Begin with End in Mind
Why do financial models become complex? Have you come across the situation where after doing the complex calculations you realize that it is of no use? Generally, the financial model beginners try to include everything (Financials and every piece of information) in a model with a mind-set that it would give a clear view of the picture.But does it really help?
The answer is “No” because it makes the model more complex, confusing, time consuming and sometimes directionless.
So, what should they do?
The most helpful way to solve this problem is to Begin with the End in Mind. It is one of the habits written in Stephen Covey’s bestseller book “7 Habits of Highly Effective People”. The rule is simple to understand. If we have seen the map before leaving for the destination, it will make us ready for the planning, execution and most importantly eliminate the chances of facing obstacles during the trip.
In the financial modelling world too, this habit plays a very vital role. If the modeler knows the purpose of the model, it will define the whole path and direction for the model. Reverse planning helps to conceptualize things in advance. When we have the picture of the end result, we will be able to interpret how the model will appear and what are the inputs that will be needed to produce the desired results.STEPS……
Step 1 : Define the purpose - Raising capital, Debt restructuring, Forecast planning, Valuation, Capex planning, Selling, Acquisition, Capital budgeting
Step 2 : Do reverse planning - For example, if the objective is to raise capital, the major focus would be capital structure, how much capital you need through what sources, what is your current position in debt service and for what purpose the capital is raised. If you are looking out for investors then, a solid business plan is needed.
If it is project finance, then a detailed model is needed as per bank requirements where capital structure, source and uses should be transparently calculated. As major funding about 70% to 80% is generally done by the banks, and they track the financials very closely.
For capital structure, you need to decide on debt-to-equity ratio and which category of capital the company is willing to raise. If company wants to raise equity, the major requirements will be dividend model, reserves and surplus account which will need profit and loss statement and retained earnings, to present good future prospects to potential shareholders.
If company wants to raise debt, all coverage ratios needs to be calculated, like debt service coverage ratio. Also, cash flow statement and income statement must be made to check the availability of cash for repayments.
Then the method of repayments, repayment schedule, interest payment schedule needs to be drafted. Companies with good credibility get a bit more leeway in raising debt, and payments terms are not harsh.
Many prefer Revolving Credit Facilities for managing working capital like Working Capital Facility, VAT facility to manage day-to-day cash requirements. These facilities are required during steady operations and repayment increases the credit that the company can take restricted by the upper limit.
If the focus of the model is long term capital of the company rather then, short term financing complex calculations are not required. To visualize the end before we begin may appear to be a daunting task for many who are beginners in this field but with time and practice, everybody learns to make the best out of it.
For beginners and experts alike, EMF Tool provides a way get their visualization into a excel model very quickly.
This is very imperative! Fully Agreed