Subject line: [Flawless Financials] How Do You Read A Financial Model? Flawless Financials the Financial Forecasting Online Newsletter from Minotaur Financial and David Brode February, 2003 Please pass on Flawless Financials to those in your network. To leave Flawless Financials, follow instructions at bottom. * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * This month: How Do You Read A Financial Model? * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * When you get a company's financial model, what do you look at first? I haven't tried to codify this before, but here's how I approach a new model. 1. Is it complete? Complete means that the financials have a full income statement, balance sheet, and cash flow statement. I check this because lots of issues can get hidden without full financials, and because how the IS/BS/CF are formatted tells me something about how the company's financial sophistication. Oh, and I also check that the balance sheet balances and that the cash flow statement ties out the change in cash against beginning and ending cash. 2. Does revenue and COS/COGS make sense? Do revenues, prices, units, and other revenue drivers make rough sense, i.e. are there no killer errors in spreadsheet formulas or conceptual logic? It's a classic mistake, because once people get a spreadsheet with revenue numbers they like, they never go back to inspect the formulas. I often check how the components of revenue change over time so I can focus on the big hitters when reading the plan or looking at the drivers. Further, I follow the calculations through to gross margin and check that COGS are variable with revenues. I had one client recently whose model showed great profitability. The only problem was that product COGS had been left out, which definitely gives a retailer great margins! 3. Do the ratios make sense? We all have our favorite ratios. If I had to pick two, I would go for Revenue per Headcount and EBITDA margin. The first tells me how realistic the forecasts are in tying expenses to revenue. The second gives me a sense of how aggressive the assumptions are in general. For some companies, EBIT margins are more appropriate than EBITDA (e.g. software companies, where there's low capital needs). I check net income margins too, just to get a sense that they are in line with the EBIT levels. (If not, it's usually the taxes which are wrong: see below.) At this level I also check out leverage to make sure there aren't unrealistic assumptions about debt financing. If it's a capital intensive business I'll look at capex/new customer or cumulative capex per cumulative customer. Typically you have to calculate these ratios yourself in the Excel sheet; it's the rare model which provides this all easily. 4. Check the taxes. It's amazing how many skilled analysts make mistakes in the tax calculations. First, check the tax rate. I use 40%, but I know some people use slightly lower percentages. Second, check the calculations around Net Operating Loss (NOL) carryforwards, as this is a common place for errors. I saw one model last month where the NI margin was 106% of revenue. How could that be? Turns out the model was ADDING taxes because it calced taxes as a negative number and then subtracted it from Earnings Before Taxes (EBT). 5. What does the level of period detail say? For me, this is kind of a check about financial IQ, attention to detail, and the ability to rise above excessive detail. I prefer models which have quarters for the first 2 or 3 years and single-period years without detail thereafter. In some cases the first year might be broken into months. I am aware that this is a personal thing and that different people want different levels of detail, yet most people are unaware of the message their period choice sends. Are people with 120 months thinking strategically? Do people with a three year forecast with no quarterly or monthly detail really understand how to implement? Overall I'm looking for something which shows the big picture easily while giving a sense of milestones along the way. Also, I check that quarters add to years and months add to quarters. This is another of those seemingly simple things that discredit so many models. 6. Does the proposition provide good returns to investors? Hopefully the model has a cap table. If I were an investor I wouldn't invest in anything until I saw a cap table forecast showing returns which beat my investment criteria. In the cap table, I check the IRR and investment return multiple (dollars returned divided by dollars invested) for each investor round. Typically I want to see that IRR decreases and I'm looking for specific levels of IRR and multiple. I check the growth in valuation from round to round and think about whether that's believable given the milestones for the period and the time between valuations. On the mechanical side, I check the logic converting investment into shares; this unfamiliar type of calc often contains errors. So that's what I'm doing when I review a model. What do you do? Please write in and share your approach. I'll publish an update on this next month with the feedback received. Until next month, all the best, David Brode – Minotaur Financial Helping Companies Create Better Financial Forecasts * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * How good is your financial model? I'm offering a limited number of free model reviews each month. To take advantage, email me your financial model (in Excel) and the PowerPoint deck. I'll follow up with a phone call where you'll get action steps which should provide significant value to the company. * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * http://www.brode.net mailto:David@Brode.net 1919 14th Street, Suite 510 Boulder, CO 80302 (303) 444-3300 * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * Summary of How I Read A Financial Model 1. Is it complete, with full IS/BS/CF? 2. Does revenue and COS/COGS make sense? 3. Do the ratios make sense? 4. Check the taxes. 5. What does the level of period detail say? 6. Does the proposition provide good returns to investors? * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * (c) 2002 Minotaur Financial, All rights reserved. You are free to use material from the Flawless Financials newsletter in whole or in part, as long as you include complete attribution, including a live web site link. Please also notify me where the material will appear. The attribution should read: "By David Brode of Minotaur Financial. More articles on financial forecasting can be found at http://www.brode.net" * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * To find out more or see if I can help with your financial forecasts, call me to discuss your issues at no charge: (303) 444-3300. I'm very accessible and glad to help. * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * DO YOU LIKE THIS NEWSLETTER? You are welcome to share this email with colleagues who would benefit from better numbers. Your feedback is always welcome and appreciated. Write in to mailto:feedback@brode.net. * * * * * * * * * * * * * * * * * * * * * * * * * * * * * * PRIVACY POLICY: I never rent, trade, or sell my email list to anyone for any reason whatsoever. You'll never get an unsolicited email from a stranger as a result of joining this list. To SUBSCRIBE FREE to this newsletter, send an email to mailto:subscribe@brode.net. 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