SUBMITTED BY DALJIT KUMAR MBA [3rd SEM] MB1012

TABLE OF CONTENTS
INTRODUCTION TO FINANCIAL MODEL TYPES OF FINANCIAL MODELS TOOLS OR TECHNIQUES OF FINANCIAL MODELLING ADVANTAGES OF FINANCIAL MODELS DRAWBACKS OF FINANCIAL MODELLING FORECASTING FINANCIAL STATEMENTS BIBLIOGRAPHY

INTRODUCTION

As finance plays a vital role in the organizational structure, Financial Management has a great role to play in the area of decision making. Financial manager uses various tools and techniques to analyze the past, present as well as future financial position of the business in order to determine the strengths and weaknesses of the business. One of these tools is financial modeling in the modern scenario. It has become an integral part of financial planning and control. Financial model is a mechanical way of preparing financial projections. The financial model uses the same algebra used in accounting like double entry framework etc. Financial model is the process of developing financial statements and ratios which typically deals with future projections based on a defined set of assumptions and logical relationship. Financial model consists of one or more input parameters along with the data and formulas which are used to perform calculations or making predictions. Financial models tend to become an end in themselves rather than useful tools for others.

TYPES OF FINANCIAL MODELS

Financial model should be such that it must provide a focus point for structuring the planning process. There are two reasons to the financial model by the enterprises. One is business and financial policy and procedure are too complex that there is a need on how to simplify it and in addition to the simplification available through modeling, there is often the hope that experimentation with the model will assist in locating a solution to the real problem.Financial model is the process of developing financial statements and ratios which typically deals with future projections based on a defined set of assumptions and logical relationship. There are various types of models to solve various complex business financial problems. These models are discussed below: 1. 2. 3. 4. 5. Optimization model Simulation model Mathematical model Computer model Sustainable growth model

1. Optimization model:
Optimization model discusses allocation of investment in order to decide what proportion of its earnings should be retained for internal investment and what proportion should be distributed among the share holders in the form of dividend. According to this model the optimal financial structure of the form is determined by the optimal financial level, the cost of capital or weighted average and cost of alternative sources of financing. The main objective of this model is to choose the smart investment programme and maximize the value of firm. Acc. to Modigliani & Miller: Optimal financial structure of the firm is determined by the optimal financing level, the cost of capital or the weighted cost of capital (P) is equal to the weighted avg costs of alternative sources of financing. P= (g/v)c+(e/v)r Where P=cost of capital/optimization level g= value of stock v= current value of the firm

c= cost of equity e= value of retained earnings r= opportunity cost of retained earnings

2. Simulation model:
Simulation models are also known as what if models. This model is a system of mathematical equations logic and dates, which describes the relationship among financial and operating variables like revenues expenses, taxes, investments and earnings etc. The main objective of this model is to influence strategic decisions by depicting the implications of alternatives values of the financial variables. A simulation model is the one in which: One or more financial variables such as expenses, revenues, investments, taxes and taxes etc. This user of this model can manipulate the value of one or more financial variables. The purpose of this model is to influence strategic decisions by reviewing the decisions by revealing to the decision maker the implications of alternative values of the these financial variables.

3. Mathematical model:
The mathematical model describes the object system by means of mathematical expressions, which are then manipulated in an attempt to gain insight into the real problem. This model provides the total cost for any level of activity. The total cost is considered as affected by the level of activity at which the new development is operating. A mathematical model provides an insight into real life problems with the help of mathematical expressions. For example: TC=FC+VC*AL Where TC= total cost AL=level of activity FC= fixed period cost VC= variable cost per unit of activity

In modeling it is necessary to distinguish between exogenous variables and endogenous variables. The exogenous variables are supplied from outside the model (and are called input variables. e.g.AL) where as endogenous variables are supplied by the model (and are known as output variables).

4. Computer model:
The models which are written in a language which can be understood by computers are known as Computer models. The specific languages are used for specific purposes of specific organizations. This had led to the development of computer packages which can be utilized for many modeling situations. The most important of these specialized tools is the electronic spreadsheet. This is a package which facilitates mass production calculation on table of data. These sheets were first developed for micro computers and were made to deal with multi-column, multi-period financial statements. The first spreadsheet package, i.e. VisiCalc was introduced in 1979. This replaced the accountants handwritten worksheets with computerized statements. From the financial modeling point of view, there are two types of high level language (such as FORTRAN, COBOL and BASIC): and second there are specialized languages (such as FCS-EPS, PlusPlan and Excel). The specialized languages are more useful than the basic languages because there are many features which are common for many type of model. The most useful of these specialized tools is the electronic spreadsheet, a package which facilitates mass production calculations on tables of data. The major spreadsheet packages make available a number of standard financial formulae and statistical formulae for data analysis. There is also usually a random number generator which enables Monte Carlo simulation to be built.

Application of Financial Model:

Applications of financial model are following: Financial forecasting and analysis Cash budgeting Projection of financial statements/ Development of budgets Tax planning Capacity planning Market analysis Cost and price projections Risk analysis

Users of Financial Model

The users of financial models are as follows:

1. Financial and Budget Analysts:

Financial analysts and budget analysts uses a simulation model in order to generate pro forma financial statements (budgets).

2. Corporate Strategists:
Corporate Strategists use financial model to see impact of changes in policy variables in the policy variables on the future profitability of the firm.

TOOLS OR TECHNIQUES OF FINANCIAL MODELLING

Tools or techniques of financial modeling

Spreadsheet

Mathematical programming package

Simulation package

A financial model consists of one or more input parameters along with data and formulas which are used to perform calculation or make predictions. In todays technological era, the finance managers of all good or reputed organizations have either computer on their desk or laptops. In market today, many micro computers software are available for analyzing financial decisions. Earlier, it was quit tedious for a financial analyst to do any kind of financial forecasting, for example, forecasting next years sales for each month. Sensitivity, algorithms and simulation were used for doing such critical financial analysis. But today, the micro computer revolution has brought a drastic change, and now analysis and forecasting is a matter of few seconds, not even hours. There are mainly three types of micro computers software available for the analysis of financial decisions:

Spreadsheet:

Spreadsheets are a very important financial modelling tool. These are available in lots in market. These are useful in analyzing many financial problems. The power of spreadsheet can be judged from its copying feature and quick execution of estimate on important outcome variable, the quick recalculation feature of the spreadsheet make analysis feasible. The data output which is provided by spreadsheet are as good as the estimated input data and algorithms used. Many people think that excel spreadsheets can only be used just for creating tables and charts and summarizing mathematical models instead of just storing, summarizing and formatting.

Mathematical programming techniques:

The spreadsheets are useful as a tool of analysis, but not optimization. The optimum solution of some of the problems of management can be found by proper application of mathematical programming techniques such as linear programming and integer programming.

Simulation:
Simulation is helpful in the development of models which are more comprehensive in nature and more adaptable to the needs and requirements of financial planners and analysts who use the models. The revision in models must be made easily and quickly. The models must be adaptable to revision and refinements.

ADVANTAGES OF FINANCIAL MODELS:

The main advantage of financial model should be such that it must provide a focus point for structuring the planning process. The implication of planning for financial models should be used as a vehicle to improve communication between individuals of same organization. The following are some of the advantages of financial models: 1. Financial model provides the alternative use of financial information.these models are used asan experiment to test and evaluate new and innovative accounting approaches. 2. Financial model is also helpful in solving financial issues and problems and issues relating to taxlaw, exchange rates, and wage price control extra. 3. Financial model also explains the financial system ina a very logical manner by cause and effectrelationships. 4. These modelling techniques can be used effectively in lots of business situations involving complexity and a degree of uncertainty.

DRAWBACKS OF FINANCIAL MODELLING:

1. 2. 3.

4.

There are many reasons due to which financial modelling could not be successful in many business firms. The main drawbacks are given below: The main drawback of financial modelling is that many firms have started adopting various financial models without their adequate knowledge or . The main drawback of financial modelling is that these models are limited use in many situations. Sometimes, very good financial models may change due to the advancements or change in the technical knowledge. Sometimes people find it difficult to understand the financial models. They try to incorporate the statistical tools in the financial models to make them more interesting. The broad gap between how the expert thinks modelling should be used and how executives resist changing.

Stages in Financial Model Development

The experiences of the companies which have undertaken financial modeling have led to a fairly standard approach to model development. It involves the following steps: 1. Feasibility Study 2. Construction of model logic 3. Programming and Debugging 4. Model testing and validation 5. Documentation 6. Implementation 7. Updating and extension

FORECASTING FINANCIAL STATEMENTS

Forecasting is simply defined as planning for future. Forecasting financial statements are the statements that aa prepared for forecasting the future income, future sale as well as profit and loss account statement and balance sheet. Forecasting financial statements are required in todays world of compitetion.

1. FORECASTED INCOME STATEMENT:

Firstly, we forecast the income statement for the coming year. This kind of statement is needed to estimate income and the addition to retained earnings.

Sales Costs except depreciation Depreciation

Actual 2005 (in $) 3000 2616 100

Forecast Basic 1.1*1998sales= 0872*1999sales = 0.1*1999net plant=

2006 Forecast First pass

Feedback

Second

Final statement 3300 2878 110

3300 2878 110

3300 2878 110

2716 2988 2988 2988 Total operating costs 284 312 312 312 EBIT 88 88 +5 93 93 Less interest 196 224 219 219 EBT 78 89 -1 88 88 Taxes (40%) 118 135 131 131 NI before preferred dividends 4 4 4 4 Dividends to preferred 131 127 127 NI available to 114 common 58 63 +3 66 66 Dividends to common 56 68 -7 61 61 Addition to retained earnings Micro Drive Inc.: Actual 2005 and Projected 2006: Income Statements (Millions of Dollars)

The above table shows the forecast for 2006. Sales are forecasted to grow by 10%. For 2005, micro drives ratio of costs to sales is 87.2% (i.e. $2616/$3000=.872). thus for each dollar of sales in 2005,Micro Drive incurred 87.2 cents of costs. Initially the companys manager assume that the cost structure remain unchanged in 2006.

2. SALES FORECAST
method assumes that the future relationship between various elements of cost to sales will be similar to their historical relationship. When using this method, a decision has to be taken about which historical cost ratios to be used? The following table shows the application of percent of sales method for preparing the Performa profit and loss account of ABC electronics for the year 2003. In this table historical data are given for two previous year that is 2001, 2002. For projection purposes, an average of two previous years has been used. For example: the average percentage of sales ratio for cost of goods sold is 65.0%. Multiplying the estimated sales of 1400 by 65.0%, the projected value of cost of goods sold has been calculated. 2001 2002 Avg percent of forecasted sales SALES of 2003 assuming sales of 1400 100.0 1400.0 65.0 910.0 35.0 2.1 4.3 490.0 29.4 60.2

This

Net Sales Cost of goods sold Gross profit Selling expenses General and administrative expenses Depreciation Operating profit Non operating surplus Profit before interest and tax Interest on bank borrowings Interest on debentures Profit before tax Tax

1200 775 425 25 53

1280 837 443 27 54

75 272 30 302 60 58 184 82

80 282 32 314 65 60 189 90

6.3 22.3 2.5 2.5 5.0 4.8 15.0 6.9

88.2 312.2 35.0 347.2 70.0 67.2 210.0 96.6

Profit after tax Dividends Retained earnings

102 60 42

99 63 36

8.1

113.4

3. Forecast the balance sheet:

The projections of various items on the asserts side and liabilities side of the balance sheet may be derives as follows. Employ the percent of sales method to project the items on the asserts side, accept invest and miscellaneous expenditure and losses. Estimate the expected value for investment and miscellaneous expenditure and losses using specific information applicable to them. Use the percent of sales method to derive the projected value of current liabilities and provisions. Obtain the projected value of the reserves and surplus by adding re projected retained earnings to the reserve and surplus figure of the previous period. Set the projected values for equity and preference capital to be tentatively equal to their previous values. Assume that the projected values for non funds will be tentatively equal to their previous levels less re payments or retirements as per terms and conditions applicable to them. Compare the total of asserts side with that of liability side and determine the balancing item. Dec 31,2001 Dec 31, 2002 Average of percent of sales or some other basis 100.0 66.5 No change Forecasted for Dec 31,2003 based as a forecast sales of 1400 1400.0 910.0 30

Net Sales Assets Fixed assets Investments Current assets, loans and advances: Cash Receivables Inventories Pre paid expenses

1200 800 30

1280 850 30

25 200 375 50

28 212 380 55

2.1 16.6 30.4 4.2

29.4 232.4 425.6 58.8

Miscellaneous Expenditures and losses Total Liabilities Share capital Equity Preference Reserves and surplus Secured loans Debentures Bank borrowings Unsecured loans Bank borrowings Current liabilities and provisions Trade creditors Provisions External funds required Total

20

20

No change

20

1500

1575

1706.2

250 50 250

250 50 286

No change 250.0 No change 50.0 Performa income 335.6 statement No change 24.4 400 341.6

400 300

400 305

100

125

9.1

127.4

100 50

112 47

8.5 3.9 Balancing figure

119.0 54.6 28.0 1706.2

1500

1575

4. Cash Budgets:
It is an estimate of cash receipts from all sources and cash payments for all purposes and the net cash balances during the budget period. It ensures that the business has adequate cash to meet its requirements as and when these arise.this model indicates the cash excesses and shortfalls, so that action may be taken in advance to invest any surplus cash or to borrow funds to meet any shotfalls. According to Guthmen and Dougal : cash budget is an estimate of cash receipts and disbursements for a future period of time.

The main characteristics of cash budget are given below:

Cash budget is a statement of anticipated cash receipts and payments. Cash budget is related to predetermine future period. Cash budget is expressed in terms of monetary values. Cash budget is forecast of financial aspirations of the enterprise. Cash budget is an outline of the future plans, policies and actions of the management.

BIBLIOGRAPHY

Books:
Chandra Prasanna, Financial Management , Tata McGraw hill Publishers Brigham F. Eugene, Gapenski C. Luis, Ehrharnt C. Michael , Financial ManagementTheory and Practice , Harcourt Asia PTE Ltd. Pandey I. M. Financial Management , Vikas Publication House Pvt Ltd

Websites:
www.scribd.com www.wikipedia.org