Understanding Project and Building Assumptions

In financial modeling, there is no one-size-fits-all. Financial models can vary widely in size, purpose, and complexity. A valuation model is vastly different from a loan repayment model. A model that's created to expand a business will be different from one that's created to dispose of a business. A model that's created to give someone a rough idea of the value of a business will be far less complex than one that's created in support of a private placement or an initial public offering of the shares of the business. It is imperative that you understand the scope and purpose of the model you have been asked to prepare. No matter how impressive your model is, it is of no use if it doesn't meet the requirements of the user. In this chapter, you will learn how to analyze projects and learn what the purpose of...

Understanding the nature and purpose of a project

In order to determine the nature and purpose of a project, you will need to address a number of questions, which are as follows:

• What is the project seeking to do?
• Are you seeking to value something, project something, or both?
• What is the focus or scope of the project?
• Are you looking at the business as a whole, or a section of the business, or a particular asset, plant, or equipment?
• Who is the target audience?
• Is it for internal or personal use, or for presentation to a wider audience?
• Is it a select, knowledgeable audience or the general public?
• Is there any specialist or technical part of the project that will require you to engage an expert in that field?

The answers to each one of these questions will have an impact on how you approach your model, what type of model you build, and how detailed it is.

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Conducting interviews

A significant amount of your modeling time should be allocated to discussions with the client's management. People are generally apprehensive when they're called into discussions with professionals, so you will need to allay their fears and create a non-threatening environment for your discussions. You need to make them understand that they are the experts and that you need their help to understand the business.

These interviews will help you understand why the decision was taken to prepare a financial model. They should cover the history of the company, including key policy decisions that have been taken and their impact on the company's results. You will need to make an assessment of key management personnel and the extent to which you can place reliance on their assertions. You will need to document your discussions as thoroughly as possible...

Building assumptions

A financial model can be defined as the collection of mathematical assumptions for the purpose of the results, financial position, and cash flow of a business in the future, often with a view to arriving at a value for the business. Building reliable assumptions is critical to the success of your model.

The following is a quick checklist for your assumptions:

• Based on actual historical figures
• Realistic
• Clearly explained
• Easily verifiable
• Properly documented
• Visually distinguishable in your model (usually with a different font) from calculated cells

General assumptions

The overall assumptions of your model are that the business will be profitable and cash flow will ultimately be positive.

You also assume...

Summary

In this chapter, we have seen that without thorough knowledge of the nature and purpose of a project, you could end up with a model that doesn't meet the specifications of your client. We have learned about the nature of and reason for assumptions, as well as the importance of discussions with management in projecting your assumptions into the future. In making our assumptions, we have realized the importance of historical financials, balance sheets, profit and loss accounts, and cash flow statements. We have also learned about historical financials, which are an essential starting point in resolving anomalies that may arise in our model.

In the next chapter, Asset and Debt Schedules, we will learn how to project long-term assets and borrowings. We will be introduced to different approaches: a complex but more accurate method, and a simple, more subjective approach...