Monte Carlo simulation and deals with building up a simulation model from scratch.
For the Finance and the Accounting professional in corporate finance and investment banking, financial modelling is largely synonymous with cash-flow forecasting and is used to assist the management decision-making process with problems related to:
○ Historical analysis of a company
○ Projecting a company's financial performance
○ Business or security valuation
○ Benefits of a merger
○ Capital budgeting
○ Scenario planning
○ Forecasting future raw material needs
○ Cost of capital (i.e. Weighted Average Cost of Capital (WACC)) calculations
○ Financial statement analysis
○ Restructuring of a company.
The same applies to the equity research analyst or the credit analyst, whether they want to examine a particular firm's financial projections along with competitors' projections in order to determine if it is a smart investment or not, or to forecast future cash flows and thus determine the degree of risk associated with the firm.
Furthermore, for the small business owner and entrepreneur who would like to project future financial figures of his business, financial modelling will enable him to prepare so-called proforma financial statements, which in turn will help him forecast future levels of profits as well as anticipated borrowing.
Finally, as more and more companies become global through the acquisition/establishment of international operations, there is an imminent requirement for sophisticated financial models. These models can assist the business/financial analyst in evaluating the performance of each country's operations, standardize financial reporting, and analyze complex information according to the various industry demand–supply patterns.
Financial modelling, unlike other areas of accounting and finance, is unregulated and lacks generally accepted practice guidelines, which means that model risk is a very real concept. Only recently certain accounting bodies, such as the Institute of Chartered Accountants in England and Wales (ICAEW), published principles for good spreadsheet practice based on the FAST Standard which is one of the first standards for financial modelling to be officially recognized.4 The FAST (Flexible Appropriate Structured Transparent) Standard is a set of rules on the structure and detailed design of spreadsheet-based models and provides both a clear route to good model design for the individual modeller and a common style platform upon which modellers and reviewers can rely when sharing models amongst themselves.5 Other standards include SMART, developed by Corality, which provides guidance on how to create spreadsheets with consistency, transparency, and flexibility6 and the Best Practice Modelling (BPM)7 published by the Spreadsheet Standards Review Board (SSRB).8 Nevertheless the above standards have not yet been widely adopted and the reader should be aware of the scope, benefits, and limitations of financial modelling. Always apply the “Garbage in Garbage out” principle.
1.2 DEFINING THE INPUTS AND THE OUTPUTS OF A SIMPLE FINANCIAL MODEL
A good model is easily recognizable. It has clearly identifiable outputs based on clearly defined inputs and the relationship between them can be tracked through a logical audit trail. Consider the following situation. Think of a wholesale company that wants to use a financial model to assess the financial implications of its credit policy. Let us say that the company has a 2-term trade credit agreement. In this agreement it offers a discount to its buyers if payment is made within a certain period, which is typically shorter than the net payment period. For example, a “2/10 net 30” agreement would give the buyer a discount of 2 % if payment is realized by the 10th day following delivery. If the buyer fails to take advantage of the discount, there are still 20 additional days in which to pay the full price of the goods without being in default, that is, the net period has a total duration of 30 days. Finally, as with net terms, the company could charge penalties if the buyer still fails to meet the payment after the net term has expired. It is expected that 30 % of the company's buyers would adopt the discount. Trade credit can be an attractive source of funds due to its simplicity and convenience. However, trade credit is like a loan by the company to its customer. There are 2 issues associated with loans: (a) what is the necessary amount of the loan and (b) what is the cost of it?
Therefore, the company needs to build a model in order to estimate:
a. the cost of the trade credit it provides to its customers, and
b. the funding impact of it, on the basis that 70 % of the company's customers will not adopt the discount, given that it has an annual turnover of €10,000,000.
So the model outputs should look like this:
The Effective Annual Rate (EAR) is the cost of the discount offered by the company to encourage buyers to pay early and is given by the following formula:
As far as the above situation is concerned:
This cost is really high and means that the company offering the discount is short of cash. Under normal circumstances it could get a bank loan much more cheaply than this. On the buyer side, as long as they can obtain a bank loan at a lower interest rate, they would be better off borrowing at the lower rate and using the cash proceeds of the loan to take advantage of the discount offered by the company. Moreover, the amount of the discount also represents a cost to the company because it does not receive the full selling price for the product. In our case this cost is:
Apart from the above cost, if we assume that the company's customers would wait until the last day of the discount period to pay, i.e. the 10th day, then the company should fund 10 days of receivables for turnover equal to:
The factor (1–2 %) takes into account the discount. These 10 days of receivables, assuming a 360-day financial year, are equal to the following amount (as we will see in Chapter 2):
If the €81,667 are financed by debt and the cost of debt is 8 % per year, then the company will bear interest of:
That is, the company will bear a cost of €60,000 per year arising from the discount of 2 % plus a further cost of €6,533 as interest arising from the funding needs of the 10-day credit period.
Concerning the 70 % of the company's customers that prefer the credit period of 30 days, this is equivalent to turnover of:
This turnover, if funded for 30 days, gives rise to receivables equal to:
Again, if the €583,333 are financed by debt and the cost of debt is 8 % per year, then the company will bear interest of:
