Cash Flow Fund Flow

Fund flow is based on a wider

Cash flow is based on a narrow
1. Inherent meaning concept called “working
concept called “cash”.
capital”.

The utility of cash flow The utility of fund flow is to

2. Usefulness statement is to find out the net understand the financial
cash flow. position of the company.

Cash flow statement starts with Fund flow statement computes

opening balance and after the difference between sources
3. Source
adjustments comes out with net of funds and application of
cash inflow/outflow. funds.

Shown in the operating

Shown in the statement of
4. WC shown activities of cash flow
changes in working capital.
statement.

5. Type of Follows cash basis of Follows accrual basis of

accounting accounting. accounting.

Through fund flow analysis

Through cash flow analysis we
6. Effect we get to know the change in
get to know the net cash flow.
working capital.

7. Is it a financial
Yes. No.
statement?

Short term analysis of cash Long term analysis of working

8. Term
flow. capital.

9. Used for Cash budgeting. Capital budgeting

There are many differences between cash flow vs fund flow. But the key differences are

articulated below –

Cash flow statement is one of the four financial statements that every investor looks at
to understand the financial position of a company. Fund flow statement, on the other
hand, isn’t a financial statement. Cash flow statement is prepared so that at the end of
a particular period the net cash flow of the company can be computed. Fund flow
statement is prepared to see the sources and uses of funds during a particular period
and how that “change in the funds” affects the working capital of the company. Cash
flow statement is created by following cash basis of accounting. Fund flow statement,
on the other hand, is created by following accrual basis of accounting. Cash flow
statement is used for cash budgeting. Fund flow statement is used for capital
budgeting. Cash flow statement is prepared to see the short-term effect of cash flow.
Fund flow statement is prepared for the long-term purpose.

Cash flow serves a company and its investors and potential investors by showing
exactly how much cash is getting injected into the company and how much cash is
being paid. On the other hand, fund flow statement helps a company set up a capital
budget and take necessary steps regarding the specific items which affect the “sources
& uses of funds” in the company.

How does an inventory write down affect the three statements?

An Inventory write down is an accounting process that is used to show the reduction of
an inventory’s value, when the inventory’s market value drops below its book value on
the balance sheet.

An inventory’s lifespan depends on what it is. Excess, stored inventory will near the end
of its lifespan at some point and in turn result in damaged or unsellable goods. In this
scenario, write-down happens by either reducing the value of the inventory or removing it
entirely. Goods that are damaged in production or when being delivered also contribute to
inventory write-down. Other common causes of inventory write-downs are stolen goods
and inventory used as in-store displays (goods put on display are not fit for consumption).

Inventory write-down should be treated as an expense, which will reduce net income. The
write-down also reduces the owner’s equity. This will also affect inventory turnover for
subsequent periods.
A write-down in a company's inventory is recorded by reducing the amount reported as
inventory. If the amount of the Loss on Write-Down of Inventory is relatively small, it
can be reported as part of the cost of goods sold. If the amount of the Loss on Write-
Down of Inventory is significant, it should be reported as a separate line on the income
statement.
Since the amount of the write-down of inventory reduces net income, it will also reduce
the amount reported as owner's equity or stockholders' equity. Hence for the balance
sheet and in the accounting equation, the asset inventory is reduced and the owner's or
stockholders' equity is reduced.

Statement of Cash Flow

The Statement of Cash Flows (also referred to as the cash flow statement) is one of the
three key financial statements that reports the cash generated and spent during a specific
period of time (i.e., a month, quarter, or year). The statement of cash flows acts as a
bridge between the income statement and balance sheet by showing how money moved
in and out of the business. The statement has three sections:

Operating Activities: The principal revenue-generating activities of an organization and

other activities that are not investing or financing; any cash flows from current
assets and current liabilities

Investing Activities: Any cash flows from the acquisition and disposal of long-term
assets and other investments not included in cash equivalents

Financing Activities: Any cash flows that result in changes in the size and composition
of the contributed equity or borrowings of the entity (i.e., bonds, stock, cash dividends)

Cash from operating activities can be compared to the company’s net income to
determine the quality of earnings. If cash from operating activities is higher than net
income, earnings are said to be of “high quality.” This statement is useful to investors
because, under the notion that cash is king, it allows investors to get an overall sense of
the company’s cash inflows and outflows and obtain a general understanding of its
overall performance. If a company is funding losses from operations or financing
investments by raising money (debt or equity) it will quickly become clear on the
statement of cash flows
Working capital

Working capital is the difference between a company’s current assets and current
liabilities. It is a financial measure, which calculates whether a company has enough
liquid assets to pay its bills that will be due in a year. When a company has excess current
assets, that amount can then be used to spend on its day-to-day operations.

Current assets, such as cash and equivalents, inventory, accounts receivable and
marketable securities, are resources a company owns that can be used up or converted
into cash within a year.

Current liabilities are the amount of money a company owes such as accounts payable,
short-term loans and accrued expenses, which are due for payment within a year.

The working capital formula is:

Working capital = Current Assets – Current Liabilities

The working capital formula tells us the short-term, liquid assets remaining after short-
term liabilities have been paid off. It is a measure of a company’s short-term liquidity
and important for performing financial analysis, financial modeling, and managing cash
flow.

Having positive working capital can be a good sign of the short-term financial health for
companies because it has enough liquid assets remaining to pay off short-term bills and to
internally finance the growth of their business. Negative working capital means assets
aren’t being used effectively, and a company may a liquidity crisis. Even if a company
has lots invested in fixed assets, it will face financial challenges if liabilities come due too
soon. This will lead to more borrowing, late payments to creditors and suppliers and, as a
result, a lower corporate credit rating for the company.

Forecasting Working Capital

Working capital is the difference between how much cash is tied up in inventories,
accounts receivables etc. and how much cash needs to be paid for accounts payable and
other short-term obligations.

From the working capital, you would also be able to understand the ratio (current ratio)
between current assets and current liabilities. The current ratio will give you an idea
about the liquidity of the company.
Generally, when you forecast Working Capital, you do not take Cash in “Current Assets”
and any debt in the “Current Liabilities”.

Working Capital Forecast essentially involves forecasting Receivables, Inventory, and

Payables.

Accounts Receivable Forecast

• Generally modeled as Days Sales Outstanding formula;

• Receivables turnover = Receivables/Sales * 365
• A more detailed approach ma include aging or receivables by business segment if
the collections vary widely by segments
• Receivables = Receivables turnover days/365*Revenues

Inventories Forecast

• Inventories are driven by costs (never by sales);

• Inventory turnover = Inventory/COGS * 365; For Historical
• Assume an Inventory turnover number for future years based on historical trend or
management guidance and then compute the Inventory using the formula given
below
• Inventory = Inventory turnover days/365*COGS; For Forecast

Accounts Payable Forecast

• Accounts Payables (Part of Working Capital Schedule):

• Payables turnover = Payables/COGS * 365; For Historical
• Assume Payables turnover days for future years based on historical trend or
management guidance and then compute the Accounts Payables using the formula
given below
• Accounts Payables = Payables turnover days/365*COGS; for Forecast
Importance of financial modeling

A financial model is simply a tool that’s built in Excel to forecast a business’ financial
performance into the future. The forecast is typically based on the company’s
historical performance, assumptions about the future, and requires preparing an
income statement, balance sheet, cash flow statement and supporting schedules
(known as a 3 statement model).

The importance of financial modeling is mainly rooted in its capability to enable

better financial decisions within a firm. It is widely used by organizations for the
purpose of future planning. By simulating the impact of important variables, financial
modeling allows for scenario preparation so that organization knows its course of
action in various situations that may arise.
Financial modeling also plays an important role in capital budgeting. Not only does it
make financial statement analysis and resource allotment for the next big investment
easier, but it also helps in determining the cost of capital. It provides a thorough
analysis of debt/equity structure for this purpose, along with the returns expected by
investors.
The output of a financial model is used for decision making and performing financial
analysis, whether inside or outside of the company. Inside a company, executives will
use financial models to make decisions about:

• Raising capital (debt and/or equity)

• Making acquisitions (businesses and/or assets)
• Growing the business organically (i.e. opening new stores, entering new markets,
etc.)
• Selling or divesting assets and business units
• Budgeting and forecasting (planning for the years ahead)
• Capital allocation (priority of which projects to invest in)
• Valuing a business

Financial modeling is a quantitative analysis which is used to make a decision or a

forecast about a project generally in asset pricing model or corporate finance.
Different hypothetical variables are used in a formula to ascertain what future holds
for a particular industry or for a particular project.
 In Investment Banking and Financial Research, Financial modeling means forecasting
companies financial statements like Balance Sheet, Cash Flows, and Income
Statement. These forecasts are in turn used for company valuations and financial
analysis.

How capital expenditures items forecasted?

In terms of accounting, an expense is considered to be a capital expenditure when the

asset is a newly purchased capital asset or an investment that improves the useful life of
an existing capital asset. If an expense is a capital expenditure, it needs to
be capitalized. This requires the company to spread the cost of the expenditure (the fixed
cost) over the useful life of the asset. If, however, the expense is one that maintains the
asset at its current condition, the cost is deducted fully in the year the expense is incurred.
CapEx can be found in the cash flow from investing activities in a company's cash flow
statement.

Project future capital expenditures by using an appropriate forecasting assumption. Apply

intuition to determine the proper forecasting assumption to use from the following:

• Capex as a percentage of sales

• Fixed recurring amount
• Reasonable “hard dollars” that one would expect a company to incur as they
operate

If applying the capex as a percentage of sales method, divide capex by sales to find
capital expenditure as a percentage of sales. Use these percentages to create an
assumption about future capital expenditure as a percentage of sales. Multiply this against
projected sales to find a forecast for capital expenditure.
Which is higher – the cost of equity or the cost of debt, and why?

The cost of equity is almost always higher than the cost of debt. This is mostly because
debt holders have less risk than equity holders of not getting their money back and are
therefore willing to accept lower returns. – Debt is secured against a company’s assets
and is therefore less risky for the creditor, which can seize those assets if the company
defaults. If a company goes bankrupt, debt holders receive proceeds of the liquidation
ahead of equity holders. And debt holders receive interest on their investment in all
situations (whereas equity holders are only paid dividends if the company is doing well).
It helps too that debt s tax deductible.

What are Financial Modeling Limitations?

The main financial modeling limitations include: (1) the heavy use of assumptions about
the future, (2) the heavy reliance on a terminal value that makes up so much of the net
present value of a business, (3) the reliance on weighted average cost of capital (WACC),
(4) the propensity of Excel models to contain errors that cannot be easily found, and (5)
the inability to reliably predict what is going to happen in the future. Despite these
limitations, financial models can still be used as a planning tool to evaluate a range of
potential outcomes.

Write short note on - Dupont Analysis

DuPont analysis is a fundamental performance measurement framework based on the

return on equity ratio that is used to analyze a company’s ability to increase its return on
equity. In other words, this model breaks down the return on equity ratio to explain how
companies can increase their return for investors. Decomposition of ROE allows
investors to focus their research on the distinct company performance indicators
otherwise cursory evaluation.
DuPont analysis focuses on three major financial metrics drive return on equity (ROE):
operating efficiency, asset use efficiency and financial leverage. Operating efficiency is
represented by net profit margin or net income divided by average shareholders' equity.
Asset use efficiency is measured by total asset turnover or the asset turnover ratio.
Finally, financial leverage is analyzed through observation of changes in the equity
multiplier.
Return on Equity (ROE) = Net Profit Margin x Asset Turnover Ratio x Equity Multiplier
Financial Model layout

There are primarily two types of Financial Model layouts – Vertical and Horizontal.

• Vertical Financial Model Layouts are compact, you can easily align the columns

and headings. However, they are tougher to navigate because a lot of data is

contained in a single sheet.

• Horizontal Financial model Layouts are easier to setup with each module in a

separate sheet. Here the readability is high as you can name the individual tabs

accordingly. The only problem is that there are many numbers of sheets which you

have interlink. I prefer the Horizontal Layouts as I find them easier to manage and

audit.
Distinguish between - Horizontal Financial Statements & Vertical Financial
Statements

Vertical analysis of an income statement results in every income statement amount being
presented as a percentage of sales. Horizontal analysis looks at amounts on the financial
statements over the past years. While horizontal analysis looks at how the dollar amounts
in a company’s financial statements have changed over time, vertical analysis looks at
each line item as a percentage of a base figure within the statement. Thus, line items on
an income statement can be stated as a percentage of gross sales, while line items on a
balance sheet can be stated as a percentage of total assets or liabilities, and vertical
analysis of a cash flow statement shows each cash inflow or outflow as a percentage of
the total cash inflows. Vertical analysis is also known as common size financial
statement analysis.

How do we build a financial model

• The core modules are the Income Statement, Balance Sheet, and Cash Flows.

• The additional modules are the depreciation schedule, working capital schedule,

intangibles schedule, shareholder’s equity schedule, other long-term items

schedule, debt schedule etc.

• The additional schedules are linked to the core statements upon their completion

The main sections to include in a financial model (from top to bottom) are:

1. Assumptions and drivers

2. Income statement
3. Balance sheet
4. Cash flow statement
5. Supporting schedules
6. Valuation
7. Sensitivity analysis
8. Charts and graphs
1. Historical results and assumptions

2. Start the income statement

3. Start the balance sheet

4. Build the supporting schedules

5. Complete the income statement and balance sheet

6. Build the cash flow statement

7. Perform the DCF analysis

8. Add sensitivity analysis and scenarios

9. Build charts and graphs

10. Stress test and audit the model

How the historical financial statements are picked up while designing the financial
model

The best practice to pick the historical financial statements is from the Annual Reports or
the Stock Exchange Filings directly. This may involve copying and pasting the data from
the annual report to the excel sheet. As you start populating the data, you will realize the
subtle changes in the financial statements that the company may have done. Additionally,
you will get a good understanding of the kind of items included in the financial
statements.

Other databases like money control or economic times provide financial statements’ data
of various companies but the reliability is not assured. These databases use a very
standardized way to report the financial statements. With this, they may include/exclude
key items from one line item to another and thereby creating confusion. With this, you
may miss out on important details.
How Do You Forecast Revenues?

For most companies, revenues are a fundamental driver of economic performance. A

well designed and logical revenue model reflecting accurately the type and amounts
of revenue flows is extremely important. There are as many ways to design a revenue
schedule as there are businesses.

Some common types include:

• Sales Growth
• Inflationary and Volume/ Mix effects
• Unit Volume, Change in Volume, Average Price and Change in Price
• Dollar Market Size and Growth
• Unit Market Size and Growth
• Volume Capacity, Capacity Utilization and Average Price
• Product Availability and Pricing
• Revenue driven by investment in capital, marketing or R&D
• Revenue based on installed base (continuing sales of parts, disposables, service
and add-ons etc).
• Employee based
• Store, facility or Square footage based
• Occupancy-factor based
 ROI is not the end of financial objectives. Explain

ROI is one of the most common investment and profitability ratios used today. However,
it does have some limitations.

One potential drawback to this formula is its inability to consider time in the equation.
Take the first two examples cited above: The 200% ROI is higher than the 150% ROI.
On the surface, the higher ROI seems like the more productive investment. But, what if
the investment took 10 years to produce that 200% ROI, while the second investment
took just one year to produce the 150% ROI?

Another drawback of using the ROI formula is that it does not have a way to account for
non-financial benefits. Businesses often calculate ROIs for such non tangible benefits,
frequently labeling these calculations as soft ROIs while the calculations made with
actual, tangible dollar amounts are called hard ROIs.

Free cash flow

Free cash flow is a measure of profitability that excludes the non-cash expenses of
the income statement and includes spending on equipment and assets as well as changes
in working capital.

Free cash flow is the cash a company produces through its operations, less the cost of
expenditures on assets. In other words, free cash flow or FCF is the cash left over after a
company pays for its operating expenses and capital expenditures or CAPEX.

Free cash flow is an important measurement since it shows how efficient a company is at
generating cash. Investors use free cash flow to measure whether a company might have
enough cash, after funding operations and capital expenditures, to pay investors
through dividends and share buybacks.

FCF = "operating cash" or "net cash from operating activities") - capital

expenditure required for current operations from it.
OR

Net income
+ Depreciation/Amortization
- Change in Working Capital
- Capital Expenditure
----------------------------
= Free Cash Flow

What are the design principles of a good Financial Model

F stands for Flexibility: Every financial model should be flexible in its scope and
adaptable in every situation (as contingency is a natural part of any business or industry).
Flexibility of a financial model depends on how easy it is to modify the model whenever
and wherever it would be necessary.

A stands for Appropriate: Financial models shouldn’t be cluttered with excessive

details. While producing a financial model, the financial modeller always should
understand what financial model is, i.e. a good representation of reality.

S stands for Structure: The logical integrity of a financial model is of utter importance.
As the author of the model may change, the structure should be rigorous and integrity
should be kept at the forefront.

T stands for Transparent: Financial models should be such and based on such formulas
which can be easily understood by other financial modellers and non-modellers.
3 Types of Financial Models

Three Statement Model

The 3 statement model is the most basic setup for financial modeling. As the
name implies, in this model the three statements (income statement, balance sheet, and
cash flow) are all dynamically linked with formulas. in Excel. The objective is to set it
up so all the accounts are connected, and a set of assumptions can drive changes in the
entire model. It’s important to know how to link the 3 financial statements, which
requires a solid foundation of accounting, finance and Excel skills.

Discounted Cash Flow (DCF) Model

The DCF model builds on the 3 statement model to value a company based on the Net
Present Value (NPV) of the business’ future cash flow. The DCF model takes the cash
flows from the 3 statement model, makes some adjustments where necessary, and then
uses the XNPV function in Excel to discount them back to today at the company’s
Weighted Average Cost of Capital (WACC).

These types of financial models are used in equity research and other areas of the
capital markets.

Merger Model (M&A)

The M&A model is a more advanced model used to evaluate the pro forma
accretion/dilution of a merger or acquisition. It’s common to use a single tab model for
each company, where the consolidation where Company A + Company B = Merged Co.
The level of complexity can vary widely and is most commonly used in investment
banking and/or corporate development.
Briefly explain about the Cost Projections in Financial Modeling

You can forecast Costs and other expenses as follows –

1. Percentage of Revenues: Simple but offers no insight into any leverage

(economy of scale or fixed cost burden
2. Costs other than depreciation as a percent of revenues and depreciation from
a separate schedule: This approach is really the minimum acceptable in most
cases, and permits only partial analysis of operating leverage.
3. Variable costs based on revenue or volume, fixed costs based on historical
trends and depreciation from a separate schedule: This approach is the
minimum necessary for sensitivity analysis of profitability based on multiple
revenue scenarios

"ROI is not an adequate measure for judging the financial performance of a

business undertaking" Explain.

There can be many ratios that are important from Financial Modeling point of view.
Some of the important ones are listed below

• Liquidity ratios like Current Ratio, Quick Ratio, and Cash Ratio

The current ratio is used to measure a company’s short-term liquidity position

and provides a quantitative relationship between current assets (CA) and current
liabilities (CL).

If Current Assets < Current Liabilities, then Ratio is less than 1.0 -> a
problem situation at hands as the company does not have enough to pay for its
short term obligations.
 Quick ratio is a liquidity ratio which is used as a measure of the ability of the
company to meet its current obligation. It is utilised to assess whether a business
has sufficient assets that can be translated into cash to pay its bills.

Quick ratio Formula = Quick assets / Quick Liabilities. = (Cash and Cash Equivalents +
Accounts receivables) / (Current liabilities – Bank overdraft)

A quick ratio of 1: 1 indicates highly solvent position. This ratio serves as a supplement
to the current ratio in analyzing liquidity.

The cash ratio is used to measure the liquidity of the firm and gives us a
quantitative relationship between cash & cash equivalent with the current
liabilities of the company.

Cash Ratio Formula = Cash + Cash Equivalents / Total Current Liabilities

Cash & Cash Equivalent > Current Liabilities; that means the organization has
more cash (more than 1 in terms of ratio) than they need to pay off the current
liabilities. It’s not always a good situation to be in as it denotes that the firm has
not utilized assets to its fullest extent

• Return on Equity

ROE – Return on Equity: ROE can be basically considered as profitability ratio

from shareholder’s point of view. This provides how much returns on generated
from shareholder’s investments, not from the overall company investments in
assets.

Return on Equity Formula = Net Income / Total Equity

DuPont ROE Formula = (Net Income / Net Sales) x ( Net Sales / Total Assets)
x Total Assets / Total Equity
DuPont Return on Equity Formula = Profit Margin * Total Asset Turnover
* Equity Multiplier

• Return on Assets

Return on Total Assets Formula = EBIT / Average Total Assets

Increase in the Return on Total Assets means better use of assets to generate
returns for the firm and decrease in the Return on Total Assets means that the firm
has a room for improvement – maybe the firm needs to reduce few expenses or to
replace few old assets that are eating out the profits of the company.

• Turnover Ratios like Inventory Turnover Ratios, Receivables Turnover ratio,

Payables Turnover Ratio

Inventory ratio = Cost of Goods Sold / Average Inventories

• Margins – Gross, Operating, and Net

Gross profit margin formula = (Sales – cost of goods sold)/Sales or Gross

profit/Sales

Operating Profit Ratio Formula = Operating profit/Sales or EBIT/Sales

Net profit margin formula = Profit After Tax (PAT)/Sales or Net profit/Sales

• Debt to Equity Ratio

Debt-Equity Ratio = Total Debt / Shareholders’ Equity

State the assumptions for projecting Depreciation

With depreciation expense, there is also room for interpretation on which forecasting
assumption to use. Apply judgment based on the industry and business undertaken to
select assumptions from the following:

• Depreciation expense as a percentage of CapEx

• Depreciation expense as a percentage of net PP&E
• Depreciation expense as a percentage of sales
• Fixed amount
• Reasonable growth rate

If it seems, in the past, that depreciation expense has remained constant, the company
may be using a linear depreciation policy, such as the straight-line depreciation method.
In such a case, it is handy to use depreciation expense as a percentage of net PP&E, or to
simply roll forward the recurring depreciation amount.

Since Depreciation expenses are a function of historical and expected future capital
expenditures and purchases of intangible assets, they are actually forecast as part of
the balance sheet buildup and referenced back into the income statement after the buildup
is complete.

Explain the role of "Finance Head" as Conflict Manager

A finance manager oversees all money-related functions with a business, including the
billing and accounting departments. Additionally, finance managers will typically
monitor the mark-up of products and services to ensure the profitability of the company.
The finance manager also reviews the budget and helps to make decisions about cuts and
increases in spending. Further, finance managers prepare and interpret financial reports
and help to forecast the company´s financial future.
Capital Budgeting Decision:

• Decision to invest in tangible or intangible assets

• Buy assets that are worth more than they cost
• It is also called the investment decision

Financing Decision:

• Raising money that the firm needs for its investments and operations
• Capital Structure - the mix of long term debt and equity financing