INTRODUCTION

TO
FINANCIAL MODELLING

By Jawwad Ahmed Farid

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CONTENTS
INTRODUCTION TO FINANCIAL MODELLING .................................................................................................. 6
1.1 Overview ..................................................................................................................... 6
1.2 Objectives ................................................................................................................... 7
RATIO ANALYSIS .................................................................................................................................... 8
2.1 Understanding the Language ...................................................................................... 8
2.1.1 Insolvency ........................................................................................................... 8
2.1.2 Fixed & Variable Costs and Cost Functions ......................................................... 8
2.1.3 Dividends ............................................................................................................ 9
2.1.4 Net Working Capital ............................................................................................ 9
2.1.5 Marketable Securities ......................................................................................... 10
2.1.6 Debt .................................................................................................................... 10
2.1.7 Stakeholders ....................................................................................................... 11
2.1.8 Managerial Efficiency (ME) ................................................................................. 11
2.1.9 Fundamental Analysis ......................................................................................... 11
2.2 Introduction to Ratios ................................................................................................. 12
2.2.1 Ratios Comparative Analysis ............................................................................ 12
2.2.2 The many faces of ratio analysis ......................................................................... 13
2.3 Liquidity, Leverage, Profitability and Productivity ...................................................... 14
2.3.1 Liquidity .............................................................................................................. 14
2.3.2 Leverage ............................................................................................................. 15
2.3.3 Productivity ......................................................................................................... 16
2.3.4 Profitability ......................................................................................................... 17
CASE STUDY 1 OFFICE DEPOT ................................................................................................................. 18
3.1 Overview ..................................................................................................................... 18
3.2 Financial Condition Review ......................................................................................... 19
3.3 Ratios Quick Reviews ............................................................................................... 21
3.3.1 Liquidity Ratios ................................................................................................... 21
3.3.2 Leverage Ratios ................................................................................................... 21
3.3.3 Productivity or Turnover Ratios .......................................................................... 21
3.3.4 Profitability Ratios .............................................................................................. 21
3.4 Industry review and a first look at ratios .................................................................... 22
3.4.1 Industry Analysis ................................................................................................. 22
3.4.2 Liquidity Ratios ................................................................................................... 22
3.4.3 Leverage Ratios ................................................................................................... 24
3.4.4 Productivity Ratios .............................................................................................. 26
3.4.5 Profitability Ratios .............................................................................................. 29
CASE STUDY 2 STAPLES & OFFICE DEPOT: COMPARATIVE RATIO ANALYSIS ...................................................... 33
4.1 Staples Overview ..................................................................................................... 33
4.2 Financial Condition Review ......................................................................................... 34
4.3 Liquidity Ratios - Comparison .................................................................................... 35
4.3.1 Current Ratio ...................................................................................................... 36
4.3.2 Quick Ratio .......................................................................................................... 36
4.4 Leverage Ratios ........................................................................................................... 37

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4.4.1 Debt to Equity Ratio ............................................................................................ 37

4.4.2 Debt to Total Assets ............................................................................................ 39
4.4.3 Times Interest Earned (Coverage) Ratio ............................................................. 39
4.4.4 Fixed Charge Coverage Ratio .............................................................................. 40
4.4.5 Productivity Ratios .............................................................................................. 40
4.5 Profitability Ratios ...................................................................................................... 43
Gross Profit Margin ......................................................................................................... 44
4.5.1 Operating Profit Margin ...................................................................................... 45
4.5.2 Net Profit Margin ................................................................................................ 45
4.5.3 Return on Assets (ROA) ...................................................................................... 46
4.5.4 Return on Equity (ROE) ....................................................................................... 47
4.5.5 Basic Earning Power Ratio .................................................................................. 47
4.6 Conclusion .................................................................................................................. 47
CORPORATE FINANCE - FINANCIAL CONCEPTS .............................................................................................. 49
5.1 Definitions ................................................................................................................... 49
5.2 Forms of Ownership ................................................................................................... 50
5.2.1 Sole Proprietor .................................................................................................... 50
5.2.2 Partnerships ........................................................................................................ 50
5.2.3 Corporations ....................................................................................................... 51
5.2.4 Limited Liability Companies (LLC's) ..................................................................... 51
5.3 Financial Statements ................................................................................................... 51
5.4 The Balance Sheet ....................................................................................................... 52
5.5 The Income Statement ............................................................................................... 53
5.6 Statement of Cash Flows ............................................................................................ 53
5.7 The Accounting Notes ................................................................................................. 54
5.7.1 The Right Way ..................................................................................................... 54
CORPORATE FINANCE REVIEW OF FINANCIAL STATEMENTS ........................................................................... 55
6.1 Assets .......................................................................................................................... 55
6.1.1 Current assets ..................................................................................................... 56
6.1.2 Property Plant & Equipment ............................................................................... 56
6.2 Depreciation ............................................................................................................... 57
6.3 Liabilities ..................................................................................................................... 58
6.3.1 Current Liabilities ................................................................................................ 58
6.3.2 Long Term Liabilities ........................................................................................... 59
6.4 Net working capital ..................................................................................................... 59
6.5 Equity .......................................................................................................................... 60
6.6 Income Statement ...................................................................................................... 61
CORPORATE FINANCE RISK AND RETURN .................................................................................................. 63
7.1 Risk & Reward ............................................................................................................. 63
7.2 Return ......................................................................................................................... 64
7.2.1 Return on Equity ................................................................................................. 65
7.2.2 Return on Invested Capital & ROE ...................................................................... 65
7.2.3 Payback period ................................................................................................... 66
CORPORATE FINANCE TIME VALUE OF MONEY: AN OVERVIEW ..................................................................... 67
8.1 Discount Rate .............................................................................................................. 67

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8.1.1 Compounding ..................................................................................................... 67

8.2 Time Value of Money .................................................................................................. 68
8.2.1 Examples ............................................................................................................. 71
8.3 Present Value in Action ............................................................................................... 74
8.4 Internal Rate of Return (IRR) ...................................................................................... 75
8.4.1 Internal Rate of Return (IRR) and comments ..................................................... 76
8.4.2 Putting it all together .......................................................................................... 76
CORPORATE FINANCE OPPORTUNITY COST AND COST OF CAPITAL ................................................................. 83
9.1 Opportunity Cost & Cost of Capital ............................................................................. 83
9.2 Weighted Average Cost of Capital (WACC) ................................................................. 84
CORPORATE FINANCE - VALUATION AND PROJECTIONS CASE STUDY ............................................................... 88
10.1 Case Study 3: Electronic Arts .................................................................................... 88
10.2 Exhibits ..................................................................................................................... 111
CREDIT ANALYSIS ................................................................................................................................... 113
11.1 Introduction .............................................................................................................. 113
11.1.1 Leverage ........................................................................................................... 113
11.1.2 Fixed and variable costs and their impact on leverage .................................... 114
11.2 Breakeven and Leverage .......................................................................................... 115
11.2.1 Breakeven Analysis ........................................................................................... 115
11.2.2 Margin of Safety ............................................................................................... 116
11.3 Fixed Costs and Operating Leverage ........................................................................ 117
11.3.1 Operating Leverage .......................................................................................... 117
11.3.2 Degree of Operating Leverage .......................................................................... 118
11.3.3 The downside of operating leverage ................................................................ 121
11.4 Financial Leverage ................................................................................................... 122
11.4.1 Introducing Financial Leverage ......................................................................... 122
11.4.2 Degree of Financial Leverage ........................................................................... 123
11.4.3 The downside of Financial Leverage ................................................................. 126
11.5 Combining Financial and Operating Leverage ..................................................... 129
CASH FLOW SUMMARY AND CASH FLOW ANALYSIS ........................................................................................ 130
12.1 Cash Flow Summary and Analysis ............................................................................. 130
12.2 Cash flow statement ................................................................................................. 144
DISCLAIMER .......................................................................................................................................... 146

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