1

= 25.55%

Note, this is the growth rate for Year 2. On excel –

Of course, you can now drag the cells for the rest of the years, up to Year 5, and take
the rolling average from Year 6 onwards.

😊
We now move to the asset side of the balance sheet. Perhaps, I’ll take it up on the next
chapter, and I promise I’ll put up the next chapter soon

You can download the excel sheet used in this chapter from here; please note, this
excel also includes the raw data. I’d encourage you to use the raw data and build the
P&L and Balance sheet from scratch.
Key takeaways from this chapter

●​ Please pay attention to model integrity, as it helps you identify accurate cell
linkages
●​ One can calculate the historical trends either as a growth rate or by taking a
simple ratio
●​ Projections are made by taking averages or by making an intelligent guess
●​ It is best when the historical trends exhibit a non-volatile range
●​ Assumptions are an art form; there is no standard method to make assumptions.
Your guess is as good as mine.
 CHAPTER 5

Assumptions (Part 2)
5.1 – Deferred tax
A gentleman posted an interesting comment in the previous chapter. The company he
chooses to model did not present the gross block data in the way the company we are
dealing with has, i.e. –

Gross block – Depreciation = Net block

Instead, the company directly reported the ‘Net block’ data.

Given this, how would one go about building the assumptions with Gross block as the
base for many balance sheet based assumptions?

While the balance sheet reports only the ‘Net block’ number, the associated notes
usually carry the gross block and depreciation numbers. One has to extract these
details from the associated notes and rebuild the gross block.
It may sound a bit complex at this stage, but don’t worry; we will take this up in the next
chapter and lay down the steps involved one at a time.

By the way, I hope you got to look at the raw data of P&L and Balance Sheet and layout
the data in a model friendly manner. Assuming you’ve done that, we will now continue
from where we left off in the previous chapter.

The previous chapter calculated the deferred tax’s growth rate from Y2 to Y5 and its
average from Y6 to Y10. While this is ok, it still results in a somewhat volatile set of
numbers. There is a better way to do this, and I’d like to discuss it.

If you understand deferred tax, you’d know that it occurs due to the way depreciation is
treated. Hence deferred tax and depreciation is connected.

So, rather than taking the growth rate of deferred tax, it probably makes sense to
consider deferred tax as a percentage of depreciation.

For Y2, the deferred tax is 16.95Cr, and depreciation is 121.73 Cr. So deferred tax as a
percentage of depreciation for Y2 is –

16.95/121.73

= 13.92%

We can continue this for Y3, Y4, and Y5 on excel –

As you see, the numbers look much more stable. I’d request you to please make this
change in your model. Now, for the projections, you need to take the rolling average.
For Y6, it would be the rolling average of Y2 to Y5; for Y7, it’s the rolling average of Y3
to Y6 and likewise.

The resulting percentage range is also relatively stable.

Before you crib and curse me for making you redo the deferred tax bit, I’d like to tell you
that the growth rate method for assumptions is critical, and we will use it in this chapter
when we take up P&L assumptions.

So in that sense, you already have a heads up 😊

5.2 – Dealing with inventory
With the deferred tax assumption, we also complete the liabilities side of the
assumption. Please note that we have not made any assumptions for share capital and
borrowings; these are line items we will deal with separately by building ‘schedules’.

So we now proceed to the asset side of the balance sheet, and the first line item to
consider is the inventory.

If you look at the inventory data as stated in the balance sheet, you’ll realise the worth
of inventory that’s lying with the company. For instance, for Y1, the inventory worth was
92.17 Crs; for Y2, it’s 194.33 Crs, Y3 it’s 160.83 Crs etc.

Any manufacturing company ends up having inventories in its balance sheet, and as
you know, the inventory is nothing but the company’s finished goods. The objective of
the company is to sell the inventory as quickly as possible. Hence lesser the number of
days the company takes to sell the inventory, the better it is for the company.

Based on the nature of every company, the company takes up a certain number of days
to convert its inventory to sales.
For example, a company manufacturing pressure cooker may convert its inventory to
sales in 30 days, but a company manufacturing cars may take 75 days to convert
inventory to sales.

When it comes to the inventory assumptions, we take the following approach –

■​ Convert the Rupee value of inventory to the number of days the

company takes to convert to sales
■​ Find the average number of days for the future years
■​ Convert the average number of days back to the Rupee value for
the future years

😊
Sounds complex? Perhaps, but let’s go ahead and execute the above steps in our
model and see how it goes. I’m sure you’ll eventually find it easy

But before we proceed, why even take the pain of doing all the above? Why not directly
take the growth rate of inventory and its average and move ahead (like how we treated
deferred tax in the previous chapter)?

When you convert the Rupee value of inventory into the number of days to sales, you
also get additional insights about the company. These insights help make investment
decisions. For instance, imagine there are two companies manufacturing cameras that
are similar in all aspects. Company A takes 40 days to convert inventory to sales, and
company B takes 70 days to convert. What can you infer from this?

■​ Company A seem to have a better inventory management

■​ Maybe Company A has a superior product. Hence the market
prefer cameras from company A
■​ Or maybe Company B’s sales incentives for merchants is not as
attractive as A’s, so merchants tend to push Company A
■​ Perhaps, company A have efficient management, meticulously
planning these things

You see, the list of insights can go on and on. Hence it makes sense to take that extra
effort to juggle and calculate the inventory number of days and let’s do that right away.

On excel, the inventory number of days is calculated easily by applying a formula. I call
it the conversion formula because it converts the Rupee value of inventory to the
inventory number of days.
For Y1 and Y2, the inventory value is 92.17 Crs and 194.33 Crs, respectively. To
convert, we apply the following formula –

= (Average inventory of Y1 & Y2 / Materials consumed for Y2) * 365

In the denominator, you may ask why we use the materials consumed for Y2 and not
Y1. Well, this is because we are calculating the inventory number of days for Y2. If we
were to do this for Y1, then the formula is –

= (Average inventory of Y0 & Y1 / Materials consumed for Y1) * 365

Since we don’t have the Y0 data, we start with Y2.

So applying the formula for Y1 and Y2 –

= Average (92,17, 194.33)

= 143.25

Material consumed for Y2 (data available in P&L) = 762.86 Crs

=143.25/762.86

= 0.18778

Finally, we multiply the above result with 365 to get the inventory number of days –

= 0.18778 *365

= 68.53

The above number means the company takes about 68 days to convert 143.25Cr of
inventory to sales.

Of course, you can do this in excel in one shot –

Please notice, I’ve included ‘inventory number of days in the assumption sheet and
executed the conversion formula directly. I’d suggest you do the same in your excel.

Once I’ve calculated the inventory number of days for Y2, I can drag the excel to rows
Y3, Y4, Y5 and get the respective values.

Notice, the inventory number of days consistently ranges between 68 to 78 days. To get
a sense of how good or bad this number is, you need to compare it to a company
operating in the same sector, of similar size. For example, Bajaj Auto and Hero Motors
are similar companies doing similar business.

Moving ahead, for the Year 6 to Year 10, we can take the moving average of the
inventory number of days.

We have calculated the historical inventory number of days and projected the inventory
number of days for the future years.

In fact, you can take a similar approach to Sundry Debtor/Account receivables as well
i.e. to convert receivables from Rupee value to receivable number days and then back
to receivable in Rupee value.

In the next chapter, I’ll probably explain the process with the help of the helper model.
For now, let us move ahead with other balance sheets and P&L assumptions.

5.3 – Other Balance sheet assumptions

If you look at the asset side of the balance sheet, these are the line items stated by the
company –

We have dealt with the inventories already.

Just like on the liabilities side, we will build a schedule for the gross block. Cash and
Bank balance in current assets will be dealt with in detail in the cash flow statement.

We will make the assumptions for the remaining line items on the asset side. Let me
quickly run you through the thought process before we jump to excel.

■​ Sundry debtors – I’ll consider this as a percentage of Gross block

(but remember there is an alternate way i.e. to convert to days and
back)
■​ Loans, advances, and deposits – As you can imagine, this line item
is related to the company’s working capital. Hence I’ll consider this
as a percentage of net sales
■​ Other current assets – This is a small number for Year 1 and does
not exist for the rest of the years, so I’ll ignore
■​ Capital work in progress – As a percentage of net sales
■​ Investments – As a percentage of Gross block

Once I calculate the historical percentages, I’ll go ahead and calculate the rolling
average for the future years. Like I’ve mentioned earlier, feel free to change the
denominator based on your understanding of the firm and its financial statements.

😊
Remember, assumptions are the art bit in financial modelling; you are free to
experiment, but ensure it is not too way out of wack

So let me go ahead and implement the above in the excel sheet. I’ll post a series of
snapshots hopefully that will be self-explanatory –

I’ve continued on the assumption sheet and lined up the line items in the same
sequence as it appears in the balance sheet. Remember, I’ll do all the necessary
calculations starting from Year 2 for consistency with the other assumptions.

I’ve calculated the percentages for Year 2, and I’ve highlighted the loans, advances, and
deposits as a percentage of net sales. You can see both the formula bar as well as the
F16 cell. I’ve highlighted this to showcases the P&L line item in the denominator.
Hopefully, you will find this as an easy step to implement. Do let me know if you find any
difficulties in implementing this by commenting below.

In the next step, I’ll drag the rows to the right till year five, and from year 6 onwards, I’ll
take the averages.

I’ve highlighted the average calculation for your better understanding. For the last
balance sheet line item, i.e. investment as a percentage of Gross Block, I’ll not calculate
the average for Y6 to Y10. Instead, I’ll assume a constant of 3.5% of the gross block.

Why not the average like other line items? Why 3.5%? Why not 4% or 3%? These are
all valid questions.

The percentage calculated is quite volatile. It ranges from 3% to 11%, I’m not too happy
with it, and therefore I’d like to keep it at a constant 3.5%.

Why not 4 or 3%? Well, that’s the beauty of a financial model. Once the model is
complete, I can change this to any value that I think makes sense. Hence I don’t have to
stress on it now and stick to 3.5% and move ahead.
With this, we have completed the balance sheet side of assumptions. Whatever is left
out will be dealt with in the form of schedules.

We will now move ahead with the P&L assumptions; this should be pretty easy.

5.3 – P&L assumptions

Let us start by taking a look at the P&L –

There is the revenue side, and then the expenses side to the P&L. Revenue side has
the sales and other income data, while the expense has the details on all the expenses
incurred during the year.

Making assumptions on the expenses side is super easy; all these line items are
calculated as a percentage of the net sales or the total income. Revenues, on the other
hand, is very interesting. You can either calculate the growth rate or deep dive to build a
revenue model.

I want to discuss both these methods. In the primary model that we are dealing with, let
us discuss the growth rate method of revenue forecasting. However, we will take the
help of a helper model to build a revenue model.

Perhaps we can do both the revenue model and the receivable number of days in the
next chapter.

Moving ahead, I’ll create another section in the assumption sheet to accommodate the
P&L assumptions. Just for your clarity, this is how my assumption sheet looks at this
stage –

Under the new P&L assumptions section, I will proceed sequentially, in the same order
that the line items are present in the P&L.
Notice, as discussed earlier, I’ve considered the growth rate for net sales, and for the
remaining line items, I’ve considered these as a percentage of net sales. For example,
other income is the percentage of the net sale; and the increase in stock is also a
percentage of the net sale. So on.

Let us start with the Net sales growth rate; the growth rate is calculated the same way
we calculated the deferred taxes growth rate in the previous chapter. Here is the
snapshot of Net sales growth rate –
Yes, 81.83% seems high, but it is based on the net sales numbers reported by the
company in Y1 and Y2. Here is something interesting that you can do. If you feel the
numbers are unusually high, then you can always cross-reference how the peer
companies performed during the same period.

If a company belonging to a particular sector has done phenomenally well for a

particular year, its peer companies would most likely have performed equally well. For
example, if MRF posts a 20% increase in revenue for Y1, you should expect Apolo
Tyres to post a 20% increase in revenue. But for whatever reason, Apollo posts 16%,
then you know that MRF probably has the edge over its competition.

Of course, this is a very rough example, but I’m highlighting this to give you a
perspective of how you can think about companies while building the model.

I’ll go ahead and complete the P&L assumptions. As you can imagine, it is pretty
straightforward, or so I assume because we have done this in the balance sheet
assumptions.
I’ve highlighted the Year 6 cell for net sales to showcase that subsequent calculations
are all simple averages. Of course, this excel will be available for you to download and
inspect each cell.

If you look at the P&L, the last two items on the expense side are Depreciation &
Amortization and interest expense. These numbers will flow from the schedules that we
will build subsequently.

The assumption sheet is now complete, and this is how it looks –

I’ve compressed the image to ensure you get to see the entire page.

I hope you followed the steps we’ve discussed in this and the previous chapter. Please
do let me know if you have any queries; I’ll be happy to reply to your queries to the best
of my abilities.

In the next chapter, we will take the help of a helper model and understand how to deal
with receivables (assumptions) and set up a revenue model.

Download the excel sheet used in this chapter here.

Key takeaways from this chapter

■​ Deferred tax is as a percentage of depreciation

■​ Converting inventory data from Rupee value to the number of days
helps us develop unique perspectives into the functioning of the
business
■​ Likewise, with the Receivable data
■​ A detailed revenue model gives granular insights into the revenue
pattern of a company
■​ All line items belonging to P&L and Balance sheet are assumed in
the assumptions sheet. A schedule is built for the items which cant
be assumed directly
■​ Specific schedules give us granular insights into the specific line
item
 CHAPTER 6

Revenue Model
6.1 – Common sense approach
In the previous chapter, we built the Balance Sheet and P&L assumption. Within the
P&L assumptions, we dealt with the revenue of the company as well. We did take a
rather simplistic approach to estimate the revenue of the company. The approach is ok
as long as you intend to build a simple financial model.

However, at times, taking efforts to build a dedicated revenue model of a company pays
off. With a dedicated revenue model, you can identify the key revenue drivers and get
some granular insights into the behaviour of these revenue drivers.

In this chapter, I’d like to discuss the approach you need to take while building a
company’s revenue model. As you can imagine, the revenue model sits within the
integrated financial model, just like the assumption sheet.

Think of the revenue model as a sub-model within the financial model.

I’ll take the example of Bajaj auto in this chapter to explain how one can build a
company’s revenue model.

A sensible way to start building a revenue model is by asking common sense questions
about the company. In most cases, these questions themselves segways into a
template for the revenue model. We will take the same approach to build Bajaj Auto’s
revenue model.

So here are a bunch of common-sense questions, and the answers to these questions
will help us build the revenue model. By the way, the answers to all the questions are in
the company’s annual report.

So let us start.

6.2 – Digging data

As a first step, I download the latest annual report (FY 2020-21) from Bajaj Auto’s
website. I’d suggest you do the same. Like I mentioned, the annual report is where you
will find all the information you’d need.
Usually, from my experience, as the company matures, the annual report also evolves
and provides you with all the necessary information you’d need.

Anyway, let us get started with our common sense QnA. We will begin with a
fundamental question.

What does Bajaj Auto do?

No brainer, we have seen Bajaj Auto’s bikes and autorickshaws flood the Indian streets.
So it is evident that Bajaj manufactures and sells 2 and 3 wheelers. We will cross-check
our assumption from the annual report as well.
From their annual report, we can see that our assumption is correct (image above if
from the annual report). Bajaj does manufacture bikes and autorickshaws. The bikes
are further segregated into different segments.

The image below shows the ‘sports segment’ or ’S segment’ bikes. Apart from the S
segment, Bajaj has the Milage or M segment, Supersport or SS segment, Pro biking
segment, and scooters.

But the point is Bajaj manufactures’ bikes’ or two-wheelers, so let us stick to that for
now and ignore the segmentation of bikes.

Apart from bikes, they also manufacture autorickshaws’ Commerical Vehicles’ (CV) or
the three-wheeler segment.
The CV category has different segments: passenger carrier (good old autorickshaws)
and goods carrier.

Why are the segments important to a revenue model?

Well, if you know the segments within a category, you can also figure out the
segment-wise revenue.

For example, the S segment is a segment within the bikes category, it will interesting to
understand how much revenue they make segment-wise, and which are their popular
segments, and what drives these segments.

With this information, you can build a granular revenue model. Unfortunately, the
segment-wise revenue distribution is not available in the annual report. Hence we will
consider revenue for the entire category as a whole, i.e. the two-wheeler (bikes) and the
commercial vehicle (3 wheelers).

How much does Bajaj Auto manufacture?

I suppose this is also a straightforward question. As a financial modeller (or even an

investor), you need to understand the manufacturing capacity of the company. The
reason is simple.

Suppose they manufacture 100 bikes in the year, and if they are selling 60 bikes, then
with this information we can interpret the following –

■​ The manufacturing plant operates at 60% capacity utilization.

Capacity utilization is a simple ratio of how much they sell versus
how much they manufacture.
■​ The company has enough manufacturing buffer to meet future
demands
■​ The company is unlikely to spend more money in terms of CAPEX
anytime soon

Other perspectives –

■​ Why is the company selling only 60?

■​ How much do their competitors sell?
■​ Where does the company stand in terms of competition?
■​ How big is the industry? How many bikes (across all companies)
are sold in a year?
 ■​ What is the company’s market share? (company sales
divided/industry sales)

These questions will help us size up the company and eventually help the investors in
the valuation process.

Anyway, we will get back to the revenue model. I found this image in their annual report
interesting –

The image gives us all the information in one shot. Let me list down the information for
you –

■​ The company has three manufacturing units (or plants) in India,

located in – Pantnagar, Waluj, and Chakan.
■​ Waluj is the oldest plant (set up in 1984), while the Pantnagar plant
is their newest.
■​ All plants have been operational for a long time now.
 ■​ Pantnagar plant has a production capacity to manufacture 1.8M
bikes, no commercial vehicles here.
■​ Waluj plant has a production capacity to manufacture 2.4M bikes
and 9.3L commercial vehicles. Waluj is a super important plant for
Bajaj auto since this plant has production of both categories plus
this is the only plant to manufacture commercial vehicles.
■​ Chakan plant has a production capacity to manufacture 1.2M units
of bikes.

Since all the manufacturing facilities are old enough, assuming that the company has
had a similar production capacity for the last few years is fair.

Where do they sell?

The question is to help us understand where their target market is. We have seen Bajaj
vehicles across India. But do they sell in other countries apart from India?

Here is an extract from the annual report –

Without reading much into the details, we know –

■​ Bajaj Auto sells within India (domestic market)

■​ Bajaj Auto also sells outside India (international market)
From the extract, we can quickly note that Bajaj Auto sells around 2M vehicles in the
global market.

How many units of two-wheelers and CVs does Bajaj Auto sell in India and the
International market?

Now that we have established that Bajaj has a domestic and international market, it
makes sense to figure out how many units of bikes and commercial vehicles are sold in
India and in the International market.

From the annual report –

The highlighted data indicates the sale of domestic bikes. For example, in the year
2020, Bajaj Auto sold 3.9M bikes. The break up of 3.9M across different segments of
bikes is not available (therefore no segment-wise revenue). But that’s ok for now.

Data for Domestic CV sales –

As far as the exports are concerned, here is the snapshot –

The company has only reported domestic sales numbers across motorcycles (bikes)
and CV for FY20 and FY21. We will have to dig up the older annual reports for historical
numbers.

Ok, a quick recap at this point. So far we know –

○​ The product the company sells

 ○​ Places where it manufactures the products
○​ The capacity of each manufacturing plant
○​ The geographies in which the company sells
○​ How many units the company sells across all their markets

That’s a fair bit of information. We now have to steer our way to find out details about
how much money the company earns in terms of revenues.

Remember, so far, we collected information by asking ourselves a few common-sense

questions. Once we collect all the necessary information, we make the revenue model
on excel, step by step.

Let us continue our QnA.

How much revenue do they make?

The most crucial question perhaps 😊

Clearly, when we talk about revenue for this company, we need to figure four essential
things –

■​ How much revenue is from domestic bikes sales?

■​ How much revenue is from domestic CV sales?
■​ How much revenue is from international bikes sales?
■​ How much revenue is from international CV sales?

If we can collect the above information, we are on track to build the revenue model.

But here is where the challenge occurs; the company does not easily give out this
information. The information we have is –

Revenue is a consolidated number, which includes both domestic and export revenue.
But thankfully, Bajaj Auto gives us the export revenue –
With both these bits of information, we have to back work the details. For example, for
FY 2020,

Revenue =Rs.29,111 Cr

Export Revenue = Rs.12,216 Cr

So Domestic revenue must be –

29111 – 12216

= Rs.16,895 Crs.

Once we have the revenue split from domestic and exports, we can do few other things
to set up the revenue model.

6.3 – Connecting the dots

We have now gathered all the info required to build the revenue model. We now have to
plug these values into an excel sheet and give it a logical sequence. Please note that if
you are doing this yourself, as a first step, you will have to get the historical data from
the annual report. In the section above, I’ve highlighted how the data is collected.
Hopefully, that will help you accelerate your data collection process.

Given the data in hand, here are the steps that I’ll follow to develop the revenue model.
As I have stressed earlier, the steps that I follow make sense to me; if you feel there is a
better way, you should explore. Remember, there is no prescribed methods to build a
model.

But I hope these steps will give you a good starting point.

Here is the overview of the steps I’ll carry out on excel –

■​ Organize the capacity data

■​ Gather the International sales data, i.e. the number of units of bikes
and CV sold
■​ Gather the India sales data, i.e. the number of units of bikes and
CV sold
■​ Add up the sales data to get consolidated bikes and CV sales data
■​ Input the historical revenue data
■​ Calculate the average cost of sale of bike and CV
■​ Identify the trend in change of average cost of sale
■​ Project the average price of the vehicle and reverse engineer the
revenue data from the average prices.

If the steps above confuse you, then don’t worry, we will execute each of the steps, one
at a time.

As a first step, we set up our excel sheet with the indexation. I’ve discussed this in the
earlier chapters, so I’ll directly post the snapshot for your reference.

I guess you are reasonably familiar with the layout. Columns A and B are indexed, C
expanded, panes frozen at E3. The actual financial years stated from F1 to J1, and the
estimated years from K1 to O1.

I have organized the manufacturing capacity data. Note I have segregated this in terms
of bikes and CV, but you can also arrange the data from the manufacturing plant
perspective.
I have populated the manufacturing capacity numbers –

Note, the numbers are constant historically and for the future years as well.

Next up is the sales data. As I mentioned earlier, I’m interested in identifying the bike
and CV sales in India and Internationally. Once I have the data, I’m also interested in
year on year (YoY) changes in sales data.
As we saw earlier, most of the sales data is available in the annual report, except for the
India sales data for bikes. But this is ok; the company gives us the total bike sales (India
+ International) and the total international bike sales data.

If we calculate the difference, we get the India bikes sales data. So a bit of number
jugglery that you will have to do.

Next, we calculate the YoY change (in percentage) bikes and CV sales in the Indian and
the International markets.
The math is simple for the YoY change –

= this year’s sales data/ previous year’s sales data – 1

= year on year change in sales, expressed in percentage.

The idea of calculating the YoY percentage change is to identify consistent trends if any.
But clearly, there is no trend in the data we have.

We could have taken a rolling average of the yoy change and projected for future years
if there was a trend. But now, we have to assume a flat YoY change.

I’ll project the YoY change without thinking much (to move ahead quickly), but of course,
if this were a serious model (based on which you’d invest), then we would have to
spend some time before we make the YoY change assumptions.

You can see the assumption I’ve made for the sales YoY change in percentage. You can
also see the calculation that I’ve made to project the future year’s sale of bikes and CV.
I’ve completed the math, and here is how the excel sheet looks –
Please note, I’ve summed up the bike and CV sales from both the Indian and the
International markets to get the total sales. For your reference, I’ve highlighted the total
sales of bikes for FY22E.

In the next step, we move our attention to the revenue data. I’ve taken the revenue data
(India and International) from the annual report.

Below the revenue numbers, I’ve set up excel to calculate the average sale cost for
vehicles (bikes + CV) across the Indian and the international markets. To calculate this,
we need to divide the India revenue number by the India vehicles sold data.

Let me do this math for FY 17 –

Revenue from India (FY17) = Rs.14,815 Cr

Total vehicles sold in India (bikes+ CV) = 22,54,617

Average selling price of a vehicle = 14815*(10^7)/2254617

= Rs.65,709.61/-

If you wonder why I used 10^7 in the math above, then it is to get the revenue number
in Crores.

Here is how it looks on Excel –

I’ve calculated the YoY change in average cost of sale as well. I hope at this stage; you

😊
can figure what to do next. If you do, then I’d be happy to know that my notes are
helping you think ahead

Anyway, here are the last two steps to complete the revenue model.

○​ Assume a YoY change for future years, it could be a rolling average, or it

could be a flat assumption
○​ Project the average cost of sale in the Indian and the International market
○​ Multiply the avg cost of sale and the number of vehicles sold to get the
revenue in the Indian and International market
○​ Sum up both to get the total revenue.

I’ve executed all the above steps in excel, and here is how it looks –
I have highlighted both the cells so that you can see the formula I’ve used.

Here are few other things that you can do with the revenue model –

○​ We have the total bike and CV sales data. Compare this with the
production data. Ensure the company is not selling more than what it is
making. If yes, then our model may be wrong and needs some tweaking
○​ If the vehicles sold are close to manufactured, the company may have to
invest in a CAPEX cycle. This is valuable information from an overall
financial modelling perspective
○​ Calculate the capacity utilization, i.e. number of vehicles manufacture
versus the number of vehicles sold.
○​ Calculate the market share. You can get the industry bike/CV sales data
from an industry report (guess even the annual report contains this),
contrast this with what the company has sold, and get the market share
number.

I guess this has turned into a lengthy chapter; I’ll stop it at this. But I hope this chapter
has given you a sense of how you can develop a company’s revenue model using a
common-sense approach. Always remember to start your revenue model by asking few
basic questions.

The revenue model we have built here can be used for other auto manufacturing
companies like Hero Motors, TVS, MRF, Maruti, Tata Motors, and even Tesla!
You can download the excel used in this chapter here.

Key takeaways from this chapter

○​ The revenue model is a sub-model within your primary model

○​ You can build complex revenue models by starting with simple common
sense questions
○​ All the data needed to make a revenue model is usually available in the
annual report of the company
○​ Use the revenue model to extract other information like capacity utilization,
CAPEX cycles, and industry market share.
 CHAPTER 7

Asset Schedule (Part 1)

7.1 – Recap and way forward
In the previous chapter, we looked at how a basic common sense approach can lead us
to build a simple revenue model of a company. We made the revenue model using the
helper model. In this chapter, we switch back to the primary model and continue to build
our financial model.

To refresh your memory, so far in the primary model, we have –

○​ Set up the basic excel layout for the financial model (indexing, grids, pane
freeze)
○​ Input the balance sheet and P&L data. The data source for the model
input is the annual report of the company
○​ Colour coded the numbers to distinguish between assumptions and facts
○​ Built the P&L assumptions
○​ Built the Balance sheet assumption

Both P&L and balance sheet assumptions are in the same sheet, called the ‘assumption
sheet’. So far, our model has only three sheets –

○​ Assumption sheet
○​ Balance sheet, sheet
○​ P&L Sheet

While we did make assumptions for line items where ever possible, we left out few line
items to build a separate schedule for the same. I’d suggest you download the excel
sheet to get a quick grasp of where we are in our journey of building a financial model.

Over the following few chapters, let us go ahead and build these schedules.

We will start with the asset schedule.

7.2 – Base rule

 😊
Before we build schedules, we need to understand the concept of the base rule. It is a
simple concept, you’d probably already know this, but I might as well discuss it now

As usual, let us take an example.

We all know electric vehicles are making a buzz in the market. Ola has plans to
manufacture and sell electric bikes.

Consider for the sake of simplicity that Ola manufactures 4000 electric bikes in its first
year of operation. Here are few data points that I’ve made up –

○​ Number of bikes manufactured in 1st-year operations = 4000

○​ Number of bikes sold = 3750
○​ Number of bikes unsold = 250

On excel –
I’ve introduced opening balance, total bikes, and closing balance here. The opening
balance in this context is the number of unsold bikes carried forward from the previous
year. It is zero in this example since it’s Ola’s first year of operation.

Total bikes are the sum of opening balance and bikes manufactured. It is 4000 in this
case as the opening balance is zero.

The closing balance is the number of unsold bikes for the given year.

Now, let us assume that Ola manufactures and sells the same number of bikes in the
2nd year.

Can you pause and tell me what the opening balance, total bikes, and closing balance
for the 2nd year is?

I hope you got that right. If not, let me quickly explain –

The opening balance for year 2 is the closing balance of year 1. So, in this case, the
opening balance for Year 2 is 250.

They manufacture 4000 new bikes, so the total number of bikes is 4250, of which 3750
bikes are sold. Hence the closing balance for year 2 is 500.
The opening balance for Year 3 is the closing balance for year 2. So on and so forth.

The technique of linking the closing and opening balance is the ‘Base rule’. We use this
pretty much in all the schedules that we build, including the asset schedule. For now,
keep the base rule in the back of your mind. We will get back to it shortly.

7.3 – CAPEX
At this stage, let’s quickly understand what we are dealing with here. If you take a good
look at the assets (or application of funds) side of the balance sheet –

You will quickly understand that the Gross block is a large item. In fact, in most balance
sheets (at least for manufacturing companies), the gross block is the most significant
chunk on the asset side. More so, when it comes to the balance sheet assumptions, we
have used gross block extensively –
Given its heavyweight, it makes perfect sense to dig deeper into Gross block and
strengthen our understanding. I would suggest you do this little exercise –

○​ Pick a company of your choice and open its annual report

○​ Open the balance sheet, check the asset side, and pay attention to the
Gross block
○​ Notice the associated note number
○​ Look at the notes in detail

What do you observe? You are likely to notice the following –

○​ Gross block is also called ‘Property, plant, and equipment.’

○​ Gross block is (most likely) the heavyweight on the asset side
○​ Few companies may report gross block, deduct the depreciation, and
report the netblock
 ○​ Few companies report the netblock directly

Further, the associated notes give you a detailed breakup of the gross block, so the
notes give you a sense of the nature of this line item. Gross block invariably includes all
the details related to the assets the company holds –

○​ Land (freehold and leasehold)

○​ Improvements for leasehold lands
○​ Buildings
○​ Plant and machinery
○​ Computer hardware
○​ Factory equipment’s
○​ Electric fittings
○​ Vehicles (including aircraft)
○​ Maintenance and repair works

The things listed here are ‘CAPEX’ in nature. Now, what is CAPEX?

Capital expenditure or just the CAPEX of a company are funds used by the company to
invest, upgrade, and maintain physical assets such as the ones listed above. For
example, if the office roof is leaky, money spent on fixing the roof gets reported as
CAPEX.

Or if a manufacturing company wants to build a new manufacturing plant, then right

from acquiring the land (or leasing), to setting up the plant with equipment and factory
machinery is considered as ‘Capital expenditure’.

Some companies can take up projects so large that the capital expenditure can run
across several consecutive years, draining the company of its financing avenues. Of
course, companies do this with an expectation that the future payoff from the project far
exceeds its current capital expenditure.

When such capital expenditure occurs across many years, it’s called ‘the CAPEX cycle’
of a company.

As an analyst, it is crucial to understand if the company is going through a CAPEX cycle

(expansion) or running just the maintenance CAPEX. If the company is in an
expansionary phase, you need to understand why, how, and will the payoff likely exceed
the current cash burn.
If the company’s CAPEX is essentially maintenance CAPEX, then you need to figure if
the maintenance CAPEX is something that the company can sustain through year on
year.

Whenever I think of how maintenance CAPEX can be taxing, I remember my friend’s

story.

A good friend of mine (a regular salaried person, like many of us in Bangalore) sold a
plot in Bangalore and suddenly became cash-rich overnight. The first thing he did was
reinvest the bulk of cash into another property. With the remaining money, he bought
himself a fancy BMW, and with that, he expended all the cash he gained from the sale
of the property.

The maintenance CAPEX on the BMW is quite heavy – its fuel-guzzling, hefty insurance
premiums, and repairs are super expensive. His salary was not supportive of such a
CAPEX in the first place. Eventually, he had to sell the car.

I detoured to give you this story to bring your attention to the maintenance CAPEX of
the company.

Ensure the company earns enough to maintain its assets.

7.4 – Estimating CAPEX

We discussed Ola earlier in the chapter, so let me continue the same example here.
Assume, Ola commenced its manufacturing operation with an initial CAPEX plan of
500Crs for year 1. Assume they invest 500Cr into acquiring land, machinery,
equipment’s, assembly lines, etc. Remember, this is also Ola’s gross block.

What do you think is Ola’s opening and closing gross block?

We know that for year 2, the opening balance is the closing balance of year 1. Assume
Ola does another 100Cr worth of CAPEX in year 2.

I hope it is clear so far. In year 3, assume Ola does not add any Capex but rather sells
off machinery worth 50Crs. What do you think is the closing balance for Year 3? And
what is and the opening balance for year 4?

Here is the table –

Again, the opening balance for Year 4 is the closing balance for Year 3. Hopefully, this
example gives you a sense of calculating the opening and closing balance of the gross
block.

When you look at the balance sheet of companies, they directly report the gross block
(or property, plant, and equipment) number. Of course, they do not state the CAPEX
number in the balance sheet. For example, in the model that we are working on, the
gross block numbers are as follows –

These numbers are good enough starting point to develop the asset schedule.
7.5 – Asset schedule
We will now start building the asset schedule for the model. As a first step, let’s set up
our excel sheet. Setting up the excel is precisely the same as the other sheets in the
model –

Let’s roll out the base rule in motion; hopefully, you get the drift here –

As you can imagine, I’ve linked the closing gross block for Year 1 as the opening gross
block for Year 2.

The closing gross block for year 2 is 310.58, and this means the assets of the company
has increased –

310.58 – 257.78

= 52.80

Hence the CAPEX for year two must be 52.80 Crs. Since the CAPEX has increased,
there has been no disposal of assets. I can add this on excel –
I hope you found this easy to understand because it is 😊
I can continue the calculation the same way for the rest of the years.

The numbers here will match the numbers stated in the balance sheet, but we have
managed to extract the CAPEX numbers from gross block, which wasn’t explicitly
available in the balance sheet.

Remember, the end objective is to arrive at the netblock of the company. Net block, as
you know –

Gross Block – Depreciation = Net block.

Sounds straightforward, but here is a twist.

I want you to quickly take a look at the Y2 depreciation numbers stated in the Balance
sheet and P&L. Tell me what you think?

Y2, depreciation in the Balance sheet is 121.73 Crs, and for the same year,
Depreciation in P&L is 24.45 Crs. Which one will you consider here?

Well, you have to consider both.

Remember, depreciation is an expense. Hence it gets stated in P&L as an expense for

that year. But this year’s depreciation gets carried over to the following year in the
balance sheet; hence it’s called the accumulated depreciation.

Let us deal with it in excel. Here is how I’ve set up my sheet –

Yes, we will apply the base rule again. I’ll take the closing balance for year 1, set that as
the opening balance for year 2. I’ll add to this the current year depreciation stated in the
P&L. When I add the opening balance and closing balance, I should get the closing
balance of the accumulated depreciation for year 2. The number I get here should
match the depreciation number stated in the balance sheet.

As per the base rule, the closing balance is 125.39Crs, but as stated in the Balance
sheet is 121.73 Crs. A difference of nearly 3.66 Crs.

How and why is this difference?

Well, the difference arises due to the small asset write-offs and adjustment that
happens. We treat this as a depreciation non-expense. If you adjust for this, the
numbers should match.
I hope you’ve been able to keep up with this. It is not too complicated, but as a person
doing this for the first time, you may find it overwhelming.

Now that we have calculated the gross block and the accumulated depreciation getting
the netblock is pretty straightforward.

Net block is the difference between the closing gross block and the closing balance of
depreciation.

I’d suggest you match this with the netblock number in the balance sheet for your
reference.

7.6 – Capex projections

Now that we have set up the asset schedule, we need to move ahead and make some
projections here.
The most crucial projection here is the CAPEX projection. It is super important to
understand how the company will be dealing with capital expenditure over the coming
years. Now, because this is such an important figure, companies usually explicitly state
their CAPEX plans. You can get this information by reading the management discussion
analysis or the analyst reports (or even watching a business channel).

I’d suggest you take some time to watch this interview to the context into how you can
project the CAPEX by considering management’s statements.

https://www.youtube.com/watch?v=Wa-kUaIcm4E
In this recent interview, the CFO of Bajaj Auto clearly states the CAPEX requirements
for the coming years. In my view, this kind of information is more valuable than any
projection we can do.

If you don’t have access to this kind of information, then you have two alternatives –

○​ Find out the average CAPEX and assume the averages hold for the
coming years
○​ Variable method, here you look at the company’s historical CAPEX. If the
company has been through an expansionary phase (high capex spend),
you taper it down. Alternatively, if the company has had a low CAPEX
cycle, you gradually increase the CAPEX spend.

Remember, both these techniques are your alternate. Your first option should be the
management itself.

In this model, we will use the variable method. Historically, the CAPEX was high, so I
will gradually taper it down with an assumption that the company is through with the
bulk of its CAPEX cycle. I’ve also assumed that the company has zero disposal of
assets.
Now that you have the CAPEX number, isn’t it easy to figure the Closing gross block
number? Of course, it is. Let us complete this –

Now that we have the closing gross block number, we can plough these numbers back
to the balance sheet.

😊
With this, we have made our first balance sheet projection, so congratulations on that

But why did we plough this back into the Balance sheet right away? Why not complete
the depreciation projections and then make the projections in the balance sheet? Well,
there is a reason for that.

I’m tempted to continue that explanation here, but I guess this is a super long chapter
already. I promise I’ll put up the next chapter quickly, which will have this explanation.

Stay tuned until then!

Download the excel used in this chapter here.

Key takeaways from this chapter

●​ As per the base rule, the closing balance for year 1 is the opening balance for
year 2. We use base rule across many schedules in a financial model
●​ Gross block includes all the assets that the company owns; usually, the gross
block number is a heavyweight on the asset side
●​ Capital expenditure or the CAPEX of a company includes all funds spent on
acquiring new assets or maintaining assets
●​ Asset schedule helps us extract the CAPEX numbers from the gross block
number
●​ To project the CAPEX, ideally, one should look at what the management has to
say
●​ Other CAPEX projections techniques include the averages and the variable
method.
 CHAPTER 8

Asset Schedule (Part 2)

8.1 – Hello depreciation
We closed the previous chapter with our first balance sheet projection, i.e. the gross
block. This chapter will complete the asset schedule and plug the numbers back to the
P&L and Balance sheet.

At this stage, here is how the asset schedule looks –

The gross block looks tidy. We will now have to work our way through depreciation. The
biggest challenge with forecasting the accumulated depreciation is getting the current
year depreciation number, which, as you realise, flows from the P&L statement.

Here is the snapshot of current year depreciation as stated in the P&L –

Investors are often confused about these two depreciation numbers, i.e. the
accumulated depreciation stated in the balance sheet and the current year depreciation
number displayed in the P&L (on the expense side).

The current year depreciation stated in the P&L is the depreciation value (in Rupee
terms) applicable only for the financial year under consideration. The company’s finance
team calculates the current year depreciation by factoring in all the assets (gross block)
on its books. The current year depreciation stated in the P&L changes for each year
based on how the gross block changes.

On the other hand, the accumulated depreciation in the balance sheet is on a

cumulative basis. The depreciation number gets rolled over on year on year basis. In
other words, the current year depreciation (from P&L) gets added over to the next year
depreciation, thus forming the accumulated depreciation for this year.

Don’t worry if you find this confusing; you will understand this better shortly, but for now,
I want to you think about the direction we are heading in.

We have already projected the Gross block number. If we can project the current year
depreciation number in the P&L, we can apply the base rule again in the asset schedule
and forecast the accumulated depreciation number.

After we forecast the accumulated depreciation, we can also calculate the netblock of
the company. Finally, the net block number from the asset schedule flows back to the
balance sheet.

By carrying out the above steps, we achieve two things –

 ○​ Project the current year depreciation number in P&L
○​ Get the projected netblock number in the asset schedule, which gets
plugged back to the balance sheet

Everything depends on techniques to forecast the current year depreciation.

Before we proceed, a slight but relevant digression 😊

I want you to think about the following situation. Assume you are a freelance
photographer with a variable monthly income. Your income depends on the work that
comes your way. You are also responsible for managing your household expenses.

Your monthly income for October is 25K, of which you spend 3K on entertainment.

The next month you earn 30K. How much do you think you should spend on
entertainment for the month of November?

The easiest way to do this is to spend in the same proportion as you spent in October.
In October –

3000/25000

= 12%

Hence for September,

12% * 30000

= 3600

We have used the method of proportions here. I want to extend this thought and project
depreciation for the current year.

For Year 5, Depreciation and Amortization stated in P&L is 41.71Cr. The gross block, as
stated in the balance sheet for Year 5, is 538.76Cr. The projected Gross Block for Year
6 is 588.77 Crs. Given this, what do you think will be depreciation for Year 6?

Let us apply the proportion technique.

For gross block worth 538.76Cr, the company reported depreciation of 41.71Cr, which
means –

41.71/538.76

= 7.74%

For Year 6, the gross block value is 588.77 Crs, so what is the depreciation given the
same proportion?

7.74% * 588.77

= 45.58Cr

With this, we can estimate that the depreciation for the next year would be 45.58Crs.
Remember, this number flows into the P&L.

The depreciation value will remain the same at 7.74%.

You can extend this a bit more. Instead of taking the previous year’s proportion and
assuming the same proportion will hold for the next year, you can calculate the
depreciation to gross block ratio for all the historical years and then take the five years
rolling average for the future years.

It will look something like this –

Y6 = Average of Y1 to Y5

Y7 = Average of Y2 to Y6

Y8 = Average of Y3 to Y7

So on and so forth.

You can choose either technique; I’ll stick to the first technique for simplicity.

Of course, the 3rd alternative is to dig deep into gross block and get into the accountant
shoe to figure the exact depreciation value; you can do that if you have a strong
accounting background.

Going back to the P&L with the 1st technique, I can directly input the formula –

As you can see, in cell J16, which points to the Depreciation expense for Year 6, I’ve
divided the depreciation amount stated in P&L for year five over the gross block stated
in the balance sheet for year 5. The result of this division is the depreciation proportion,
which I then multiply by the gross block projected for Year 6.

The resulting value is the depreciation amount for Year 6. Note, this is a projection that
we are making. I can extend the same math to all the future years and get the
depreciation expense for the year.
 😊
By the way, we also made our first P&L projection, so it’s a tiny baby step in our
financial modelling journey

At this point, my P&L looks like this –

Alright, with this in place, let’s go back to the asset schedule.

8.2 – Accumulated depreciation

Some of you may have guessed the next few steps already. It is pretty simple, we go
back to the asset schedule sheet and plug in the current year depreciation number from
P&l. Once we have that, we use the base rule to complete the accumulated
depreciation.

Here is how I’ve plugged the number from P&L –

We have the closing balance for Y5, i.e. 223.68Cr, which becomes the opening balance
for Y6. Add to this the current year depreciation, and we should get the closing balance
for Y6. Of course, we won’t get into the depreciation non-expense bit as there is no
visibility on this line item. Hence will keep it at zero for all the future years.

I’ve applied the base rule to get the closing balance of accumulated depreciation. The
netblock is the gross block – accumulated depreciation, which I’ve projected for future
years.

Of course, you take the accumulated depreciation number from the asset schedule and
complete the netblock calculation in the balance sheet.
With this, we have projected the Fixed assets section in the balance sheet.

In the next chapter, we will discuss the debt schedule.

Key takeaways from this chapter
○​ Accumulated depreciation stated in the balance sheet is on a cumulative
basis.
○​ The current year depreciation stated in the P&L is for the year only
○​ You can use the method of proportions to forecast the depreciation for the
year
○​ You can apply the base rule to forecast the accumulated depreciation
○​ Netblock = Gross block – accumulated depreciation
 CHAPTER 9

Debt Schedule
9.1 – Dealing with debt
We dealt with fixed assets in the previous chapter. The fixed assets, as you realize, is
the most oversized line item on the asset side of the balance sheet. In this chapter, we
will deal with the debt, which is present on the liabilities side of the balance sheet.

We will use the base rule again to help us deal with debt.

If you glance over the balance sheet, on the liabilities side, you’ll see the debt figures –

There are three things to note here –

○​ The debt numbers are ‘non-current, in nature. This means these are
long-standing debt, carried across multiple years
○​ Secured loan – loan against collateral (mainly in the form of tradable
securities)
○​ Unsecured loan – Non-collateralized loan.

Generally speaking, an unsecured loan comes at a higher rate. In our model, we have
secured and unsecured loans stated separately, but this may not always be the case.

To give you a perspective, I’ve picked the balance sheet of Relaxo Footwear here to
highlight the borrowings –
The borrowing is under current liability, which means the borrowing is short term in
nature. As you can see, the company generalizes the ‘borrowing’ and does not specify if
it’s secured or unsecured. To figure the nature of borrowing, you can dig deeper into the
associated notes; note 15 in this case.
The notes specify that there is no non-current borrowing. But if you notice, there was a
non-current, secured loan in 2019, which is repaid.

For FY 2020, the current loan outstanding (Rs.19.16 Crs) is secure. Further, we can
also see the securities tendered for securing the loan.

Take another example –

We have the balance sheet of Biocon Limited for March 2021. The company has
borrowings under both current and non-current liabilities side. Note that the company
does not give any details of the nature of these borrowings in the balance sheet.
Instead, the associated notes give us all the details.

Here is the snapshot of Note 14, giving the details of the borrowings under the
non-current liability side –

The borrowing is both secured and unsecured.

The details of the current liability borrowings are as follows –

Now, as long as you get the split of the loans, you can build a debt schedule using the
technique we will discuss in this chapter.

9.2 – Sheet setup

We will set up a sheet similar to the asset schedule. I suppose you are pretty familiar
with how to go about setting up the sheet –

We follow the usual format protocol here, i.e., index columns A & B, expand column C,
freeze panes, and link Y1 to Y10 from cell E to N. I hope you are comfortable with the
base rule to deal with the opening and closing balance figures. Else, I’d suggest you go
through the previous chapters to figure how.

As you can see below, I’ve set up the base rule for both secured and unsecured loans.
In cell E8, I’ve linked the secured loan value of Year 1 to denote the closing balance for
Y1. As per the base rule, the closing balance of Y1 works as the opening balance of Y2.

For Y2, the closing balance of the secured loan is Rs.226.65 Crs, clearly suggesting
that the company has new loan issues to the extent of Rs.119.16Crs.

Further, in Y3, we see that the closing balance for the secured loan is Rs.207.83Crs,
which implies that the company has repaid a portion of the loan.

You can extend the same for all the years for secured and unsecured loans and build
the sheet. Here is how my sheet looks now –

The next bit is the projection of how the future year new issues and repayments will look
like. The best way to estimate this is by understanding the management’s CAPEX
plans. If the management has ambitious CAPEX plans, I think it’s fair to project the
debt, keeping the management’s guidelines in perspective.

I’d like you to watch this video clip, where the CMD of HPCL talks about CPAEX plans
and the means to fund the CAPEX –
https://www.youtube.com/watch?v=HiCybI9sjEY

The CMD also states figures to indicate the amount via debt. The point here is that
when you have to project the new issue and repayment figures, always look for what the
management has to say. You can find this information by skimming through the annual
reports, analysts conference call transcripts, management interviews etc.

If none of that is available, then you will have to project based on the previous trend.
The trend in our model is easy to establish. In the years Y1 and Y2, the company had a
large outstanding loan, which over time has reduced.

The company availed no new fresh issues, and we can also see that the company has
repaid the loan. We can expect a similar trend to continue and project for the future
years. To do that –

○​ Keep new issue at zero

○​ Calculate the average repayment
If the above technique does not fit well with your approach, let the debt remain. The
worst that will happen with some debt on the book is that our final valuation may turn
out a bit conservative, which is not a bad outcome, in my opinion.

I’ll keep the debt as is in this model and complete the secured and unsecured loan.

Please look at the schedule at this point. There is an opening balance and a closing
balance, and then there is secured and unsecured debt. If I were to estimate the
company’s debt position, how can I do that? Should I consider the opening balance as
on 31st March or the opening balance on 1st April?

To address this, we can take the average across the opening and closing balance of
both secured and unsecured debt and get the average loan outstanding.

Next, from the P&L, we know the interest expense for the year. By dividing the interest
expense over the average outstanding loan, we get the interest rate applicable to the
company. I’ve executed both these steps on excel, and here is how my sheet looks now
–
As you can see, I’ve calculated the average of the opening and closing balance across
both secured and unsecured loans.

I’ve divided the interest expense stated in P&L over the average outstanding loan for
the interest rate.

Now that we have the applicable interest rate, we can project the future year interest
rates by taking an average.

At this point, we have the average interest applicable, plus we have the average loan
outstanding, with we can project the future year’s interest expense as well. All we have
to do is multiply the interest rate with the average loan outstanding.

We can do this directly in the P&L.

Note the numbers from the debt schedule are flowing into the P&L, and with that, we
have made the 2nd P&L projection.

We can pull the numbers from the debt schedule to complete the non-current liabilities
on the balance sheet.

You can download the excel sheet used in this chapter here. In the next chapter, we will
look at the reserves schedule.
Key takeaways from this chapter

■​ Debt can be secured or unsecured

■​ The balance sheet gives us the overall debt; associated notes give
us the split between secured and unsecured loan
■​ We can calculate the average of opening and closing balance
across secured and unsecured loans to get the average loan
■​ The best way to project debt is by understanding the management’s
view on CAPEX
■​ If there is no management guideline, its best to keep debt at the
same level
 CHAPTER 10

Reserves Schedule (Part 1)

10.1 – Share Capital
So far in this module, we created a few schedules to help us understand the granular
details in the financial statements. This chapter will learn how to build another schedule
called the ‘Reserves Schedule’.

Although it is called the Reserves schedule, we also include the share capital in the
same schedule, calling it the ‘Equity Schedule’. But in most cases, there is not much to
analyze with share capital. The bulk of the action is in the reserves and surplus; hence, I
refer to it as the ‘reserves schedule’ as a personal preference.

We will again take the help of a ‘helper model’ to understand how to build a reserve
schedule. Once we figure the nuances, we switch back to the main model that we are
working on and continue to make the model.

For the ‘helper model’, I’ve picked Bata India. For the sake of simplicity, I’ll only consider
the last year’s annual report.

From the latest annual report, I’ve highlighted the Equity portion of the balance sheet.
Notice there are two components here –

○​ Equity share capital

○​ Other Equity
Some companies explicitly mention that other Equity as Reserves & Surplus, while few
companies like Bata call it the “Other Equity”. But it would be best if you remembered
that both are the same.

On the other hand, share capital is referred to as the ‘Share Capital’. The share capital
of a company has three sections called the Authorized share capital, Subscribed share
capital, and issued share capital. Check this snapshot from Bata –

Many get confused with the classification, but it is pretty straightforward to understand.
Let me give you an analogy.

If you are in Bangalore and plan to build a house on a vacant piece of plot that you own,
then here is what you need to do.

○​ Hire an architect, get your house designed.

○​ Submit your design to the administrative body for civic amenities (BBMP,
in Bangalore)
○​ Get the design approved
○​ Start the construction work

For example, assume you own a 2400 Sq feet plot, plan to build a house (built-up area)
for 1000 sq feet and leave the rest as a garden area.

BBMP, will evaluate your 1000 Sq Feet plan, and approve the same, provided the plan
complies with the civic regulatory framework.

After you start the construction process, if you change your mind and want to extend the
built-up area and build for another 200 Square feet, i.e. a total of 1200 Square feet, then
the additional 200 Square feet need separate approval. Remember, you can build only
to the extent of what is already approved.

The authorized share capital of a company is somewhat similar. At the time of company
formation, each company decides the number of shares they want to issue the
promoters, investors, management etc. Accordingly, the company must submit the plan
to the regulatory authorities (ROC/MCA).

For example, if the company wants to allot 50,000 shares across all its key people,
perhaps it states the authorized share capital as 75,0000 and asks for the regulator’s
permission. It is common to get additional shares authorized so that you don’t have to
deal with the regulatory process again and again.

Once approved, the company can issue all or part of the authorized share capital.
Going back to the analogy, out of the 1000 sq feet, I can choose to build for the entire
1000 sq feet or only for 800 sq feet. I’ll probably keep 200 sq feet as a buffer to build
later.

The actual usage built area is similar to the issued share capital of a company. Think of
the issued share capital as the exact number of shares used up. Issued share capital is
equal to or less than the authorized share capital but cannot be more than the
authorized shares.

Finally, the issued share capital must get subscribed by the investor. Think about an
IPO here – a company has an authorized share capital of, let us say, 1000 shares. Of
which, the company decides to issue 800 shares.

The company opened up for IPO, but the subscription rate was terrible, and there was
only 80% subscription. Then out of 800 issued shares, 640 (80%*800) shares will be the
subscribed and fully paid-up share capital.

On the other hand, all 800 shares will be subscribed and fully paid up if the IPO is 100%
subscribed.

Keeping the above in perspective, I want you to relook at Bata’s share capital again.
Notice the following –

Authorized share capital is INR 700 Million; each share has a face value of Rs.5. Hence
the number of shares is –

700 Million / Rs.5

= 140,000,000.

Out of INR 700 Million, INR 642.85 Million is issued (maybe at the time of IPO). If you
divide 642.85 million by Rs.5, you will get the number of shares issued, i.e.
128,570,000.

Lastly, the paid-up and fully subscribed shares (remember it should be equal to or less
than issued) is INR 642.64 Million or 128,527,540 shares.

I hope this helps you understand the distinction between the different share capital. If
not for anything, I want you to remember the following –

○​ You can calculate the number of shares outstanding by dividing the share
capital value by the face value of the share.
 ○​ Suppose the paid-up and fully subscribed share capital is less than the
issued share capital. In that case, the company’s IPO is undersubscribed
(check Zomato’s IPO details for further understanding).
○​ If the demand for the IPO is more than the issued share capital, the IPO
issue is said to be oversubscribed.
○​ If the company intends to raise more funds via Equity, then the company’s
authorized share capital will increase.

On a related note, here is something else I want you to understand.

Imagine a company issues 10,000 shares in IPO. The face value of the share is Rs.10;
hence the share capital of this company is –

Share capital = Issued shares * Face value

= 10,000 * 10

= Rs.1,00,000/-

Consider the IPO gets priced at Rs.250 per share, and the shares are 100%
subscribed. The company via the IPO receives –

= number of issued shares * IPO price

= 10,000 * 250

= Rs.25,00,000/-

The company’s share capital is 1L, but the company received 25L via IPO. The
additional 24L over and above the share capital will now sit on the liabilities side of the
balance sheet, under ‘Reserves & Surplus’, in a sub header called ‘Securities Premium
Reserve’.

From the financial modelling perspective, let us dig a bit deeper into the Reserves and
Surplus.

10.2 – Reserves & Surplus

Let us take another look at the Reserves & Surplus section (also called Equity) of Bata
India.
We have two-line items within this section, i.e. the Equity Share capital and the Other
Equity. The associated notes 12 and 13 contain the details related to these two line
items.

Share capital remains pretty unchanged, at least for Bata. So there is nothing much to
model. Of course, if the company had raised more money, the share capital would
change.

The other equity part, or the reserves and surplus part, has a few components that we
need to examine. Here is a snapshot of Note 13 –
I will use the base rule concept again to build a schedule around this. I will not bore you
with setting up the excel sheet; I guess we have repeatedly done that in the last couple
of chapters.

Instead, let me show you the excel set up directly –

I’ve done the usual excel set-up here, i.e., indexing the columns and including the line
items, keeping the base rule in perspective. The excel set-up matches with the data
present in the associated Note 13. Like I mentioned earlier, I’ve only considered the
latest annual report.

Let us input the data into our schedule.

I’ve kept the share capital the same across all years. Note this is the fully paid-up share
capital.

The first subheader within the reserves and surplus is the securities premium reserves.
We discussed the ‘Security Premium Reserve’ earlier in this chapter. If a company has
not raised fresh Equity during the year, there is no change to the security premium
reserve.
In the annual report, we only have the data for March 2020 and 2021. However, we
know that the closing value of March 2019 should be the opening balance of March
2020, so on and so forth. I’ve applied the base rule to develop the securities premium
reserve fully.

Next up is the ‘General Reserve’. The general reserve is earmarked for various
business operations of a company without any specific purpose. The company can
maintain its general reserves or add a bit every year from the P&L.

Bata India, I suppose, has opted to maintain some funds without any yearly additions;
hence applying the base rule is pretty straightforward to the general reserve.
The company’s ‘general reserves’ are used for working capital requirements and other
business expenses.

Moving ahead, we look at the ‘Retained earnings’ part. Here is something that you need
to know. The profits after tax or the PAT of the company, also called the company’s
bottom line, represent the profit earned for the given financial year. These profits get
accumulated in the company’s balance sheet under the retained earnings header.

By the way, the PAT flows to the balance sheet and sits in the retained earnings
(liabilities side), and that’s one of the ways the two financial statements are
interconnected.

The company also pays out the dividends and the dividend distribution tax from the
retained earnings part of the balance sheet. Continuing on the excel sheet –

The closing balance for March 19 is the opening balance for March 2020. Add to this
the PAT from P&L, i.e. INR 3289.53 Million; this number comes from the P&L –
The company then has two other line items, i.e. remeasurement of gains/losses on
defined benefit plan and impact from Ind AS 116. These arise from the accounting
treatment and usually do not have any long-term implications. You can note these
numbers, but I believe there is nothing much to forecast and model.

Further, you can see that the company has paid dividends and the related dividend
distribution tax; both get deducted from the total.
The retained earnings closing balance is the total of all. Note, for March 2021, the
company has reported a loss, and the same is carried to the balance sheet. When the
company makes a loss, retained earnings shrink.

The Share Capital of the company plus the Reserves & Surplus of the company is the
‘Net worth of the company’. Now imagine if a company makes a loss year after year,
then the retained earnings reduce or, in other words, the company’s net worth shrinks.

Finally, the total of the Securities premium reserve plus the general reserves plus the
retained earnings forms the ‘Equity’, as stated in the balance sheet.
You can download the excel sheet for Bata’s reserve schedule from here. The next
chapter will jump back to the main model to build and forecast the reserves schedule.

And I promise to put up the next chapter soon 😊

Key takeaways from the chapter

○​ Think of the authorized share capital of the company as the overall

approved shares a company can issue
○​ For new equity issues (over and above the authorized share capital), the
company must increase the authorized share capital.
○​ Share capital stated in the balance sheet is the fully paid-up share capital
of the company.
○​ Dividing the share capital by the face value of the shares gives us the total
number of shares.
○​ The security premium reserve of the company is the excess of funds
available over and above the share capital.
○​ The security premium reserve increases when the company raises fresh
Equity.
○​ General Reserves of the company is earmarked for business operations of
a company without any specific purpose.
○​ The bottom line of the company, i.e. the PAT, flows into the retained
earnings section of the Reserves, and that’s one way the P&L and the
Balance sheet are connected.
○​ Dividends and dividend distribution tax gets paid out from the retained
earnings.
 CHAPTER 11

Reserves Schedule (Part 2)

11.1 – Move and Copy
The last chapter helped us understand how to build a reserves schedule for a given
company. We made the reserves schedule for Bata India Limited and, in the process,
discussed the concept of share capital, security premium reserve, capital reserve, and
general reserve. Most importantly, we also discussed how the bottom line from the P&L
statement flows into the reserves in the balance sheet, thus linking the P&L and
Balance sheet statements.

This chapter will switch back to building the reserves schedule for the main model we
are working with. As you know, we do not have access to the balance sheet and the
associated notes of this company; hence we will have to make do with the raw data.
You will soon realize that the reserves schedule we are about to build is no different
from Bata India’s reserves schedule.
I’ll keep this chapter short because there is no conceptual explanation. This chapter will
demonstrate how to build the reserve schedule. Given how straightforward this chapter
is, you can also skip it. Or maybe skim through it as a revision of the previous chapter.

Setting up the excel for reserves schedule is straightforward, but let me take this
opportunity to introduce a shortcut on excel. We know that the reserves schedule sheet
on excel will look just like the other schedule that we have already built. Each column
will represent the same years, and that won’t change. Given the consistency across the
financial model, we can create a copy of any of the schedules (debt or asset) and
modify the same.

To create a duplicate, go to the sheet (I’ll go to the debt schedule) and right-click on the
tab –
Click on ‘Move or Copy’ and click on the sheet you want to copy.

Clicking on ‘Create a copy’ will create a duplicate copy of the sheet you’ve selected, the
debt schedule sheet in this case. Here is how it looks –
The number 2 in the bracket indicates a copy of an already existing sheet in the
workbook. Once the copy is created, you can delete the contents on this sheet and
retain the column indexing, like seen below –
The move and copy technique is a shortcut and saves time setting up the sheet. We
avoid going through several steps, and our sheet gets set up quickly.

11.2 – Building the schedule

Initially, the share capital of the company was INR 13.9Crs. The company raised equity
in the 3rd year, bumping the share capital to INR 17.08Crs. We can assume that the
company won’t raise fresh money and keep the share capital constant.

For the split-up of reserves, here are the line items. Of course, we don’t have the
associated notes for this; you must consider what I state here as the actual data.

The company has Capital reserves at just Rs.11,500/-. I know it is a relatively small
number, but I suppose the company maintains this for optics.

The security premium reserve is at INR 31.19 Crs across all the years. The opening
balance of Year 1 general reserves of the company is at INR 83.81Crs. The yearly
addition to general reserves is mentioned in the P&L, which we can pull to the reserves
schedule.
The bottom line of PAT feeds into the surplus part of the ‘Reserves and Surplus’
schedule.

With this data, we can build the reserves schedule. Here is how the sheet looks –

As you can see, I’ve linked the yearly additions for the general reserves from P&L. Like I
stated earlier, the surplus in the Profit and loss account is the PAT from P&L.

To complete the reserves schedule, we will have to project the general reserves addition
during the year; this is a P&L projection. We can go back to the assumption sheet and
build a separate assumption or make a projection directly in the P&L.
But as you can see, the appropriation to general reserves depends on PAT, which
further relies on revenue and expenses. In the next chapter, let us compile everything
we have done and project both the balance sheet and P&L. Of course, we will also
complete the reserves schedule in the next chapter.

You can download the excel sheet used in this chapter.

Key takeaways from this chapter

○​ Move and copy feature in excel helps you replicate excel sheets in the
given workbook
○​ Some companies, in their P&L, give the split of apportions they would
make towards the general reserves
○​ To complete the reserves schedule, one must ensure the P&L is fully
projected.
 CHAPTER 12

Projections
12.1 – Milestone
When building a financial model, there are two essential milestones. We will hit the first
one in this chapter and the 2nd milestone in the next.

Before we proceed, I’d like to jog your memory and run you through the various steps
we have performed in our financial modeling journey. If you are struggling with any of
the following topics, I’d suggest you revisit the relevant chapter and read through it
again. Don’t forget to ask your queries and get them answered.

○​ We started the module with a blank excel workbook and formatted a

financial modeling-friendly sheet. We indexed the columns and froze the
 panes. We ensured each column refers to the same year across the
model to maintain certain integrity.
○​ We reviewed the company’s annual report to ensure the statements were
consistent; we copied the last five years’ P&L and Balance Sheet data
onto the formatted excel sheet. The P&L and Balance Sheet data are the
only hard-coded numbers in the financial model; the rest are assumed or
calculated.
○​ We introduced an assumption sheet and dumped all the P&L and Balance
Sheet assumptions. The assumptions are based on growth rate or
calculated as a more prominent line item percentage.
○​ The first thing to build after the assumption sheet is the revenue model.
The revenue model gives a granular view of all the variables which control
the revenue.
○​ We introduced the concept of ‘schedules’ in our model. Schedules are
essentially assumptions, but the assumption is broken down into several
parts to gain more significant insights.
○​ Schedules follow the base rule concept, where the closing balance of year
1 is the opening balance of year 2.
○​ With the assumptions and schedules, we have managed to project the
balance sheet and P&L to some extent.

As you may have noticed, the numbers criss-cross from one sheet to another, making
the model wholly integrated.

This chapter will fully project the P&L and Balance sheet for the next five years, and
that’s a mini-milestone in our financial modeling journey.

12.2 – P&L Projection

We are at an exciting phase in our financial modeling journey. One financial modeling
enthusiast related this phase to a wedding kitchen scene.

In a typical wedding kitchen, usually, there is one person chopping veggies, one person
grinding the masala, one person frying stuff, another mashing, another preparing the
garnish, and whatnot. Finally, in the end, everything comes together and falls into one
gigantic vessel for the final dish to take shape.

Likewise, so far in this financial model, we have done several things in isolation. But
now, it’s time to tie things up and integrate our model.
Let’s start by taking a look at the P&L snapshot –

Except for the depreciation and interest expense, none of the other line items in the P&L
statement are projected. We projected depreciation from the asset schedule and the
interest expense from the debt schedule. We will now project the rest of the P&L, which
is an easy task.

Starting with revenues, we look at our assumptions for net sales. Recollect, we
calculated the year-on-year growth rate of net sales and then projected the average
growth rate.

We know the net sales for the 5th year and the net sales growth for the 6th year (the
projected year); we have to do the math to get the actual value. The math is quite
straightforward –

The net sales growth rate for the 6th year = 33.71%

Net sales for 5th year = Rs.1761.12 Crs

Net sales for 6th year = 1761.12*(1+33.71%)

= 2354.71 Crs.

On excel, I’ve calculated using the same approach for all future years –

One thing that I always make a point to check is the cell linkages. I liked cell J in the
P&L sheet and cell J in the assumption sheet. The association is correct, and I need not
worry about inadvertent linkage errors.

Once the net sales numbers are in place, we can proceed with other projections since

😊
most projections are based on net sales. I’ll demonstrate one of the line items and
assume you can do the rest

We need to multiply the percentage in the assumption sheet with the net sales and get
the value. You can see from the screenshot above that I’ve done this for other income
and ‘increase in stock.’ Here is how the fully projected Revenue numbers look –

We can do the same thing for the expense as well –

Next is the calculation of Profit before tax (PBT), which is essentially the difference
between the total income and the total expenses. After calculating the Profit before tax,
we need to calculate the tax amount. The tax amount calculation is a very tricky job, and
one would need the auditor’s help to arrive at the exact value. Since we must continue
the model, we will depend on the averages.

To calculate the average, we have to calculate the tax paid with respect to the PBT in
percentage terms. For example, in Y1, the tax paid is 24.15Cr against the PBT of
71.2Cr. In percentage terms,

= 24.15/71.2

= 34%

I can now do the same math across Y1 through Y5 and get the yearly percentages.
Once the percentage is in place, I can find out the average across the last five years
and treat that as the tax percentage for year 6. You can do this math in one shot in excel
–
Please get comfortable with this technique; we will be using it again shortly. Anyway, we
now have the PBT and the provision for current year taxes, PAT of the company is
PBT-Taxes, which I’ve calculated.

We are now the last leg of P&L projections. I want you to take a look at this section of
P&L –

The previous year’s Profit is the last year’s closing balance, i.e., ‘balance carried to
balance sheet.’ Yes, we apply the base rule again. We now add up the PAT and the
Profit available for appropriation to get the total corpus available for allocation.

The transfer to the general reserves is based on the PAT. Here is a tricky part, we have
to calculate the appropriation to general reserves, which from P&L goes back to the
Reserves schedule. The dividend and dividend tax, too, are calculated. All these
calculations are made exactly like how we calculated the tax provision.
Now the closing balance of Rs.634.37Cr for Year 6 is the opening balance for Year 7
and so on. Here is the complete projected P&L for your reference.

We have an old task to complete before moving to the balance sheet projections.

12.3 – Reserves Schedule

We were stuck with the reserves schedule because we had no new yearly additions to
the general reserves. We can now pull that data from the P&L and complete the
reserves schedule.
Of course, we will pull the reserves schedule data back to the balance sheet. I hope you
appreciate how the model is integrated with numbers moving from one sheet to another.

😊
The model will only get tighter from here, and even after this many years, I get excited
looking at these financial models slowly taking shape

Over to the balance sheet.

12.4 – Balance sheet projections

The balance sheet projection is very similar to the P&L projection. Like the net sales in
P&L, the gross block is the alpha line item in the balance sheet. Most of the balance
sheet assumptions are based on gross block. I will skip through the few line items in the
balance sheet that I think is straightforward and post the snapshot for your reference –
Here, current liabilities and current provisions are calculated as a percentage of the
gross block. Shareholders’ funds and loans are calculated separately in their respective
schedules. Deferred tax liability is calculated as a depreciation percentage (from asset
schedule).

Moving ahead, we have the application of funds or the assets side of the balance sheet.
The first line item we have to deal with is the inventory. We probably need to spend
some time on the inventory.

The inventory value that we see in the balance sheet is the Rupee value of the
inventory. We take the inventory data and calculate the ‘Inventory number of days,
which is the number of days the company requires to covert the inventory to actual
sales. The inventory number of days was calculated in the assumption sheet.

In a sense, the inventory number of days helps us develop an opinion on management’s

efficiency, the product’s popularity, market acceptance, etc. For the future years, we
take the average of the inventory number of days.

We have the inventory data in Rupee terms in the balance sheet; we have the inventory
number of days in the assumption sheet. We also have the inventory number of days for
the future years. We now have to convert the inventory number of days for the future
years back to the inventory value in the balance sheet. To summarize –

Balance sheet inventory data >> convert to inventory number of day >> project using
averages >> convert back inventory number of days back to Rupee value.
The formula to convert inventory number of days back to Rupee value is –

Two*(Inventory number of days * (Material consumed/365))-Previous year inventory.

I will not get into how this formula is derived as that would be a digression; maybe you
can look it up online.

I’ve applied the above formula directly on excel (balance sheet), and here is how it looks
–

The rest of the balance sheet projection is a breeze. I’ll make the projections as per the
balance sheet –
Well, congratulations on this mini-milestone. At this point, we have the complete P&L
balance sheet projected, except for the cash and bank balance.

We will project the cash and bank balance in the next chapter by building the cash flow
statement, which in my opinion, is a significant milestone in our financial model, and
there is a reason for that. As you can imagine, the cash and bank balance numbers
from the cash flow statement will flow back to the balance sheet. When the cash

😊
numbers hit the balance sheet, I’d expect the balance sheet to balance. So, let’s see if
that happens in the next chapter

One last thing before we conclude this chapter. We are dealing with so many numbers
and projections we are bound to make mistakes. For example, two months after building
this model, I may feel that the gross block number for Y6 is 700Cr instead of 588.77Cr;
what should I do? Do I have to change the entire model?

No necessary. Since we are building the model in an integrated fashion, we only have to
change in one place. The rest of the changes will reflect on their own. So don’t worry
too much about the model’s accuracy just yet. We can play around with it as and when
we want.

I hope you update your models and bring them up to this level. Do post your queries in
the comment section.

Download the excel sheet used in this chapter here.

Key takeaways from this chapter

○​ Most of the P&L and balance sheet projections are straightforward. Take
the cues from the assumption sheet.
○​ Taxes, general reserves, and dividends can be estimated directly in the
P&L statement by taking historical ratios and then their average
○​ The appropriation to general reserves from the P&L statement flows back
to the reserves schedule to complete the reserves schedule, which flows
back to the balance sheet.
○​ Inventory is converted to inventory number of days and back to inventory
in the balance sheet.
○​ All line items in the P&L and balance sheet are projected except for the
cash and bank balances.
○​ To project the cash and bank balance, we need the cash flow statement
○​ The expectation is that the balance sheet gets balanced when the cash
and bank balance number flows from the cash flow statement back to the
balance sheet
○​ Since the model is fully integrated, we can change any number in the
balance sheet without worrying about its impact on other parts of the
financial model.
 CHAPTER 13

Cash Flow Statement

13.1 – Indirect cashflow
We are at a crucial juncture in our financial modeling journey. This chapter will derive
the cash flow statements and plug that cash flow number into the balance sheet. After
we do, hopefully, the balance sheet balances. Notice, I used the words ‘derive the
cashflow statement’. What do I mean by that? You need to take a few steps back and
think about the cash flow statement and its purpose.

The cash flow statement of a company gives the company’s cash position. The cash
position itself is estimated after reviewing the cash inflow and outflow from the
company’s operations, investments, and financing activities. Each of these activities
either generates cash or consumes cash. If you are new to cash flow statements, I’d
suggest you look at this chapter –
https://zerodha.com/varsity/chapter/cash-flow-statement/.

Think about the high-level summary of cash flow and how the company’s CFO and their
team prepare the statement. Like the P&L and Balance Sheet, the cash flow is also
prepared by considering the voucher entries, bills, receipts, and bank reconciled
statements. Preparing the cash flow statement with bank reconciled statements,
invoices, and receipts is called the ‘Direct cashflow method.’

As a financial modeler, you have two options to prepare the cash flow statement in the
financial model.

○​ Get access to bills and vouchers of the company and prepare the cash
flow just like the finance team
○​ Hardcode the historical statement just like the way we did for P&L and
Balance sheet and then project for future years
Of course, option one is ruled out for obvious reasons. Option 2 is possible, but we miss
out on the ‘validation of the model’ part if we take the hardcoded approach. I’ll explain
what this means in a bit.

There is a third approach to cash flow. It is called the ‘indirect method’ of cash flow
preparation. In the indirect method, we take the P&L and the Balance sheet data of the
company as input and process the input based on a series of logical steps. The result of
the process is the company’s net cash flow. Here is the good part – the net cash flow
derived from the process should match the company’s cash flow stated in the balance
sheet. If it does, then it kind of validates the model for us. If the numbers don’t match,
then it is because we’d have made an error somewhere in the model, and it allows us to
recheck. For this reason, we will use the indirect method of preparing the cash flow
statement.

By the way, speaking of validating the model, you may argue that the model is heavily
dependent on the assumptions that we make and therefore bound to have errors. Yes, I
won’t argue with that. I’m aware of this fact, but at the same time not concerned.
Think about it this way; our main focus is to build the structure of a house with a solid
foundation. Once the house is built with the proper foundation, we can mix and match
the interiors as many times until we find it to our satisfaction. Extending the same
thought, our objective is first to build the model with the right linkages. Once the model
is fully built and completely integrated, we will spend time debating each assumption,
figuring out if it makes sense, and changing the values accordingly.

I’m sure you have questions about this, but hang on and read through the rest of the
chapter (and module), and I’m sure you will get all your answers. For now, let’s look at
the indirect method of cash flow statements.

13.2 – Cashflow activities

A company can be looked at from the perspective of its activities. Broadly speaking, the
activities are –

○​ Operating activities
○​ Investing activities
○​ Financing activities

Consider Bajaj Auto, for example; what does the company do? It manufactures two and
three-wheeler vehicles, sells these vehicles, and services these vehicles. The company
needs to invest in plants, machinery, and equipment to carry out the operations. To
finance the operations, it may (or may not) needs funds from external sources. If the
company borrows money, they have to repay. Then, of course, from the profits,
dividends are distributed.

Can you think of any other activity that the company does? You can extend this
framework to any company and realize that all the activities are within the scope of
these three categories.

Each of these categories either generates cash or consumes cash. For example,
consider the inventories of a company. The inventory of a company is directly related to
the company’s operations. If the company’s inventory has increased compared to the
previous year, then it means that more money is stuck in terms of finished goods.
Hence, inventory (which is an operational activity) has consumed cash. On the other
hand, if the inventory is less in year two than in year one, inventory has generated cash
or conserved cash.
Let us take another example. Assume that a company has borrowed money from the
bank to fund operations. Borrowing funds is a financing activity, and by borrowing, cash
is credited to the company’s bank account, hence considered as generated cash.

Likewise, when paying dividends (financing activity), money goes out of the company’s
account; hence, it is treated as an activity that consumes cash.

Imagine if you can look at all the line items (mainly from the balance sheet) and –

○​ Categories them as operating, financing, or investing activities

○​ Figure out if it is consuming or generating cash

Then, by summing cash flow from different activities, you should generate the
company’s cash flow statement and get the company’s cash position.

Let’s go ahead and do this for our model.

13.3 – Categorizing line items

The idea is simple, we list all the balance sheet line items and figure out their impact on
the cash position if it were to increase or decrease. Eventually, each line item either
tends to generate cash or consume cash.
For example, if the company were to issue more shares and increase the share capital
(raise more equity), then cash comes into the company, and the cash position tends to
increase. If the CAPEX spend were to reduce, then from the perspective of the cash
position, it tends to increase cash.

13.4 – Cashflow from operating activity

Using the above framework, we can now derive the cash flow statement in the indirect
method. The idea here is simple, we treat each line item basis the activity type and then
figure if that particular line item increases or decreases the cash position.

You know the drill, we create a new excel within the workbook and rename it as
‘Cashflow.’ We index it like we did the other sheets. We will start with the operating
activities first.

The idea here is to find out if the company’s operation has generated cash or not. We
start with the PAT, add back depreciation, and then add the net change in working
capital by considering each line separately.
Remember, depreciation is an accounting expense. Hence we need to add back
depreciation. Here is the snapshot of the excel sheet –

I want you to notice two things here. First, I’m starting the sheet by directly working on
the Year 2 data. There is a reason for this, which you will soon realize. Second, I’ve
extracted the depreciation value from the balance sheet and not the P&L, and this is
because the P&L depreciation is only for the year, but in the balance sheet, you not only
get the yearly depreciation but the depreciation non-expense as well. Alternatively, you
can also get the depreciation data from the asset schedule.

Continuing on the operational activity, we now look at working capital changes and their
impact on the cash position. Here is the excel setup –

As you can see, since we are calculating ‘increase’ for the previous year, we are starting
from Year 2 and not Year 1.

All the line balance sheet items that I’ve considered here are related to the current
assets and liabilities. These two together help me identify the net change in working
capital. Let me do the very first calculation and explain a particular nuance here.
From the balance sheet, Y1’s Current liability is 73.53 Cr, and Y2’s current liability is
102.74Cr. An increase in current liability is –

Y2 – Y1

= 102.74 – 73.53

= 29.21 Cr

We discussed earlier that if the current liabilities increase, then from a company’s point
of view, the company retains the cash as it is deferring payments against its liabilities to
a later date. It’s as simple as, ‘I owe you money, but I will pay later instead of paying you
now. Hence my bank balance tends to increase.

Therefore, if there is an increase in current liability, we will add it. Now, let us flip the
numbers for a momentum –

Current liability of Y1 = 102.74

Current liability of Y2 = 73.53

If we do Y2-Y1

= 73.53 – 102.74

= – 29.21 Crs.

Here is a situation where the company is reducing its current liability, which means it will
tend to reduce the cash balance.

If we plug this on our ‘Add: Increase in current liability framework,’ we automatically

deduct cash, thanks to the negative sign.
I hope this explanation is clear; else, please do feel free to ask your queries, and I’ll be
happy to explain whichever bit you find challenging to understand. I’ve extended the
same to all the other line items, and here is how it looks –

One common query at this stage is why we are adding things like provisions and current
liabilities and deducting things like inventories and sundry debtors. We are calculating
the increase in value in Year 2 over Year 1. Some of these line items tend to increase
the cash balance, and some tend to decrease.

The total of all the values of all these line items is the net change in working capital.
Cash flow from operations is (indirect method) –

= PAT + Depreciation + net change in working capital

For Year 2, the operating cash flow or operating activity is –

94.36+20.99-147.84

= 32.69 Crs.

At this point, financial modelers will usually quickly check the company’s annual report
and compare the stated cash flow from operations to check if it matches.

The numbers won’t match for obvious reasons. But don’t worry about that; in the
Indirect cash flow method, or primary concern is to match the overall cashflow number
i.e.

Cash from operating activity + Investing activity + financing activity

Here is what the cash flow from operating activity looks like –

Next up is cash flow from investing and financing activities

13.4 – Cashflow from investing and financing
activities
The first thing we need to consider while dealing with investing activities is the CAPEX
spend. If the CAPEX spend increases, then it consumes cash, and if the CAPEX spend
decreases, it generates cash (or conserves cash). We can get the CAPEX data from the
asset schedule.

Notice, I’ve specified ‘Less: CAPEX’ to indicate that the increase in CAPEX results in
cash consumption. I’d also request that you notice the necessary adjustment in the
formula bar.

The company has not disposed of any assets, and we know this from the asset
schedule. Hence, the disposal of assets will be zero.

The other two line items, i.e., capital work in progress and investments, are
straightforward, and we get that from the balance sheet. The total of all the four-line
items is the cash flow from investing activities.

Next up is the cash flow from Financing activities. I’ve completed this on excel, do check
the snapshot –
I think you know what’s happening with the increase in share capital, secured and
unsecured loans. I’ll focus on the last four line items. Past service cost of employee
benefit is a one-time cost specific to this company. Costs such are one time in nature
should be dealt with slightly differently. Here, you don’t consider the difference between
the two years; instead, take the expense applicable for that year directly.

Dividends, too, are a yearly expense, and the company may even decide not to pay
dividends for a year. So all such one-time costs should be treated as is. I’ve highlighted
the same in the formula bar above.

We have now calculated the cash flows from all three activities. The sum of these three
activities gives us the cash flow for the year. Here is the same –

Now, don’t be in a hurry to plug these numbers into the balance sheet. It won’t balance
just yet. Remember, we have calculated the cash position for the given year.
What do we need to do to get the complete cash flow picture? Please look away from
your device and think about it for a few minutes.

I hope you got the answer. The number we calculated above is for the current year’s
cash position. To this number, we need to add the previous year’s closing balance (of
cash position) and then arrive at the total cash position for the year. Yes, we are talking
about applying the base rule here.

We can get the closing balance of cash and cash balance for Year 1 from the balance
sheet. The exact value is now the opening balance of the cash position in Year 2. Add to
this the cash flow for the year (which we calculated); we get the closing balance of
Year2.

This net cash flow that we have calculated should match the balance sheet numbers. To
clarify the same, I’ve pulled the balance sheet numbers –

The historical numbers match (ignore the decimals), so we can now pull the cash flow
numbers back into the balance sheet for future years. Yet again, by linking cash flow
back into the balance sheet, we continue to integrate the financial model.
I’ve done the same, and like magic, the balance sheet balances 😊
As I mentioned earlier, this is a landmark moment in our financial modeling journey. At
this point, we are at least 80% done with the model. In the next chapter, we will take up
the valuations.

You can download the excel used in this chapter here – [Cashflow statement Excel].
Key takeaways from this chapter.
○​ One can derive the cashflow from P&L and Balance sheet; this is called
the indirect method of cash flow preparation
○​ Few line items tend to increase the cash balance, and some tend to
decrease the cash balance
○​ We should use the depreciation from the balance sheet (or asset schedule
) in the cash flow statement
○​ After deriving the cashflow numbers, we need to add the previous year’s
cash flow to get the closing balance of the cash position
○​ The net cash flow flows back into the balance sheet to balance the
balance sheet.
 CHAPTER 14

Valuation (Part 1) - Overview

14.1 – Valuations basics
We are at the last stage in our Financial Modelling journey. As the last step, we have to
build a valuation model, which will sit within the integrated model that we are building. A
valuation model helps us measure the value we are willing to pay for a given business.
There are many ways to build a valuation model, but regardless of the approach you
take, the final output results in estimating the worth of the company on a per-share
basis.

With the valuation exercise, the idea is simple, we value the company and arrive at the
share price. We refer to this as the fair price of the company’s stock. Fair price because
we have considered everything that matters in our model (remember all the
assumptions and schedules). We then compare the fair price of the company with the
actual market price of the company traded on the stock exchange and conclude as –

○​ Overvalued, if market price > fair price

○​ Undervalued if market price < fair price
○​ Fairly valued if market price = fair price

By the way, it almost feels weird to discuss ‘valuation’, in a world where almost no one

😊
cares about valuations. But that is a debate for another day, let us go ahead and do
what we are supposed to do

Valuations in the context of investments help us understand the price we are willing to
pay to acquire a portion of the business. There are three main techniques based on
which we can value a company, they are –

○​ Relative valuation
○​ Option based valuation
○​ Absolute valuation

In this chapter, I’ll briefly touch upon all three techniques to help you develop a
perspective, and then in the subsequent chapters, we will discuss one of these
techniques and figure out how we can implement that technique within our financial
model.

14.1 – Relative valuations

The relative valuation is based on the theory that if there are two identical companies in
the market, then their valuations should be similar too. By identical, I mean the
companies you compare should be similar in terms of business, products, size,
geographic spread, financials, etc, regulatory landscape, etc. You cannot compare TCS
with HDFC Bank or for that matter, you cant compare SBI Bank with HDFC Bank
although both are banks. SBI is a public sector bank and HDFC Bank is a private sector
bank. You can however compare HDFC Bank with ICICI Bank, they are similar in all
ways, probably even Kotak Bank. A few more examples of similar companies include
Infy and TCS, Bajaj Auto and Hero, PVR, and INOX. Of course, there are many more
companies that can be bucketed under the same category and can be compared.
Let’s put this in context. Assume there are only 3 companies in the country that
manufactures cars. The Profit after tax for these companies along with the respective
stock prices are as below –

Company 1 – PAT is Rs.100, a stock trading at Rs.1005 per share

Company 2 – PAT is Rs.220, a stock trading at Rs.2185 per share

Company 3 – PAT is Rs.75, a stock trading at Rs.785 per share

If you do a simple ratio check i.e. dividing the company’s stock price by its profitability
(measured in terms of PAT), we get the following results –

Company 1 : 1005/100 = 10.05x

Company 2 : 2185/220 = 9.93x

Company 3 : 785/75 = 10.46x

From the above, we know that the industry as such is valuing the car industry at roughly
10x its earnings. Now, assume a 4th company enters the market with similar dynamics.
The earnings of this company are Rs.300, what is the likely stock price?

Well, by the method of relative valuation, we can assign roughly 10x the earnings, so
the stock price should be around Rs.3000. However, if the stock price is higher or lower
than Rs.3000, then we can conclude that the stock is overvalued or undervalued
respectively. While I’ve considered just one ratio to illustrate the relative valuation
method, there are several other ratios that you can consider.

Most investors find conducting relative valuations on companies easy since it is very
intuitive and relative to the industry. But there are a few limitations with relative
valuations.

One, the markets themselves could be valuing the industry wrongly by sometimes
assigning very high valuations to companies (remember the dot com era where all
stocks were highly valued) or sometimes assigning super-low valuations. Super low
valuations could be because the market as a whole can find it difficult to understand
business models.

The other problem is that there are no two companies that are the same. In reality, each
company is different, and these differences have an impact on valuations. For example,
in the above example, assume the 4th car manufacturing company has a revenue of
Rs.600, that means the company enjoys a 50% PAT margin, which is phenomenal, and
therefore maybe the market assigns a higher value.
For this reason, as investors, it is best if we look at other valuation techniques as well.
Let me quickly give you an overview of the options-based valuation before we move to
absolute valuations.

14.2 – Option based valuations

I guess we all know who Rajinikanth is 😊 , just in case you’ve been living under a rock
and the name Rajinikanth has escaped your attention, then look him up on Google.
Don’t worry, I’m not digressing to discuss Rajinikanth or his movies. I’m only interested
to explain how he charges his producers for the movies he acts in.

Most normal actors in India get paid a certain amount before they signup and act in
movies. However, I believe Rajinikanth does not do that. His remuneration is a
percentage of the profits his movie generates, and the profits as such are based on the
outcome of the movie. So if the movie does well, Rajinikanth makes money, or else he
won’t make the money.

Just to reiterate, the outcome of Rajinikanth’s financial success (or the monetary value
of Rajinikanth) is contingent upon the success of the movie, and clearly, his success
and the movie’s success are directly proportionate.

Now, keep that in mind.

Let us talk about a company, maybe an EV car manufacturing company. The company
announces that they have set up an R&D to develop an EV car that can run 2,000 Kms
per single charge. The announcement is phenomenal as most EVs can run up to 450
km per charge.

How will the market value such an announcement?

Well, for now, it is just an announcement and the market knows that the R&D
experiment can fail. However, if it’s a success, the value of the company can grow
multi-fold. In other words, the value of the company is contingent upon a certain event,
the event happens to be the success of the R&D experiment.

We can generalize this – ‘the value of a company should be X provided Y happens’, this
is similar to ‘Monetary value of Rajinikanth will be A provided B happens’. And both
these are similar to – ‘The value of a certain option will be X, provided the spot value
changes to Y’. For people who are familiar with options, you will immediately recognize
that we are talking about a call option here.
Remember this equation ‘ Intensive Value of a Call option = Max[(Spot-Strike), 0]. If you
are familiar with it, good, else don’t worry about it as long as you get the point that the
value of the company (or option) will be Rs.XYZ provided ABC happens.

Given this, if you were asked to value such companies, how will you value them? Well,
you can value the basis of the framework on how you value options. Such a valuation
technique is called the ‘option-based valuation technique’.

Option based valuation technique is a very niche technique and cant be used across all
companies. But this is something you should be aware of. Many tech companies in the
US are valued based on the option-based valuation technique. Probably in India too,
this may become popular. For example, think about a company that has an internet
business. Their business model can be dependent on acquiring n number of customers
of which a certain percentage of them will turn into paying customers.

We will now move to the last valuation technique, perhaps the most popular one called
the ‘Absolute valuation’, of a company.

14.3 – Absolute valuations

When we value a company based on absolute valuation, we do so based on the stock
concept. What do I mean by that?

Well, after we do the valuation, the result is the value of the company. The value of the
company is as of today. The valuation is not based on what the value was last year or
the year before nor is the value based on what it will be next year or the year after. We

😊
are calculating the value as of today based on all the inputs. The inputs however are
based on how we expect the future to unfold

In this chapter, I’ll give you an overview of the absolute valuation technique and in the
subsequent chapters, we will develop our understanding of all the different components
of absolute valuation, and eventually build the absolute valuation piece within the main
model.

Let us start with the basic balance sheet equation that we are all familiar with. For any
balance sheet to balance, we know =

Asset = Liabilities.

Now, the assets can be broken down into two parts

Assets = Cash + Fixed Assets

The value of cash is easy to figure, it is how much it is. For example, if a company has
Rs.100Cr cash on its balance sheet, the value is Rs.100Crs, nothing more, nothing less.

On the liabilities side, we can break it down into two parts –

Liabilities = External Borrowings (Debt) + Equity

Given this, we can rewrite the balance sheet equation i.e. Assets = Liabilities as

Cash + Fixed Assets = Debt + Equity

We can now further modify this as –

Fixed Assets = (Debt – Cash) + Equity

Debt – Cash, is also called the Net debt of the company. So,

Fixed Assets = Net Debt + Equity

This is a balance sheet equation, re-ordered. Now, if you were to value any company,
you can either value its assets or its Equity. If you choose to value the assets of the
company, then you are essentially valuing the overall company and that’s called the
‘Enterprise Value’, of the company, also called the value of the firm.

However, if you choose to look at only the equity portion, then it is just that, you are
valuing the company from an equity holder’s perspective because the value of equity is
what matters to the shareholders.

Both techniques are fine, as long as you understand their nuances.

When it comes to measuring the value of a company (either via the enterprise or equity
holders), you need three things –

●​ Cashflow estimation
●​ Discount rate
●​ Timing of cash flow

The cashflow is either –

●​ The cash flow to the firm/ enterprise or

●​ The cash flow to the equity holders

Once you identify the cash flow (past and future), you need to discount the cash flow.
The concept of net present value kicks in here. I hope you are familiar with it, else
please do look it up here.
The question however is at what rate do we discount the cash flow? The debt holders
will expect a lower rate of return compared to equity holders. The Equity holders will
expect a higher return than the risk-free rate.

Equity Holders = Rf + Rm

Where Rf = Risk-free rate and Rm = Equity risk premium.

Since an enterprise will have both debt and equity holders, the discount rate should
reflect the expectation of both these parties. The blended discount rate is called,
”Weighted average cost of capital”, or just WACC. We will discuss more on WACC in
the subsequent chapters.

Lastly, we need to know the timing of the cash flow so that we can discount these cash
flows appropriately. Of course, you will know what I’m referring to here if you are familiar
with the concept of net present value. Over the next few chapters, we will build the
valuation model step by step and integrate it within the main model.
Key takeaways from this chapter

●​ Relative valuation is based on valuing two or more companies on similar metrics

●​ Relative valuation works only if two companies are identical
●​ Option based valuation is applicable if the financial outcome of a company is
dependent on a certain event
●​ One can apply the framework of the option theory to value companies whose
fortunes are dependent on the outcome of events
●​ An absolute valuation can be done either by valuing assets or the equity
●​ The three variables that are important for absolute valuation are cash flow (either
to the firm or equity holders), discount rate (we consider WACC), and the timing
of the cash flow.
 CHAPTER 15

Valuation (Part 2) - FCFF & FCFE

15.1 – Building blocks
Picking up from the previous chapter, we discussed relative and absolute valuation
concepts. At its core, three key inputs drive the absolute valuations –

○​ The cashflow
○​ The timing of the cashflow
○​ The rate at which the cash flow gets discounted

Let us deal with the broader concept of cash flow in this chapter. Remember, starting
from the previous chapter to maybe the next few, we only discuss the theory behind the
valuation. Once we get to a stage where we understand the valuation concept well, we
will build the valuation model and integrate it within the model we have built so far.

The cash flow that we refer to here is called the ‘Free Cashflow.’ Free here implies that
the company is free to allocate the cash generated from its operations to whatever
purposes the company thinks is best—extending the thought, who owns that cash that
the company’s operations generate? To answer that, you need to think about the
company from its funder’s perspective. A company gets funds from two sources, i.e.,
debt and equity.

The debt and equity holders together finance the assets of the company. Hence, the
following equation represents a company –

Debt Holders + Equity holders = Assets of the company

In its simplest form, the debt and the equity holders finance assets, the assets, in turn,
generate a cash flow for the company. So the cash generated by the company belongs
to both these funders in proportion to their funding. Further, we value the cash flow by
factoring in the cash flow timing and the discount rate to develop our sense of the
company’s valuation.

The point to note here is that the cash generated belongs to the company, i.e., the Debt
+ Equity funders. The cash that belongs to the company is called ‘The free cash flow to
the firm’ (FCFF). Or, from the free cash flow to the firm, you can deduct whatever cash
is supposed to go to the debt holders and value only the cash flow that belongs to the
equity holders, and that is called the ‘Free cash flow to Equity (FCFE).

15.2 – Free cash flow calculation

To calculate the free cash flow (FCFE or FCFE), we need to start all over from the P&L
again. Don’t worry, I won’t do a P&L deep dive but rather quickly discuss the overview. It
may perhaps help you jog your memory. Have a look at this –
The company’s business operations ideally should generate positive cash, which is also
the company’s revenue. The company pays off the cost of goods sold from the revenue
generated. After paying for the cost of goods sold, the company pays the sales and
general administrative costs. Usually, both get clubbed as the ‘expenses’ of the
company. After adjusting for this, the company is left with ‘Earning before the interest
and Tax’ or the EBIT. EBIT is one of the key margin metrics we use to analyze a
company.

From EBIT, interest is paid to get us to the Profit before tax or PBT. From PBT, the
company pays the taxes due for the financial year and finally arrives at the company’s
bottom line, i.e., Profit after taxes or PAT.

All the above is very intuitive, I guess. The point to note here is the source of free cash,
irrespective of whether you look at it from the firm’s perspective or equity holder’s
perspective starts with the company’s operations after adjusting for expenses and
taxes. This implies that we can start figuring out the true ‘Free cash flow’ by starting with
the company’s bottom line, i.e., the Profit after taxes (PAT). What do I mean by ‘true’
free cash flow? I’m talking about identifying all the non-cash expense and adding it back
to the PAT to figure out the free cash flow.

The cost of goods sold part usually includes depreciation as well. Remember that
depreciation is just an allocation of charge, and it is not an actual expense. It is an
accounting entry. Likewise, amortization is also a non-cash expense; it is an accounting
entry. The first step in calculating the free cash flow (irrespective of FCFE or FCFF) is to
add back depreciation and amortization to PAT.

Think about deferred taxes; this too is not an actual expense, but instead, the company
is deferring its tax payment to a later date. Given this, you can add back deferred taxes
as well.
So we have –

PAT + Depreciation + Amortization + Deferred Taxes

Please think of the above equation as the starting cash position. We now have to
account for changes in the company that consumes cash. The changes I’m referring to
are working capital changes and changes in the fixed assets position of the company.

To keep the operations going, the company should spend on working capital. As you
may know, working capital is the funds required to run the day-to-day operations of a
company. Day-to-day operations like picking up raw material on credit by a vendor,
receiving an advance from the customer, stocking inventory, etc., are all activities that
come under the company’s working capital. The balance sheet equation of working
capital is –

Working capital = Current Assets – Current Liabilities

Note, since both assets and liabilities are current, working capital is also current.

Assume the average working capital requirement of a company is 100Crs, but for
whatever reason, the working capital requirement increases to 120Cr, then the
additional 20Crs will have to be accounted for when calculating the free cash flow. It is
reduced from PAT + depreciation + amortization + Deferred Taxes.

Likewise, if the working capital decreases to 80Crs, it frees up 20Cr for the company,
added back to the free cash flow calculation.

Next up are the fixed assets of the company. The company must invest in fixed assets.
The general opinion is that these fixed assets will help the company generate higher
operating cash in the future. Usually, the company’s fixed assets spend is predictable,
but just like the working capital changes, the changes in fixed assets should also get
factored in.

Considering both the above, our free cash flow equation looks like this –

PAT + Depreciation + Amortization + Deferred Taxes – Change in working capital –

change in fixed asset investments.

Now, here is an interesting bit. If you relook at this again –

When we start free cash flow calculation, we start with the PAT of the company. But
before we arrive at PAT, we payout interest or the finance charges. Now, think about it,
to whom does the interest payout belong to? It goes to the debt holders, which means
that if you were to look at the free cash flow to the firm, then we also need to add back
the interest to our free cash flow calculation. Hence, the equation now looks like this –

PAT + Depreciation + Amortization + Deferred Taxes + Interest charges – Change in

working capital – change in fixed asset investments.

The above equation is the free cash flow to the firm or the FCFF. Now, from the free
cash flow to the firm, if you separate the cashflow which portion belongs to the debt
holders and that will leave you with the part that belongs to the equity holders, which
can then get valued and get a sense of company’s valuation from the equity holder’s
perspective.

Think about what the debt holders expect from the company? Unlike the equity folks,
debt folks have a different payout expectation. The debt funders lend a certain amount
(principal) to the company and expect the company to pay interest against the principal
amount. At the end of the tenure, the debt holders expect the principal to be repaid in
full. So from the free cash flow equation that we arrived at earlier, if we separate the
principal repayment and the interest payments, we are left with the ‘Free cash flow to
the Equity.’

I hope the above explanation is clear about arriving at both FCFF and FCFE. We will
get into a more detailed description in the next chapter, especially when we implement
the absolute valuation model within the financial model we are building. But for now, I
intend to give you an overview of how various elements of valuation come together.
15.3 – Return expectations
We now have a broad overview of how to calculate the free cash flow to the firm and the
free cash flow to equity holders. Let’s quickly understand the return expectation from the
firm and equity holder’s perspective.

To get a sense of the return expectation of the firm, we should be clear about what the
debt holders expect. The debt holders of the firm, as we discussed earlier, expect an
interest payment against the principal amount, plus at the end of the tenure, they expect
the principal itself to be repaid.

The firm has to satisfy the debt holders’ return expectations. But the firm also has equity
holders, who will have a different return expectations. So when you are thinking about
the firm’s free cash flow, then because the firm has both debt and equity holders, the
return expectation of the firm should be such that it satisfies both debt and equity
holders. If you build a valuation model based on FCFE, the cash flow is discounted with
a blended rate, satisfying both the debt and equity holders.

Let me give you an example. Assume a company has 350Cr, of which debt is 125Crs,
and the equity holders fund the balance 225Cr. The debt holders expect a 9% return,
and the equity holders expect a 15% return. Why they expect what they expect is
something we will discuss later. However, from the company’s point of view, it should
generate a blended return to satisfy both, i.e., the expectation of the firm is the weighted
average return –

= (9%*125) + (15%*225) / 325

=13.85%

The blended rate of return is also called the ‘Weighted cost of capital (WACC). We will
discuss this later.

Think about the equity holder’s return expectation. The equity holders will expect a
higher return than the debt holders because the equity holders take more risk. Equity
holders expect at least the risk-free rate that prevails in the economy plus a risk
premium for the additional risk (over the debt holders) that they take. The return
expectation of equity holders is called, ‘The cost of capital’.

Cost of capital = Risk-free rate + Risk premium

Note that the cost of capital is always higher than the WACC. In this chapter, I’ve laid
down the basic foundation for the FCFF and FCFE and touched upon the return
expectation. In the next chapter, let us try and take a closer at the same.
Key takeaways from this chapter

○​ A firm can be looked at as a combination of debt and equity holders

○​ The debt and equity holders finance the assets of the company
○​ To get the FCFF, we start with PAT and add back all non-cash expenses
○​ From FCFF, we deduct interest and principal repayments to get FCFE
○​ The weighted cost of capital is a blended rate, and it is the expectation of
the firm
○​ Cost of capital is what return expectation of the Equity holders
○​ The cost of capital is always higher compared to WACC
 CHAPTER 16

Valuation (Part 3) - Risk Premium & Tax Shield

16.1 – Market risk premium
In the previous chapter, we discussed that the equity holders expect a higher return
than the debt holders. The higher return (rate) is what we will use to discount the free
cash flow to the equity holders. But the question is, how much higher?

You can think about it this way: if the risk-free rate (Rf) is 7%, how much more would
you like (over and above the risk-free rate) so that you feel encouraged to invest in
equities? If you were to ask a bunch of investors and take an average of the expected
return, you would arrive at the rate. However, most individual investors won’t have
access to such a consensus. Hence we can probably apply an equation to get our
answer.
Re = Risk free rate (Rf) + Risk premium

Where Re = Return expectation of equity holders.

The risk premium is the additional return over and above the risk-free return to
encourage an investor to invest in equities. The risk premium is –

Risk premium = β*(Rm – Rf), where

Rf = Risk-free rate

Β = Beta of the stock

Rm = Market rate

Of course, we can rearrange the Re equation –

Re = Rf + β*(Rm – Rf)

By the way, this equation in finance is called ‘The Capital Asset Pricing model’ or
CAPM.

Let’s take an example and see how this works. The best proxy for the risk-free rate is
the 10-year-old Govt bond yield. We can look it up on the CCIL portal –

I’ve highlighted the last traded yield of the 10-year Government bond maturing in 2032.
The yield is 7.4586%. The yield indicates that if I were to invest in this bond and hold it
for 10 years, I would earn a return of 7.4586% without any risk. Without any risk,
because we don’t expect Govt of India to default on its debt obligations, default risk is
almost non-existent.
Government defaulting on debt is a severe issue, so governments try their best not to
default. Also, why are we considering 10 years and not any shorter-term bond? This is
because we are interested in longer-term yields as we also forecast the free cash flow
for the long term.

Next up is the Beta. Beta, as you may know, is the company’s stock price sensitivity with
respect to the stock market. I’ve explained the concept of Beta and what it means in this
chapter. I’d suggest you review it if you are not familiar with the idea of Beta as
explained in section 11.5 of this chapter.

Rm is the market rate, and this is the market’s long-term average return. I’d suggest you
keep this around 8% to 9%, maybe 10 or 12%, if you are bullish.

Please note that when we build the final model, all these rates can be changed to
whatever you think makes sense. Let’s assume that the Beta of the company we are
dealing with is riskier compared to market, and therefore we assign the Beta as 1.3.

By the way, you can easily calculate the Beta of any company in excel. Anyway, let us
plug in these numbers and see how the return expectation of equity holders works –

= 7.4586% + (1.3) *( 8.5%-7.4586%)

= 8.81%

Of course, when we integrate this within our model, you are free to change the values to
what you think makes sense. For example, if you feel the risk-free rate should be 8%
instead of 7.45%, that’s fine, but whenever you make any change, make sure you have
a reason for that change.

16.2 – Tax shield

In the last chapter, we learned that we could get the Free cash flow to the firm by adding
non-cash expenses back to the Profit after taxes. The non-cash expenses included the
following –

○​ Depreciation
○​ Amortization
○​ Deferred taxes
○​ Proceeds from the sale of assets
○​ Interest expense
Adding the interest expense part is tricky, and we need to spend some time
understanding how to add the interest. Let me take an arbitrary example to illustrate
this, have a look at this –

As you can see, we have a fairly straightforward bottom line P&L of a company. The
EBIT is 700 Crs, and the company pays 70Cr as interest charges at 10%. The PBT is
630 Crs, and at a 25% tax rate, the company pays a tax of 157.5Crs. The bottom line
i.e. PAT = PAT – Taxes = 472.5 Crs.

Now, to calculate the Free cash flow to the firm, we start with PAT and add back
non-cash expenses. We also add back the interest paid because the interest goes back
to the debt holder of the company. If we were to do this –

PAT = 472.5

(Add) Interest = 70

= 542.5

But there is a problem doing this. You see, when we pay interest, the tax outflow
reduces. For instance, the tax here is 157.5 Crs while the interest paid is 70. Now,
consider the interest as 0, this would make PBT 700, and at 25% tax, the tax outflow is
175.
So in a sense, interest shields us from a higher tax outflow. So interest that we add back
should be factored in for tax shield. To do that –

Interest (with tax shield) = Interest *( 1 – tax)

= 70*(1-25%)​
52.5

So when you add back interest to PAT to calculate the FCFF, we add 52.5 here and not
70. In this example –

PAT = 472.5

Interest = 52.5

525

Just to refresh, for FCFF calculation –

FCFF = PAT + Depreiciation + Amortization + Interest*(1-tax rate) + deferred taxes –

working capital changes – investment in fixed assets (CAPEX).

We start the FCFF calculation with PAT, but instead, we can even begin with EBIT. If we
were to start with EBIT, we need to add back the tax shield.

FCFF = EBIT *(1-tax rate)+ Depreiciation + Amortization + deferred taxes – working

capital changes – investment in fixed assets (CAPEX).

Let’s plug in the above equation for the arbitrary example –

= 700*(1-25%)

= 525
Of course, for the sake of simplicity, I’ve ignored the non-cash expense, CAPEX, and
working capital changes. But the point is that you can start your FCFF calculation with
either PAT or EBIT; both will lead you to the same result.

You can extend the calculation to figure out the free cash flow to the equity holders by
deducting the net debt from the free cash flow to the firm.

Free Cash flow to Equity = FCFF + [Debt – Principal repayment]

Where, [Debt – Principal repayment] = Net debt

Hence,

Free Cash flow to Equity = FCFF + Net debt

We will get back to this later when we implement the FCFF and FCFE within our model.
Key takeaways from this chapter
○​ Equity investors expect a return over and above the risk-free rate and that
is called the risk premium
○​ The risk premium depends on the beta of the stock. Higher the beta,
higher the premium
○​ When the company pays interest, it gets a tax shield
○​ When you add back in interest, you need to factor in the tax shield as well
○​ You can start the calculation of Free cash flow either by PAT or by EBIT,
both yield similar results
 CHAPTER 17

Weighted Average Cost of Capital and Terminal

Growth
17.1 – Recap
As far as the theoretical concept of valuation is concerned, we are now almost at the
end of it. In this chapter, we will discuss two critical points, and then in the next chapter,
we will start implementing the Discounted cash flow valuation model in our primary
model.

A quick recap of the last few chapters before we proceed –

○​ There are three valuation techniques – relative valuation (also called the
method of comparable), option-based valuation technique (valuation
contingent upon an event), or the absolute valuation technique employing
the discounted cash flow analysis
○​ We are discussing the discounted cash flow analysis or the DCF model.
The DCF valuation is on a stock basis and not year on year basis
○​ When we re-order the balance sheet equation, we get Fixed assets = Net
Debt + Equity
○​ From the above equation, you can choose to value the assets of the
company, which is essentially valuing the entire firm, also called
‘Enterprise valuation,’ or you can choose to value just the equity portion of
the company
○​ Valuation is driven by the cashflow, the growth rate of the cashflow, and
the timing of the cash flow
○​ To calculate the free cash flow, you start with PAT and add back non-cash
expenses, interest charges, and factor in changes in working capital
○​ If you are valuing based on the entire company, then the return
expectation is a blended rate called WACC (we will discuss more in this
chapter). If you value basis just the equity, then the cost of capital is the
return expectation
○​ Return expectation of equity holders is always higher than the debt
holders, and this can be estimated using the CAPM model
○​ Lastly, when you add back interest to PAT in the FCF calculation, we need
to ensure the tax shield is considered.
We have discussed all the above over the last three chapters. If you cannot follow, I
suggest you revisit the previous three chapters, read them, and post your queries to
seek clarification. In this chapter, we will wind up the conceptual discussion around the
discounted cash flow model.

17.2 – Effective cost of debt

By now, we are very clear about the discount rates we need to use when calculating the
free cash flow to the firm (FCF) and the free cash flow to equity (FCFE). To reiterate –

○​ If we are valuing the company basis the free cash flow to the equity
holders (FCFE), then we use the CAPM model to figure the equity holder’s
return expectation i.e., Re = Rf + β *( Rf – Rm). Please refer to the
previous chapter for more details on this equation.
○​ If we value the company basis the entire firm (firm = equity holders + debt
holder), then we have to discount the cashflow basis the blended rate
called the weighted average cost of capital (WACC)
We briefly discussed the concept of WACC in chapter 15 under section 15.3, but now
that we learned about the tax shield in the previous chapter, let’s revisit the idea of
WACC.

Perhaps the best way to understand WACC is by taking an example. Assume a

company has Rs.300Crs in debt and Rs.200 Crs in Equity. Equity folks expect a 12%
return, while debt holders expect 8%.

Given the capital structure, what is the blended rate or the weighted average cost of
capital?

We know that WACC is = Weight of debt * return expectation of debt holders + weight
of equity * return expectation of equity holders.

The total capital = Debt + Equity

= 300 + 200

= 500 Crs

Weight of debt = 300 / 500

= 60%

Weight of equity = (1-weight of debt)

= 1- 60%

= 40%

Hence, the blended rate or WACC is =

= 60% * 8% + 40%*12%

= 9.6%

But, here is the twist. The company also enjoys a tax shield on the interest that the
company pays. Think about it; assume the following –

EBIT of a company = 100 Crs

Interest expense = 20 Crs

Profit Before tax = 80Crs

Tax = 30% or 24 Crs

PAT = 56 Cr

Now, for a moment, think there is no interest obligation. In this case, PBT is 100 Crs,
and the tax payout at 30% will be 30Cr. The presence of interest expense reduces my
tax outflow, which is called the ‘tax shield’; we discussed this in the previous chapter.
Hence, whenever we consider the cost of debt, we also need to consider the tax shield
benefit and factor in the tax shield benefit. The cost of debt after considering the tax
shield is referred to as the ‘Effective cost of Debt.’

The formula for the effective cost of debt is : Cost of Debt *(1-Tax rate). In this example
–

= 8% *(1-30%)

= 5.6%

Notice how the rate reduces once you incorporate the impact of tax on the. We can plug
the effective cost of debt back into the WACC example and check the new rate –

= 60% * 5.6% + 40% * 12%

= 8.16%

We will incorporate the effective cost of debt equation in the main model as well

17.3 – Terminal value

Think about a company; we invest in the company with an expectation to create wealth.
Wealth creation does not happen overnight but rather over multiple years. The implicit
assumption is that the company will continue to exist and function efficiently for all those
years and beyond. In essence, the company is a going concern. As much as I’m
personally uncomfortable with the assumption, the discounted cash flow model
assumes that the company will continue to exist to infinity.

Let us live with that assumption for now.

Now, think about it: on the one hand, we are projecting the future cash flow up to the
next five years; on the other hand, we expect the company to exist forever, which
implies it will continue to generate a cash flow as long as it exists. If you were to
imagine a timeline of sorts, it would look like this –
We assume a specific growth rate when we project the cash generated for the next five
years. We need to do something similar to the cash generated from the 5th year
onwards to infinity, which means we need a growth rate for cash from the 5th year ahead
to infinity.

The growth rate is called ‘The terminal value growth rate,’ and the terminal value growth
rate is usually equal to the long-term inflation. I hope you have noticed the following so
far –

○​ For the first five years of our model, we make a detailed analysis of the
cash flow
○​ From the fifth year onwards to infinity, we stop making a detailed analysis,
and we assume growth in cashflow (terminal value)
○​ The implicit assumption is that the cash flow from the 5th year onwards will
be stable and also a positive cash flow. Discounted cash flow analysis will
not work if the cashflows are negative.

Once we have the terminal value growth rate, which is usually equal to the long-term
inflation of the country, we can calculate the present value of each future cash flow by
applying a discount rate. The discount rate is either the return expectation of equity
investors or the return expectation of the firm (WACC). But practically speaking, we
cannot apply the standard present value formula to identify the current value of the
future cash flows because this cash flow goes up to infinity. Hence, for calculating the
present value of the terminal value, we use a unique formula –

Present value of Terminal Value = C (1+ g)/(r-g)

Where –

C = cash as of today

g = growth rate i.e. inflation rate

r = discount rate (either for equity investors or the firm as such)

The formula’s derivation is fairly easy, but I’ll skip getting into the details for now.
However, please think through what we are trying to do here. Assume, from the 5th year
onwards, i.e., for the 6th year and onwards towards infinity, we start computing the
cashflow –

6th Year – FCF is 50Cr

7th Year – FCF is 53 Cr

8th Year – FCF is 55 Cr

So on and so forth till infinity. When you compute the present value of the terminal
value, you essentially calculate the lump sum amount you are willing to pay today for
this stream of cash flow in the future.

I hope you’ve got a gist of what we are trying to discuss here. Do go through this
chapter again if you found it confusing. In the next chapter, we will implement everything
we have discussed over the last few chapters and complete our valuation model.

The DCF model is super sensitive to the company’s terminal value because the terminal
value is a huge number, so any slight change in our assumption will significantly impact
our final valuation, which will become apparent to you in the next chapter.
Key takeaways from this chapter

○​ While calculating WACC, the debt holder’s return expectation should

factor in the tax shield, which is called the effective cost of debt.
○​ The company is a growing concern, expected to generate cash at a
steady rate.
○​ The detailed analysis stops at the 5th year.
○​ We expect the cash to grow at the inflation rate.
○​ We apply the principle of present value to get the terminal value
○​ The discounted cash flow model is sensitive to the terminal value
 CHAPTER 18

Discounted Cash Flow Analysis (DCF)

18.1 – Recap
We started chapter 1 with an introduction to financial modeling. I did talk about how
financial modeling is always taught to students in a classroom program. An attempt to
explain financial modeling in Varsity’s long-from approach was an interesting

😊
experience. The module took maximum planning and several rewrites, but I hope you
recognize the complexity involved in this module

As we approach the last chapter in this module, let us quickly recap everything we have
learned so far in this module.

●​ As a first step, we discussed how to set up the excel sheet for building a financial
model. We discussed format hygiene and how important it is to ensure cells are
systematic across sheets. For example, column J represents Year 6’s data in
sheet 1; then, we ensure column J is linked to year 6 data across all the sheets.
●​ We moved to import the historical data from the annual report. We copied mainly
the P&L and Balance sheet statement. Just to let you know, there are multiple
places where you can source these financial statements, including 3rd party
websites. But the best source for getting this information is the company’s annual
report. So always try and stick to the annual report. We also color-coded
assumptions and calculated numbers.
●​ We set up an assumption sheet, where we dumped all the assumptions on one
page. The page itself is divided into P&L assumptions and Balance sheet
assumptions. We discussed two techniques of assumption – the growth driver by
taking historical averages and the percentage technique.
●​ For some companies having a dedicated revenue model helps. A revenue model
gives us granular insights into things that can impact the company’s revenue.
●​ We built the asset and debt schedule of the company. Asset schedule gives us
insights into depreciation and CAPEX. The debt schedule gives us insights into
the cost of debt. Both these sheets link back to the balance sheet.
●​ The Reserve schedule is another schedule we built, with numbers from both P&L
and balance sheet.
●​ With all the schedules and assumptions in place, we make P&L and Balance
sheet projections. At this stage, all the line items in the P&L and Balance sheet
 get projected. What remains are the cash and cash balance numbers on the
balance sheet.
●​ We built the cash flow statement using an indirect method to get the cash
balance. The final cash value flows back to the balance sheet, and if the
calculations are correct, the balance sheet should balance at this stage.
●​ The financial model is said to have hit a milestone when the cash value hits the
balance sheet to balance the balance sheet.
●​ After the cash flow statement chapter, we discussed the theory of valuations, and
now, it is time to implement the valuation model and bring all the concepts
together.

Over the last few chapters, mainly from chapters 14 to 17, we discussed theoretical
concepts related to valuation. In this chapter, let us implement the discounted cash flow
valuation (DCF) model within the primary model. The output from the DCF model is the
share price of the company.
18.2 – Assumptions
From a format perspective, the DCF model sheet will look a bit different from the rest of
the model sheets because we are not dealing with any historical data. However, as
usual, we will start by indexing columns A and B and rename the sheet to ‘DCF
valuation.’

To begin with, we will dump all the data we need to implement DCF.

😊
I hope you’ve read the previous few chapters so that these terms don’t suddenly look
alien to you

●​ We can use the long-dated Govt securities (bond) yield as a proxy for the
risk-free rate. The data is available for you on RBI’s website. As of today, I’ll take
the 10-year bond’s yield as a proxy, which is at 7%
●​ The beta of the stock is pretty easy to calculate. I’ve explained it in this chapter
here. Refer to section 11.5. I’ll assume the beta of the company we are modeling
as 1.2. As you may know, a beta of 1.2 is high beta. But don’t worry; you can
change these numbers anytime since this is an integrated financial model.
●​ The expected market return is the standard market expectation and can range
between 10% and 12%. Let us go with 12% for now.
●​ The cost of Equity is derived from the CAPM formula discussed in the previous
chapters. It is the risk-free rate plus the difference between the expected market
rate and the risk-free rate multiplied by the company’s beta. It is easy if you look
at the excel formula.
●​ The cost of debt is the rate at which the company borrows funds—assuming this
to be 10%.
●​ The tax rate is 25%. Of course, you can change this to any percentage you think
makes sense.
●​ The target debt-to-equity ratio is assumed to be 50%. While it’s nice to be
debt-free, most companies cannot afford to be. They do end up taking debt to
fund CAPEX, but a well-run company will aim not to cross the 50% threshold.
●​ The terminal growth rate is a super important assumption that we make. The
entire DCF model relies heavily on this assumption. As discussed in the previous
chapter, we will assume the terminal growth rate to be close to the long-term
inflation number of the country, so between 4 and 5%.
●​ The weighted average cost of capital (WACC) is something that we will calculate
in excel directly. But I do hope you recollect the discussion we had previously on
WACC.
WACC is the weighted average return expectation of debt holders and equity holders
(check highlights). We will use the WACC to discount the cash flows.

18.3 – Free cash flow to the Firm

Once we have the assumptions in place, we have to calculate the free cash flow to the
Firm (FCFF). Remember, we are calculating the future free cash flows to the Firm.
Hence we have to deal only with data from year six onwards. We start the calculation
with EBIT and take the tax shield effect on EBIT.

Of course, we have not calculated EBIT specifically in P&L, so we will have to quickly
figure that in P&L. EBIT is earnings before interest and taxes; hence to calculate EBIT,
we subtract all the expenses from total income, except the interest.
We multiply EBIT with (1-tax rate) to factor in the tax shield effect on EBIT. To this, we
add back all the non-cash charges and deduct working capital and CAPEX charges to
arrive at the free cash flow to the Firm. I’ve made these calculations in excel, and here
is how my sheet looks now –
Notice that I’ve indexed columns E,F,G, and H to ensure I link columns J to N with years
6 to 10, just like in the other sheets. You are free to format this sheet in whatever way
you think makes sense.

EBIT and depreciation numbers come from P&L. The working capital and CAPEX
numbers come from the cash flow statement. I’ll provide the link to download the excel
sheet at the end of this chapter, so please do download the sheet and check the cell
linkages.

18.4 – Terminal Growth value

We now have the free cash flow to the Firm, projected up until the next five years, i.e.,
till year 10. However, this does not mean the company will stop generating free cash
flow after five years. We assume that the company will not only continue to exist but will
also continue to generate free cash flow. The rate at which the cash flow grows is called
the ‘terminal growth rate,’ which is usually equivalent to the long-term inflation value of
the country.

I want you to use a bit of imagination here. Fast forward to 5 years from now. From the
5th year onwards, you are looking outwards at eternity and imagining all cashflows that
the company will generate. You need to sum up all the cash flow and bring it to the 5th
year, i.e., the current year.

You can do this by applying the terminal growth value formula –

= 5th Year cash flow * (1+terminal growth rate)/(WACC-terminal growth rate)

I’ll not get into the technicalities of how the formula is derived. But that’s the formula to
figure out the sum of all the future cash flows.

Here is the calculated value –

The terminal value is a big number and has an impact on the final valuation of the
company.

So, we have the next five year’s free cash flow to the firm numbers. We also have the
terminal value number. We now have to discount all these cash flows and bring them
back to the present-day terms, i.e., we need to calculate the present value of all the
future cash flows.

For example, the free cash flow in Year 8 is 294.14 Crs. Year 8 is three years away from
the present day. To calculate the present value –

= 294.14/(1+10.25%)^3

= 219.4923 Crs.

We can do this systematically in excel –

I first calculated something called a discount factor, which is –

1/(1+WACC)^(time)

The time for this particular example is three years. So the discount factor for year 3 is
0.746. I have to multiply the discount factor with the free cash flow to get the present
value.

So 0.746 * 294.14 = 219.4923Crs.

Notice that I’ve also calculated the present value of the terminal growth value.

18.5 – Share price

We’ve come to the last bit, finally 😊
We sum up all the present value of the future free cash flow, i.e., from Year 6 to 10,
along with the current value of the terminal value to arrive at the ‘Enterprise Value. We
deduct the present-day debt from the enterprise value and add the present-day cash to
give equity holders the free cash flow.

The present-day debt and cash value come from the balance sheet.

And, here you go –

The share price is Rs.300. What does this mean?

The price you see here is an outcome of the entire valuation exercise. We have made
many assumptions here, and if these assumptions are made intelligently, then with
some confidence, we can conclude that Rs.300 is the fair value of the stock. You can
now compare the stock’s market value on the stock exchanges and decide to buy or
wait. For example, if the stock is trading at Rs.425, then you know that it is overvalued
compared to its fair value; hence you can avoid buying the stock.

If the stock is trading at Rs.225, the stock is undervalued, and you can go ahead and
invest in the stock. Or if the stock is trading at Rs.300, it is said that it is fairly valued.

18.6 – Closing thoughts

The model we have built is integrated, meaning that any change in any number in this
model will impact the share price.

For example, in the assumption sheet, I’ll change the material consumed as a
percentage of sales for Year 6 to 60% from 65%. The share price will change to Rs.462
from Rs.300.
Or I can change the terminal growth rate to 4.5% from 4%, and subsequently, the share
price changes to Rs.323. I encourage you to make these changes and see for yourself,
which is the beauty of this model. All the sheets and numbers are linked, and any
difference across the sheet will result in the final output.

You can make these changes when you think the difference is justified, which brings me
to my next point.

Building a financial model is pretty straightforward. A seasoned modeler will probably

create a good model in a few days. But what is essential is to keep the model up to
date. Once you build a model, track the company closely, especially the management
interviews and statements. Whenever new information comes, make an appropriate
change in the model.

For example, during the following quarterly result announcement, the company may say
they want to slow down their CAPEX spending. Immediately, tweak your model and
adjust for a lower CAPEX spend, and accordingly, the share price changes and gets
re-rated. Maintain a separate sheet in the workbook detailing the reasons based on
which you made the changes. The sheet acts as your working notes.

One last thing before I end this chapter and module – the final output, i.e., the share
price is Rs.300. That does not mean, Rs.300 is strictly the fair value of the stock. The
share price is an output of a model we have built, and the model is undoubtedly prone
to inadvertent errors. Therefore, you need to factor in model errors. I’d assign a 10%
band as a modeling error, which means I’ll consider the stock’s fair price anywhere
between Rs.270 to Rs.330.

I’ll be happy to buy the stock anywhere within this range, preferably at the lower end, as
it gives me some margin of safety.

I hope you enjoyed reading through this module as much as I enjoyed writing this for
you.

You can download the excel sheet from here.

Key takeaways from this chapter

●​ The stock’s beta represents the stock’s riskiness with respect to the market and
can be easily calculated.
●​ We use the CAPM equation to figure out the cost of equity
●​ WACC is a blended cost of capital that we use to discount the cash flow
●​ Free cash flow to the Firm is calculated by starting with EBIT
●​ You can calculate the discount factor to calculate the present value easily
●​ Enterprise value is the sum of all the present value of future cash flow
●​ As and when new information flows, one needs to update the model
●​ The final share price is just an indicator of fair value. It makes sense to factor in
model errors and assumes a fair value price band rather than a since price as the
fair value of a stock.