IB Manual

The Corporate Finance Institute Investment Banking Manual
Investment Banking Manual
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About CFI’s Investment Banking Manual
The following eBook’s purpose is to outline all the necessary technical skills needed to succeed in a
career in investment banking. The three-part guide will walk you through fundamental accounting
analysis, valuation techniques, and Excel modeling skills. Produced after hours of research and planning
by current and former professionals in the investment banking industry, you will become familiar with
applicable knowledge that will allow you to thrive in all your future analyst positions.
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At various points in the manual a number of financial analysis issues are examined. The financial
analysis implications for these issues, although relatively standard in treatment, remain an opinion of
the authors of this manual. No responsibility is assumed for any action taken or inaction as a result of
the financial analysis included in the manual.
Table of contents
7 Accounting
8 Introduction
12 Accounting and analysis fundamentals

12 Accounting framework
23 Balance sheet issues
75 Income statement issues
84 Cash flow statements
88 Accounting and analysis for mergers and acquisitions

88 Introduction
93 Acquisition accounting
124 Accounting for associates and joint ventures
131 Considerations for investment banking
132 Comprehensive examples
133 New M&A accounting rules
143 Valuation
144 Discounted cash flow techniques

144 Discounting fundamentals
148 Estimating free cash flow for valuation purposes
153 The key value drivers of cash flow
156 Calculating the terminal value
166 Putting it all together – DCF with terminal value calculation
175 Cost of capital

175 An introduction to risk
179 Capital asset pricing model (CAPM)
201 The cost of debt and WACC
Table of contents
208 Comparable company analysis

208 Why do we do comps?
210 Comparable universe
211 Sources of information
213 From Equity Value to Enterprise Value
219 Which multiple?
222 Using comps
225 Special situations
240 Keys to success
242 Precedent transaction analysis

242 Introduction
244 Mechanics
250 Valuing the target
254 Control premia
256 Problems with precedent transactions
257 Financial Modeling
259 Best practice financial modeling

259 Introduction
265 Introducing the Ribbon
268 Quick Access Toolbar
271 Page Layout menu
272 View menu
276 Model set up
286 Model structure
296 Referencing
307 Formatting
322 IF and some other logical functions
328 Data retrieval – the LOOKUP school
347 Volatile functions
349 Consolidating data
354 Arrays
361 Dates
368 Switches
373 Sensitivity
Table of contents
378 Validating data
384 Pivot tables
395 Model completion
398 Charts
405 Historic financials
408 Forecast financials
414 Debt modeling
417 Formatting Continued
429 Formulas
432 Names
437 Data functionality
438 Auditing and error detection tools
451 Auditing a model – a process
456 Appendix
456 Excel tricks
462 Excel function keys
464 Other shortcuts
PART 01
Accounting
Introduction
This section aims to provide investment bankers with the

To learn more, please check required level of accounting knowledge necessary to:
out our online courses
• Interpret, understand and adjust the numbers within a set of
financial statements
• Create meaningful and appropriate forecast financials.
The intention of this manual is to furnish investment

bankers with a thorough grounding in accounting and its
impact on analysis.
Accounting rules provide the guidance and requirements for

accountants when they prepare the financial statements of
organisations. Although accounting rules still vary across the
globe, the vast majority of companies now report under either
International Financial Reporting Standards (IFRS – formerly
International Accounting Standards, IAS) or United States
Generally Accepted Accounting Principles (US GAAP).
At the time of writing (early 2009) there is a concerted effort to

bring IFRS and US GAAP closer together, and there are many
joint projects considering how to improve the rules in a way that
eradicates the remaining differences. There is early talk of
complete convergence to one set of global accounting rules by
2014.
There are still many differences between IFRS and US GAAP,

however most of them are rather obscure and technical, and
often don’t actually result in different financial reporting. There
are however a smaller number of differences which are
important and may have a significant impact on how the
performance or position of an enterprise is reported.
This manual generally avoids talking specifically about IFRS or US

GAAP rules, but instead refers simply to the accounting rules.
Where this is the case, the reader can assume that the rules are
effectively the same. Where the differences do arise, the page
splits into two, with each set of rules explained separately.
Accounting effect on key metrics
The focus of the manual is the analysis impact of accounting

issues. Set out below are the key issues which will be covered,
whether these issues have an impact on key metrics and where
in the manual they will be discussed.
Impact on
Net Debt
EBITDA
Equity
EBIT
EPS
FCF
EV
Balance sheet items
Current vs. non-current
Tangible assets
Depreciation √ √ √
Impairment tests and write downs √ √ √
Revaluation √ √ √ √
Capitalisation of interest √ √ √ √
Intangible assets
Goodwill – group / individual entity level √
Amortisation periods √ √ √
Tax deductibility √ √ √
Impairment tests and write downs √ √ √
Revaluations √ √ √
Research and development √ √ √ √
Other internally generated intangibles √ √ √ √ √
Capitalisation of software cost √ √ √ √ √
Brands, licenses, copyrights √ √ √ √ √
Liabilities
Net debt definitions √ √ √
Leasing – finance / capital and operating √ √ √ √ √ √ √
Sale and leaseback transactions √ √ √ √ √ √ √
Provisions
Obligation vs. prudence √ √ √ √ √ √
Deferred retirement benefits √ √ √ √ √ √
Deferred tax √ √
Capital instruments
Debt vs. equity √ √ √ √ √
Preference shares √ √ √ √ √
Incomes statement items
Revenue recognition √ √ √ √
Events after the balance sheet date √ √ √ √
Discontinued operations √ √ √ √
Exceptional items √ √ √ √
Extraordinary items √ √ √ √
Treatment of capitalised costs √ √ √ √ √
Share based payments √ √ √ √ √ √
Foreign exchange rates √ √ √ √ √ √
Hyper inflations √ √ √ √ √ √
The 2nd income statement √
EPS – basic/diluted √
Cash flow statements
Cash definitions √ √
Categories of cash flows √
Free cash flows √
Mergers and acquisitions
Associates – equity method √ √ √ √ √ √ √
Joint ventures – equity √ √ √ √ √ √ √

method/proportional consolidation
Purchase/acquisitions accounting √ √ √ √ √
Control √ √ √ √ √ √ √
Consideration √ √ √ √ √
Goodwill/fair value accounting √ √ √ √
Negative goodwill √ √ √
Minority interests √ √ √ √
Demergers √ √ √ √ √
Special purpose entities √ √ √ √ √ √ √
Impact on analysis
The derivations of key metrics are subject to accounting issues

that may undermine their analysis. The appendices include a
table indicating the sort of adjustments which could be made.
As ever with analysis, the key is to ensure consistency of

treatment of like items throughout. Consequently, not all
adjustments are appropriate at the same time and when some
adjustments are made, others become inappropriate for the
same category.
For example, if joint ventures (JVs) are deemed to be core to the

business’ activities, then it is not good enough to merely include
the results of the JV in EBIT – if the sales figure does not include
the JV’s sales then margins will be inconsistent; if interest does
not include the JV’s interest then coverage ratios will be
inconsistent; if net debt doesn’t include the JV’s net debt then
enterprise value will be inconsistent, etc.
More information is available on each adjustment in the relevant

section in the manual.
Accounting and analysis

fundamentals
Accounting framework
To learn more, please check
out our online courses Underlying most international accounting is a conceptual
framework. Without knowledge of this framework, the full
implications of the accounting we shall discuss in the later
sections may not be fully appreciated.
Reporting elements
Although this may seem a very basic way to commence an

accounting manual, it is a necessary step. As more complicated
areas of accounting are examined, such as mergers and
acquisitions, it is the basic understanding of the fundamentals
of accounting that often let people down.
As a starting point we shall briefly examine the basic

components of financial statements. This basic framework
provides an approach to discussing more complicated
Asset Liability
Past event ➞ present Past event ➞ present

control ➞ future benefit obligation ➞ future outflow
Expense Income
Benefit used up Benefit earned
accounting later.
There are four key reporting elements:
Balance sheet components
Assets
An asset is a resource that is:
• Controlled by a company
• Expected to result in future economic benefits.
Typically, this would be something owned by the company, such

as a machine or cash, or another financial asset created by a
loan but there are many different types of asset that will be
covered in this chapter.
Liabilities
• A liability is a present obligation:
• Arising from past events
In respect of which economic benefits are expected to flow

from the company.
Typically these are amounts of money owed to third parties as a

result of some kind of contract.
Equity
Equity is the residual interest in the assets of the entity after

deducting all its liabilities. Equity can be thought of as the
residual interest that the owners have in the business, or the
owner’s claim on the residual assets.
The two principal elements of equity are:
• The equity (or shares) that have been issued to the owners of
the business
• The retained earnings of the company since it started.
Every year, the total profit or loss from the income statement is
transferred into retained earnings. So retained earnings
represent the cumulative retained profits and losses of the
company since day one.
Recognition criteria
Assets and liabilities are only recognised if:
• There is sufficient evidence of existence
• The monetary amount can be measured with sufficient

reliability.
For example, a contingent asset such as a possible cash inflow

resulting from a legal action will not be recognised as an asset in
the financial statements if there is significant uncertainty over
the outcome, or the amount cannot be reliably measured.
In assessing whether an item meets the definition of an asset,

liability or equity, attention needs to be given to its underlying
substance and economic reality and not merely its legal form.
Income statement components
It is important to understand the differences between incomes

and expenses that appear on the income statement, and cash
inflows and outflows that appear on the cash flow statement.
Neither of the income statement components has any direct
recognition relationship with cash or cash equivalents.
Income
Income is recognised in the income statement when an

increase in future economic benefits related to an increase in
an asset or a decrease of a liability has arisen that can be
measured reliably.
This means income recognition occurs simultaneously with the

recognition of increases in assets or decreases in liabilities.
For example, if an investment increases in value by $100, then

not only has the asset increased in value, but an income will
often be recognised (even through there is no cash inflow).
Expenses
Expenses are recognised in the income statement when a

decrease in future economic benefits related to a decrease in
an asset or an increase of a liability has arisen that can be
measured reliably.
So similar to the example above, if the investment falls in

value by $100, then the decrease in value of the asset may be
accompanied by the recognition of an expense in the income
statement (even though there is no cash outflow).
Cash flow statement
The cash flow statement is a record of cash flows over an

accounting period. At its simplest it is a list of cash inflows and
cash outflows, and it explains the difference between opening
and closing cash on the balance sheet.
For ease of interpretation, cash flows are categorised as

operating, investing or financing. This distinction is explained
further later in this chapter.
Accounting mechanics
An understanding of the relationship between the income

statement and the balance sheet is essential before moving on
to the analysis and interpretation of financial statements.
Balancing balance sheet
The balance sheet of a company will always balance:
Assets = Liabilities + Equity
Part of the reason for this has been touched upon above, the
fact that changes in assets and liabilities are often accompanied
by incomes or expenses in the income statement, which flow
though to retained earnings within equity.
In fact, whatever happens at a company, there will always be

two equal and opposite effects in the financial statements,
maintaining the equilibrium.
Dual effect
When accountants talk about double-entry bookkeeping and

debits and credits they are referring to the fact that there is
always a dual effect whenever anything impacts a set of financial
statements.
This is best illustrated with some examples. The table

illustrates, for a number of events, the impact on assets,
liabilities, income and expenses:
Company borrows
money from the bank Cash (asset) ↑ Loan (liability) ↑
Equal and opposite movements on the balance sheet
Company buys a vehicle Cash (asset) ↓ Vehicle (asset) ↑
Equal and opposite movements on the balance sheet
Company pays
staff wages Cash (asset) ↓ Wages (expense) ↑
The expense will reduce retained earnings (equity) which will match the fall
in assets
Company sells goods Cash (asset)↑10 Sales (income)↑10
(cost $6) for cash of $10 Inventory (asset)↓6 Cost of sales (expense)↑6
Balance sheet assets increase by 4 which matches the 4 increase in

retained earnings
This basic interaction between the income statement and the

balance sheet underpins all of accounting. Regardless of what
has just happened at a company, the accounting for it will
always be represented by one or more of these dual effects.
Presentation of financial statements
The exact content and presentation of financial statements will

vary widely depending on the regime (IFRS or US GAAP) and the
particular requirements and needs of the preparers and the
users of the statements. Both IFRS and US GAAP have a
minimum requirement for presentation on the face of the
balance sheet, income statement and cash flow statement but,
beyond this minimum, practice varies considerably.
Presented here are typical examples of IFRS (Tesco) and US

GAAP (WalMart) income statements, balance sheets and cash
flow statements for comparison purposes. In addition there is
an IFRS Statement of Recognised Income and Expense, and the
US equivalent, the Statement of Shareholders Equity. Although
there are many differences in presentation, there are many
similarities. The similarities have been highlighted.
Non-recurring items
When analysing financial statements, it is important to be able

to distinguish between the normal, core, recurring performance
of the business and the impact of any non-recurring one-off
items, such as the sale of a company, or a significant write-off of
an asset.
Accounting rules require that the impact of non-recurring items

should be presented separately in the financial statements if not
doing so would make the accounts misleading.
IFRS US GAAP
Non-recurring items (often Highly unusual items (often

referred to as “exceptional referred to as “extraordinary
items”) should be presented items”) should be presented
separately in the income net of taxes in a separate
statement before operating section of the income
profit/EBIT statement below operating
profit/EBIT
Discontinued operations
Discontinued operations are those that have been disposed of

by the year-end or are planned to be sold or discontinued
during the next year. Accounting rules require that the results
of such operations be presented separately on the face of the
income statement. Similarly the balance sheet must show
separately the amounts relating to assets and associated
liabilities held for sale at the balance sheet date.
On the day that assets are classified as held for sale they cease
to be depreciated, and, if required, are immediately written
down to their fair value less costs to sell.
Balance sheet issues
Items are presented on the balance sheet in order of liquidity, in

other words, closeness to cash. Liquid items are close to cash
and can be converted to cash quickly and cheaply, like short-
term deposits, or receivables that are expected to be paid
shortly. Illiquid items are difficult to convert to cash, for
example land and buildings.
The terminology used on the balance sheet is “current”, for

items expected to be settled in cash within 12 months and “non-
current” for items not expected to settle within 12 months.
Assets
Current assets
Cash and equivalents
Often the first item on the balance sheet is the most liquid,
which is cash and cash equivalents. This section normally
includes all cash held at the bank or on deposit, and any short-
term investments that can quickly and cheaply be converted
into cash.
Receivables
Receivables are amounts of money that are owed to the

company by others. The only accounting issue here is that
accountants are required to be prudent or cautious so must
ensure that the balance sheet value of receivables does not
exceed the expected recovery.
From time to time, doubts may be raised about whether a

particular third party will be able to pay their debt, and the
receivable may need to be written down, or completely written
off. The accountants estimate how much will be recovered,
reduce the receivable by the appropriate amount, and recognise
a corresponding expense in the income statement.
Inventory
Inventory is defined as items used by a company that represent

or contribute to the finished goods that are eventually sold to
customers.
Cost
Inventory sits on the balance sheet at cost. This includes all

costs of purchase, conversion and other costs incurred in
bringing inventories to their present location and condition.
This would include the wages of production staff and even some
allocation of overheads such as utilities or property rentals.
In the same way that receivables can require write-downs,

inventory can “go bad” from physical damage, deterioration, or
obsolescence. The accounting treatment is the same: the
balance sheet asset falls with a corresponding expense in the
income statement.
FIFO, LIFO or weighted average?
A systematic method must be used to model the flow of

inventory through the production process. “Cost of sales” in the
income statement is the cost to the company of the goods that
have been sold in the period. This can be difficult to determine
where there are complex flows of inventory throughout the
process and the purchase cost of raw materials is changing all
the time. Consider the following example:
A sugar manufacturer buys 100 tonnes of unrefined sugar in

April at $1,000/ton and a further 200 tons in September at
$1,200/tonne. In November they sell 250 tonnes of refined
sugar. What should the “cost of sales” number be?
There is no right or wrong answer to this question. The answer

depends on how the flow of sugar is modeled through the
process.
First In First Out (FIFO)
Cost of sales = (100 x 1,000) + (150 x 1,200) = $280,000
Last in First Out (LIFO)
Cost of sales = (200 x 1,200) + (50 x 1,000) = $290,000
Weighted Average
Cost of sales = 250 x ((100 x 1,000) + (200 x 1,200)) / 300 =

$283,334
The Finance Director will select the policy that is most

appropriate to the business. This choice of accounting policy
will be disclosed in the notes to the financial statements and is
generally not permitted to be changed over time.
IFRS US GAAP
LIFO is not permitted as a All appropriate methods are

costing method permitted including LIFO
Considerations for investment banking: Current assets
Write downs of current assets such as receivables and

inventory are non-cash charges to the income statement
hence it is important to adjust for them when deriving a cash
flow number from a profit number. This is often part of a
“changes in working capital” adjustment along with other
components of working capital such as current liabilities.
When comparing profit metrics from one company to another

it is important to ensure (if inventory is a material number in
the accounts) that the inventory costing models are
comparable. Where one company uses FIFO and the other
uses a weighted average, adjustments may need to be made
to make the numbers more comparable.
Non-current assets
Non-current assets are those that the company expects to

benefit from over a longer time in the future, typically greater
than 12 months. A vehicle, or a piece of plant or machinery
would be classified as a non-current asset as the company
would expect to be using the asset for an extended period of
time.
Tangible non-current assets
Tangible non-current assets are those that have physical form or

substance. In other words, you can touch them. You can touch a
vehicle, so it is a tangible asset, as opposed to a trademark
which has no physical form and is not a tangible asset.
A tangible non-current asset is initially measured at cost. Cost

comprises:
Purchase price
• Any costs directly attributable to bringing the asset to the

location and condition necessary for it to be operational
• The initial estimate of the costs of dismantling and removing

the item and restoring the site on which it is located.
Directly attributable costs would typically include:
• Costs of employee benefits arising directly from the

construction or acquisition of the asset
• Costs of site preparation
• Initial delivery and handling costs
• Installation and assembly costs
• Costs of testing whether the asset is functioning properly
• Professional fees.
IFRS US GAAP
IFRS provides a choice of US GAAP permits

two methods for the only the cost
ongoing measurement of model
tangible non-current assets
after initial recognition; the
cost model or the
revaluation model.
Although this is a free
choice for the finance
director, it must be made by
class of asset. In other
words, if a decision is taken
to adopt the revaluation
model for a property, then
all properties will need to be
revalued.
Cost model
After recognition, the tangible non-current asset is carried at its

cost less any accumulated depreciation and any accumulated
impairment losses.
Depreciation
With the exception of goodwill, land and other assets with

infinite useful economic lives (rare), all assets are depreciated
through the income statement over their useful economic life.
This is the matching of the cost of the asset to the time periods
which benefit from the use of the asset. The dual effect is asset
down on the balance sheet, and depreciation expense up in the
income statement.
Assets should be depreciated in a manner that reflects the

pattern in which the benefits of the asset are consumed over
time. For simplicity, this is often “straight-line” over the life of
the asset with an equal proportion of the cost of the asset
being depreciated each year. Another common method is
accelerated depreciation, where a constant percentage of book
value is charged each period, resulting in higher expenses in
the early years to reflect the fact that a greater proportion of
the benefit arises when the asset is new.
Revaluation model
IFRS US GAAP
If the revaluation model is Revaluation model not an

chosen, then after recognition option.
the tangible non-current asset
is carried at a revalued
amount, being its fair value at
the date of the revaluation less
any subsequent accumulated
depreciation and subsequent
accumulated impairment
losses.
Movements in value over time

are not reflected in the
income statement, but in a
separate component of equity
called the revaluation reserve.
This avoids the income
statement becoming
misleading as the gain or loss
is not yet realised.
Assets must be revalued with

sufficient frequency to ensure
that the carrying value is kept
up to date (no requirement for
annual revaluation).
Capitalisation of borrowing costs
The standard treatment for borrowing costs is to recognise

interest expense in the income statement. However, the
accounting rules require an alternative treatment where the
financing is specifically for the purpose of buying or
constructing an asset. A company must treat the cost in the
same way as all other direct costs of the asset, and capitalise
the amounts as part of the asset itself. This has the
consequence of improving net income in the short term with a
corresponding reduction in net income in the future when the
additional depreciation will need to be recognised.
Illustration – interest capitalisation
Tesco capitalise interest paid on funds specifically related to financing of assets under the course of
construction. The impact is to remove an interest charge from the income statement and capitalise it into
fixed assets. This is purely an accounting policy decision and does not change the amount of cash interest
paid in the period.
BORROWING COSTS Borrowing costs directly attributable to the acquisition or construction of

qualifying assets are capitalised. Qualifying assets are those that necessarily take a substantial
period of time to prepare for their intended use. All other borrowing costs are recognised in the
Group Income Statement in the period in which they occur.
Source: Tesco Annual Report
From the accounting extract below, £103m has been capitalised from net interest payable into fixed assets.
This has reduced the net interest payable from £262m to £159m; the interest cover (as illustrated = EBIT ÷
Net interest payable) is reduced from 17.5x to 10.6x.
Capitalised interest will subsequently hit the income statement through the depreciation charge. There is
generally no tax effect of capitalising interest either at the time of capitalising or at subsequent expensing.
NOTE 5 Finance income and costs

2008 ₤m
Finance costs
Interest payable on short-term bank loans and (47)
overdrafts repayable within five years
Finance charges payable under finance leases (13)
and hire purchase contracts
4% 125m GBPunsecured deep discount loan -
stock 2006
6% 150m GBPMedium Term Note (MTN) 2006 -
0.7% 50bn JPY MTN 2006 - Finance income 91
7.5% 258m GBPMTN 2007 (8) Finance cost (25)
6% 125m GBPMTN 2008 (7) Net interest payable 159
5.25% 500m EUR MTN 2008 (18) Interest capitalised 103
5.125% 192m GBPMTN 2009 (10) Net interest payable adjusted 262
6.625% 150m GBPMTN 2010 (10) EBIT 2,791
4.75% 750m EUR MTN 2010 (25) Interest cover 17.55x
3.875% 500m EUR MTN 2011 (13) Interest cover adjusted 10.65x
4% RPI GBPMTN 2016(b) (20)
5.5% 850m USD Bond 2017 (12)
5.5% 350m GBPMTN 2019 (19)
5% 415m GBPMTN 2023 (18)
3.322% LPI GBPMTN 2025(c) (19)
6% 200m GBPMTN 2029 (12)
5.5% 200m GBPMTN 2033 (11)
1.982% RPI GBPMTN 2036(d) (11)
6.15% 1,150m USD Bond 2037 (18)
5% 300m GBPMTN 2042 (15)
5.125% 600m EUR MTN 2047 (21)
5.2% 500m GBPMTN 2057 (13)
Other MTNs (13)
Capitalised interest 103
Total finance costs (on historical cost basis) (250)
Considerations for investment banking: Tangible non-

current assets
The following will impact capital employed (and equity),

depreciation and profit or loss:
• PPE can be revalued under IFRS
• All assets with a finite useful life must be depreciated
• Interest should be capitalised during the construction of an

asset.
Intangible non-current assets
Intangible non-current assets have no physical form or

substance such as patents, licenses, trademarks, brands, and
rights to do certain things. They generally take the form of a
contract.
Purchased intangibles
Purchased intangibles such as telecoms licenses, or rights to

explore for oil and gas, are treated in the same manner as
tangible assets. They are recognised on the balance sheet at
cost and depreciated (or amortised) over their useful economic
lives.
IFRS US GAAP
There is an option to No option to revalue

revalue purchased
intangible assets, but only if
there is an active market
for the asset, which is
unusual.
Goodwill
Goodwill is a particular type of purchased intangible asset that

arises in the financial statements of a group that has acquired
a company. It is the excess of the consideration for the
acquisition over and above the fair value of the identifiable net
assets acquired. Goodwill is not amortised but must be tested
for impairment every year. Goodwill is covered in more detail

in Accounting and analysis for mergers and acquisitions.
Internally generated intangibles
Reputation, knowledge, experience and human capital are all

examples of intangible assets that are generated internally
rather than acquired. They are not recognised on the balance
sheet and any expenditure on developing these is expensed
through the income statement.
Research and development
Speculative research is always treated as an expense in the

income statement.
IFRS US GAAP
Development expenditure Development expenditure

on particular projects is generally expensed as
should be capitalised in incurred, with the exception
specific circumstances, of certain costs associated
where the company can with the development of
demonstrate all of the internal use software and
following: websites.
• The technical feasibility of

completing the project
resulting in a product that
will eventually be available
for use or sale
• Its intention to complete

the project and use or sell
the product
• Its ability to use or sell the

product
• How the project will

generate probable future
benefits
• Its ability to reliably

measure the expenditure
attributable to the project.
This treatment is often

adopted for drugs
companies or high tech
industries that invest large
amounts of money on the
development of products
that will bring benefits in
the future.
Amortisation
Amortisation is depreciation for intangible assets. However, the

two words, depreciation and amortisation are increasingly used
interchangeably.
Considerations for investment banking: Intangible non-current

assets
The following will impact capital employed (and equity),

amortisation and profit or loss:
• Purchased goodwill is capitalised and reviewed annually for

impairment rather than amortised as it was in the past
• Intangibles acquired as part of an acquisition of a business

should be capitalised separately from goodwill – see Accounting
and analysis for mergers and acquisitions
• Intangibles arising from development must be capitalised if

they fulfil the IFRS criteria.
In order to ensure cross-border comparability between

European and US companies, bankers may need to:
• Re-define EBITDA, EBITA, EBIT, EPS and adjusted equity and

capital employed (adjusted for intangibles) to account for the
differing impacts of intangibles
• Focus on EBITDARD (earnings before interest, tax,

depreciation, amortisation and research and development) in
certain sectors, such as pharmaceuticals.
Impairment
Prudence dictates that assets on the balance are not overstated

(that they don’t exceed the value of the future economic
benefits). Where an asset is carried on the balance sheet at a
higher value than the recoverable amount of the asset, the asset
will need to be written down or impaired.
Impairment indicators
An enterprise assesses at each balance sheet date whether

events or changes in circumstances indicate that an asset has
become impaired. Indicators of impairment would include:
• Current period operating loss
• Significant decline in market value
• Obsolescence or physical damage
• Significant adverse changes in business, market, statutory

environment, regulatory environment or indicator of value used
to measure fair value on acquisition
• Commitment to significant reorganisation
• Significant change in market rates of return likely to affect

recoverable amount.
IFRS US GAAP
No quantitative test to Impairment test not

indicate whether an required where gross
impairment test is required (undiscounted) value of
or not. future cash flows exceeds
carrying value of the asset.
Recoverable amount
The recoverable amount (RA) of an asset is the higher of its net

realisable value (NRV) and its value in use (VIU). An impairment
test determines the recoverable amount of the asset and if that
is lower than the balance sheet carrying value then the asset is
impaired and will be written down to the recoverable amount.
Net Realisable Value: Selling price, less directs costs of selling

the asset
Value in Use: Present value of the future cash flows directly

attributable to the asset
Income statement impact of impairment losses
If the asset is held on the balance sheet at historic cost then any
impairment loss is taken to the income statement. If the asset
has been revalued upwards in the past then the impairment loss
will reduce the revaluation reserve down to nil, with any
additional impairment creating an income statement expense.
Impairment testing illustration
Circumstances have indicated that the asset outlined below has

suffered impairment. The details of the impairment review and test
are outlined below.
IFRS will determine that an asset is impaired by comparing the

carrying value of the asset to the recoverable amount. In the case
outlined above, the recoverable amount (the higher of the value in
use [$155,173] compared to the net selling price of the asset
[$150,000]) of $155,173 indicates that the asset requires an
impairment adjustment of $24,827 [$180,000-$155,173]. This
impairment adjustment will be charged directly to the income
statement.
Note: There would be no such impairment under US GAAP as an asset is

deemed not to be impaired if the sum of the future cash flows
(undiscounted) is higher than the carrying value of the asset.
Reversals of impairment losses
IFRS US GAAP
Where the indicators of Impairments never

impairment have reversed, reversed.
past impairments should
potentially be reversed for
all assets apart from
goodwill.
Considerations for investment banking: Impairment
In the same way that write downs of current assets are a non-
cash expense, so are impairments of non-current assets. Care
is needed when analysing historic impairment charges or even
considering the likelihood of future impairments. Impairment
testing by its very nature is subjective as both NRV and VIU
often rely on inputs and assumptions that can be difficult to
validate.
Liabilities
Similar to assets, liabilities are presented as either current

(falling due within 12 months of the balance sheet date) or non-
current (falling due after more than 12 months following the
balance sheet date).
Debt
Debt comes in a wide range of forms but the accounting for it

has a number of consistent themes.
Debt vs. equity
Financial instruments issued by a company must be classified

for accounting purposes as either debt or equity. It is usually
quite clear whether the instrument represents debt or equity:
• Ordinary shares issued for cash are clearly equity as there is

no obligation to deliver cash (pay a dividend)
• A bank loan is clearly debt, as there is a contractual obligation

to deliver cash (pay interest).
However there are certain instruments which exhibit

characteristics of both debt and equity.
Preference shares and redeemable securities
Legally, a preference share is a share of the company that gives

some kind of guaranteed return to the investor, and hence
exhibits debt like characteristics. Whether preference shares are
presented as debt or equity on the balance sheet (and the
servicing as interest or dividends in the income statement)
depends on the exact features of the instrument, but many
preference shares are treated as debt due to the guaranteed
payout.
IFRS US GAAP
Redeemable securities Redeemable securities

where the holder has the typically presented as part
option to ask for their of equity or, for SEC
investment back are registrants, mezzanine
typically presented as debt. equity.
Considerations for investment banking: Debt vs. equity
The debt vs. equity issue can have a significant impact on the
financial statements of a company that is moving from one
accounting regime to another. For example, in the period when
a European company transitions from its local GAAP to IFRS, it
may find that some of its issued instruments (redeemable
preference shares) that have been presented as equity in the
past need to be moved into the debt category. This can result
in a significant change to the shape of the balance sheet and
the reader might be fooled into thinking that something real
has happened at the company, when nothing actually has
happened. The company is simply reporting under different
accounting rules.
Convertible debt
IFRS US GAAP
Debt that is convertible to Convertible debt is

equity shares at the option generally treated as entirely
of the holder is split into a debt unless there is a
debt element and an equity beneficial equity conversion
element on the balance feature that exists at the
sheet of the issuer. It is inception of the instrument.
treated as a vanilla debt
instrument with an equity
conversion option.
Effective interest rate
Accounting for interest payments on simple loans is

straightforward. When a payment of interest is made there is a
cash outflow and a corresponding interest expense in the
income statement.
Difficulties arise when the interest cash flows do not match the
interest expense suffered over an accounting period. Consider
an extreme example, where all the interest is rolled up into the
loan and not paid until a later date. In the future there will be
interest on interest and there is a method of dealing with this in
the financial statements called the effective interest rate
method.
The effective interest rate (or internal rate of return) of an

instrument is the discount rate that discounts all the cash flows
to a zero net present value and can be determined in
straightforward examples by:
FV = PV (1 + r) ^ n
FV = future value
PV = present value
r = discount rate
n = number of time periods
It is this effective interest rate that drives the accounting for
these instruments, as illustrated in the following example.
A company borrows €100,000 on 1 January from a bank. The

bank agrees that the interest can be rolled up into the loan and
repaid on 31 December four years later along with the capital.
The total repayment on that day will be €120,000.
How does the company reflect this arrangement in its financial

statements over the 4 year term of the loan?
1 Jan accounting
The company would reflect an increase in cash of €100,000 and

an increase in liabilities of €100,000.
Ongoing accounting
The ongoing accounting would be determined by the effective

interest rate:
FV = PV(1+r)^n
120,000 = 100,000 (1+r)^4
1.2 = (1+r)^4
4√1.2 = 1+r
1.047 = 1+r
r = 4.7%
The company is suffering interest at 4.7%, but only paying it at

the end of the loan. The annual accounting entries for the 4
years would come from the following table.
Operating Interest Cash Closing

loan expense flow loan
balance at 4.7% balance
100,000 4,700 0 104,700
104,700 4,921 0 109,621
109,621 5,152 0 114,773
114,773 5,227 0 120,000
The balance sheet liability grows from €100,000 to €120,000 over

the 4 year period, with corresponding entries as interest expense
each year.
This “effective interest rate” method must be applied to all such

arrangements in order to determine the accounting treatment.
Net debt
Net debt comprises debt less (the aggregate of) cash and cash
equivalents.
Debt
Debt comprises:
• Borrowings (instruments issued as a means of raising finance

which are classified as liabilities)
• Obligations under finance/capital leases.
Cash equivalents
Cash equivalents (or liquid resources) are short-term, highly

liquid investments which are readily convertible to cash and
subject to insignificant changes in value.
Money market deposits and certificates of deposit are likely to

meet this requirement.
Where is net debt used?
• As a component of enterprise value:
Equity value X
Add: net debt X
Add: minority interest X
Less: JVs & associates (X)
Capital Employed X
And so used in most multiples and needed to derive equity

value from DCF valuations.
• As a component of capital employed:
Equity shareholders’ funds X
Add: net debt X
Add: minority interest X
Less: JVs & associates (X)
Capital Employed X
And so used in most returns analysis (return on capital

employed, etc.) and either on its own or as part of capital
employed in credit analysis:
• Returns analysis (e.g. return on capital employed)
• Credit analysis
• Net debt to EBITDA multiples
• Gearing ratios
• Net debt to funds from operations multiples
• Total coverage ratios.
• In the breakdown from enterprise value to Equity value:
Enterprise value X
Less: net debt (X)
Less: minority interest (X)
Add: JVs & associates X
Equity value X
Leases
If a company needs a particular non-current asset, the

obvious course of action would be to buy it. If the company
does not have the cash to do this then it could consider
borrowing the money required. However, there is an
alternative which is to lease the asset from a lessor
company. Where a company is leasing an asset, the
accounting treatment is driven by the economic substance
of the arrangement rather than its legal form.
Lease classification
For accounting purposes, leases fall into one of two

categories. Operating leases are held off balance sheet and
finance (or capital) leases are held on balance sheet.
Whether any particular leased asset is on or off balance
sheet is determined by consideration of a number of
criteria. The exact criteria are slightly different under IFRS
and US GAAP but the following list highlights typical factors
that would indicate a finance lease under both regimes:
• The lease transfers ownership of the asset to the lessee

by the end of the lease term
• The lessee has the option to purchase the asset at a price

which is expected to be sufficiently below fair value at the
date the option becomes exercisable such that, at the
inception of the lease, it is reasonably certain that the
option will be exercised
• The lease term is for the major part of the economic life
of the asset even if title is not transferred
• At the inception of the lease the present value of the

minimum lease payments amounts to substantially all of
the fair value of the leased asset
• The leased assets are of a specialised nature such that

only the lessee can use them without major modifications
being made.
The distinction between operating and finance lease is a

matter of judgement and is based on the factors above.
Operating lease accounting
Lease payments under an operating lease are recognised

as an expense in the income statement on a straight line
basis over the lease term (unless another systematic basis
is more representative of the time pattern of the user’s
benefit). The payments are treated as operating cash flows
in the cash flow statement.
For operating leases there is a requirement for the

company to disclose in its financial statements the
operating lease expense for the year, and the lease
payments it is committed to making in future years. These
operating lease commitments disclosures are useful for
bankers needing to capitalise operating leases (see
Operating lease conversion).
Finance lease accounting
The accounting for an asset held under a finance lease is

similar to that if the company had borrowed money to buy
the use of the asset. A depreciating asset and an
amortising liability are recognised on the balance sheet.
Balance sheet
At the inception of the lease an asset and a matching lease

obligation are recognised on the balance sheet at the
present value of the future lease payments, usually
measured at the company’s incremental borrowing cost.
The asset depreciates as normal over the term of the lease,

usually straight line.
The liability increases over time as interest accumulates

but then decreases with the lease payment, which not only
pays off the notional interest but also pays off some of the
capital. This continues for the duration of the lease until
the outstanding obligation has reduced to nil.
Income statement
The lease payments are not treated as an expense in the

income statement. The income statement is impacted in
two ways. Operating profit is reduced as a result of the
depreciation expense and profit before tax is reduced
further because of the interest expense.
Cash flow statement
The lease payments are treated as partly repayment of

interest and partly repayment of capital. The repayment of
capital element is always treated as financing in the cash
flow statement but care is needed with the interest
element, which may be presented as operating, investing
or financing.
Operating lease conversion
When comparing the performance or position of one company

with another, it is important to ensure that the impact of
different accounting treatments in the two companies is
neutralised as much as possible. Where one of the companies
has a number of operating lease arrangements (off balance
sheet) and the other has a number of on balance sheet finance
leases, adjustments can be made to bring the two into line with
each other. Generally the operating leases are capitalised or the
financial statements are adjusted as though the leases had
always been treated as finance leases.
There are two approaches used to complete this adjustment:
• The discounted cash flow approach
• The multiple approach.
The discounted cash flow approach
Information required:
• An interest rate to apply to the future lease commitments
• The future lease payments
• The lease term.
Interest rate
• Use a benchmark interest rate (e.g. 10 year government gilt

rate) and add a credit risk premium or
• Examine the notes to the accounts and use the interest rate
disclosed in either:
• The pensions note (used by the actuaries to calculate

the present value of the pension scheme benefit
obligations) or:
Discount rate 6.00%
Projected future remuneration increases 2.75%
Projected future pension increases 1.75%
Source: Bayer Annual Report
• The financial instruments note:
Short term borrowings (excluding the short-term

portion of debentures) amounted to €2.0 billion
with a weighted average interest rate of 6.2
percent. The Bayer Group’s financial obligations
are primarily unsecured and of equal priority.
Source: Bayer Annual Report
It would seem that using a pre tax interest rate of about 6.00%
to discount the future lease commitments would be
appropriate.
Lease term and commitments
Identifying the lease term and the future cash flow

commitments on the operating leases can be a more involved
process due to the quality of disclosure in the accounts.
The operating lease extract below is typical. With this

information, once an interest rate has been identified,
discounting the first 5 years of cash flows is straightforward.
Minimum non-discounted future payments relating

to operating leases total €478 million. The respective
payment obligations mature as follows:
Maturing in € million
2004 124
2005 93
2006 76
2007 64
2008 55
2009 or later 66
478
Source: Bayer Annual Report (reporting under IAS)
In the case of Bayer, 66m of the total operating lease

commitment arises after year 5. Given that the annual
commitment for years 4 & 5 were €64m and €55m respectively,
it would be fair to say that the term of the lease commitment
beyond year 5 is limited.
An example of a present value calculation of the future cash flow

commitment for the Bayer operating leases:
Bayer operating lease conversion
Discount rate 6.00%
Payments Discount PV
€m factor €m
1 2004 124 0.943 117.0
2 2005 93 0.890 82.8
3 2006 76 0.840 63.8
4 2007 64 0.792 50.7
5 2008 55 0.747 41.4
6 2009 66 0.705 46.5
PV of the future operating lease commitments 401.9
Sum of discount factors 4.917
Given the assumptions made above, the present value of

the operating lease commitments for Bayer is €402m.
The charge in arriving at operating profit for operating

lease payments reflected in the income statement of Bayer
was €124m. If the leases are now treated as finance leases
this charge needs to be restated as interest and
depreciation. Depreciation is charged above the operating
profit line and interest below.
By applying a 6% interest rate to the €402m, a notional

pre-tax interest charge can be calculated as €24m.
Operating profit can be restated by adding back €24m
Bayer income statement adjustments
Operating Finance
lease Lease lease
charges reclassified charge
EBITDAR - -
Operating lease charge (124) 124 -
EBITDA (124) -
Depreciation - (100) (100)
Operating profit (124) (100)
Interest on finance leases - (24) (24)
Profit before tax (124) (124)
A similar issue needs addressing for the cash flow statement.

The operating lease cash payment is classified as an operating
cash outflow. As a finance lease, the cash outflow is split into a
repayment of principal (a financing cash flow) and a servicing of

finance (interest as an operating cash flow in the following
illustration).
An alternative approach to the cash flow adjustment would be

to treat all leases as if they were acquired assets. In this case,
any new leases would be treated as capital expenditure
financed by new borrowings. It is only by this adjustment that
we have consistency of treatment of all assets used by the
business.
The multiple approach
The discounted cash flow approach to converting operating

leases to finance leases is an academic resolution to the
conversion issue. However, its use is to provide a theoretical
foundation to the commonly used multiple approach to
operating lease conversion.
The multiple approach assumes that the operating lease

commitment is an annuity (a series of equal annual cash
flows). The present value of an annuity is calculated using the
annuity factor equation below.
Annuity calculation
Number of time periods (n) 6 periods
Discount rate (r) 6.00%
Annuity factor 1 1 4.917

(1 − )
𝑟 (1 + 𝑟)𝑛
Note: this is the same result as the sum of the discount factors
in the present value calculation for the Bayer operating lease
conversion.
Inputs required:
• The number of periods of the annuity
• An interest rate.
The annuity, therefore, reflects the expected length of the

operating lease commitment and the risk of that commitment.
Rating agencies have standard multiples that they will apply

in this calculation. (See ratings agencies’ operating lease
adjustments table.) The annuity factor should then be
applied to the expected annuity.
(Most rating agencies will apply the annuity factor to the gross
Annuity calculation
Number of time 6 periods
periods (n)
Discount 6.00%
rate (r)
Annuity 1 1
(1 − )
𝑟 (1 + 𝑟)𝑛 4.917 A
factor
Assumed cash flow annuity
(average of cash flow commitment

79,7 B
(2004-2009))
PV of the future operating lease

391.7 (AXB)
commitments (€)
income statement operating lease rental charge, however
different models will provide varying estimates for the
appropriate figure to be used – see ratings agencies’ operating
lease adjustments table).
An example of the multiples approach is outlined below for
Bayer:
Ratings agencies’ operating lease adjustments
Lease
adjustments
Debt NPV of future minimum, 8X gross income statement 8X gross income statement
adjustment non cancellable leases (at charge added to debt charge added to debt
10% discount rate) added

* Subject to note below
to debt (alternatively 5X
multiple of net income
statement charge)
Interest Interest component of 1

⁄3 gross income statement 1
⁄3 gross income statement
adjustment rents (10% of NPV result, charge added to EBIT and charge added to interest
or 1⁄3 of net income interest
statement charge) added
to EBIT, EBITDA and
interest
Depreciation Depreciation component 2

⁄3 gross income statement 2
⁄3 gross income statement
adjustment (remaining amount or 2⁄3 charge charge
of net income statement

Full rent expense added to Full rent expense added to
charge)
EBITDA (becomes EBITDAR) EBITDA (becomes EBITDAR)
* The multiplier of 8 is derived using a standard interest rate of
6% on an asset with a 15-year useful life. This is not appropriate
for all leases and Moody’s varies the multiplier depending on the
industry. Some of these are presented here:
Industry Multiplier
Technology 5
Telecommunications 5
Housebuilding 5
Aerospace/defence 6
Automotive 6
Chemicals 6
Healthcare 6
Transport services 6
Considerations for investment banking: Leasing arrangements
Metric comparability: Operating leases can be termed a source of
off-balance sheet financing. Where comparability is required across
companies which have financed their assets through outright
acquisition, finance leases and operating leases, it may be
necessary to adjust the financials so that the metrics are calculated
on a consistent basis. Capitalising all operating leases will treat all
assets as if they have been acquired/finance leased.
Operating lease conversion – metrics impacted:
• EBITDA
• EBIT/operating profit
• Depreciation
• Interest
• Operating cash flow
• Financing cash flow
• Free cash flow
• Funds from operations
• Net debt.
Provisions
The word “provision” has two meanings in the accounting

world:
1. A decrease in an asset such as a provision against a

receivable where it is believed that the full amount will not
be collected
2. An increase in a liability such as a litigation where there

may be a payout in the future
The common feature here is uncertainty. The extent of the

decrease in asset or increase in liability is not known
exactly so an estimate must be made. Provisions against
assets have already been covered in this chapter.
Provisions as liabilities with uncertainty are covered here.
Definition and recognition
A provision is a liability with uncertainty. For a provision to

be recognised there must be a present obligation (legal or
constructive) as a result of a past event that will probably
result in an outflow of resources, and can be reliably
measured.
There must be a past event that has triggered the

provision. It is not possible to simply book provisions for
events that may or may not happen in the future. For
example, if a company has potentially been negligent in
the past, and is being taken to court, then there is a past
event to trigger a provision. However, a company cannot
simply book provisions every year to cover them for the
eventuality that they may be taken to court.
The accounting treatment for provisions depends on the

level of certainty of the future outflow, as follows:
Probable Recognise a provision
Possible No provision recognised. However, the

existence of a “contingent liability” would need
to be disclosed
Remote No accounting or disclosures required
When a provision is recognised, a liability and resultant expense

are created. In the future when the payment is made, there is a
decrease in cash with a corresponding decrease in the liability.
If the provision doesn’t exactly match the cash outflow then
there will be a gain or loss recognised in the income statement
representing the difference between the two.
IFRS US GAAP
Where the effect of Provisions generally

discounting is material, undiscounted.
provisions should be
measured at the
discounted present value of
the future cash flow.
Common types of provision
The common types of provision include:
• Restructuring: A restructuring provision may only be booked

where the company is fully committed to the restructuring
programme by the balance sheet date
• Litigation: In recognition of a probable future payout as a

result of a legal action
• Environmental: Future clean-up costs of pollution and other

environmental damage
• Decommissioning: A particular kind of environmental

provision, with specific accounting rules, explained below.
Decommissioning provisions
Decommissioning provisions recognise the cost of taking heavy

infrastructure assets out of service at the end of their lives. They
arise on assets such as power stations and oil platforms.
The estimated costs of decommissioning are:
• Provided for when stations are constructed
• Capitalised as part of the cost of construction
• Depreciated over the same lives as the stations.
Due to the typically lengthy timeframes involved, the effect of

the time value of money is often material and the amount of the
decommissioning provision is usually the present value of the
expenditures expected to be required to settle the obligation.
When discounting is used, the carrying amount of the provision
increases in each period to reflect the passage of time. This
increase is reflected as a borrowing cost.
Illustration
6 years ago, a radioactive facility was commissioned. Future decommissioning costs to be

incurred 25 years after construction are estimated at £800m at future prices. The nominal
rate of interest which reflects the risks specific to the liability is 5.987%.
Balance sheet Income statement Cash flow statement
£m £m £m
Decomissioning Operating
asset - cost 187 expenses (dep'n) (8)
- acc dep'n (45)
- NBV 142
Provision
s (265) Finance charges (15)
Workings
Decomissioning asset
On commissioning of facility
£187
£800m ÷ (1.05987)^25 m
Annual depreciation charge
£187m ÷ 25 £8m
Accumulated depreciation to
date
£7.5m ÷ 6 £45m
Decommissioning provision
At beginning of current period
£250
£800m ÷ (1.05987)^20 m
Unwinding of discount in
period
£250m x 5.987% £15m
At end of period
£265
£800m ÷ (1.05987)^19 m
Considerations for investment banking: Provisions
Metric comparability: Provisions are estimates of future,

probable economic outflows. They can also be used to
manipulate profits from one period to another. Financial
analysis needs to attempt to ascertain whether the provision is
genuine or not. This is not an easy task.
Careful monitoring of balance sheet provision movements and

the reconciliation of operating profit to operating cash flow are
key watch areas. Also consider the timing of these provision
movements with the income statement performance. Typical
profit smoothing with provisions will be cyclical with income
statement performance.
Deferred tax
Introduction
Deferred taxation is an area of accounting that is much

maligned and misunderstood. The accounting is technical and
requires detailed calculations and forecasting. However, the
idea is reasonably straightforward. Accountants like to be
prudent (that is, they like to anticipate potential future losses
when applicable and probable) and accountants also love to
match (again, they like to account for items in the period that
they relate to).
Deferred tax applies these concepts by accounting in the

current period for future tax implications of transactions in the
current period. Hence a deferred tax liability is exactly what it
states it is – a probable tax outflow (liability) that is deferred
until a later date.
Definitions
Deferred tax liabilities
Deferred tax liabilities are the amounts of income taxes payable

in future periods in respect of taxable temporary differences.
Deferred tax assets
Deferred tax assets are the amounts of income taxes

recoverable in future periods in respect of:
• Deductible temporary differences
• Carryforward of unused tax losses
• Carryforward of unused tax credits.
Recognition
Temporary differences
Temporary differences are differences between the amount at

which an asset or liability is recognised in financial statements
and its tax base. The tax base is the amount that will be
deductible or taxable in respect of the asset or liability in the
future.
The rationale for recognising deferred tax on temporary

differences is that the entity should provide for the unavoidable
tax consequences of recovering the carrying values of assets or
settling liabilities at the amounts shown in the accounts. It is
inherent in the carrying value of an asset that it will generate
(pre-tax) cash flows at least equal to that carrying value. Any tax
payable on generating those cash flows is inherently a liability of
the entity.
Taxable temporary differences
A deferred tax liability is recognised for all taxable temporary

differences, unless the deferred tax liability arises from:
• Goodwill for which amortisation is not deductible for tax

purposes
• The initial recognition of an asset or liability in a transaction

which is not a business combination and, at the time of the
transaction, affects neither accounting profit nor taxable profit.
Deductible temporary differences
A deferred tax asset is recognised for all deductible temporary

differences to the extent that it is probable that taxable profit
will be available against which the deductible temporary
difference can be utilised, unless the deferred tax asset arises
from:
• Negative goodwill
• The initial recognition of an asset or liability in a transaction

which is not a business combination and, at the time of the
transaction, affects neither accounting profit nor taxable profit.
Unutilised tax losses
A deferred tax asset is recognised for the carry forward of

unused tax losses (and unused tax credits) to the extent that it is
probable that future taxable profit will be available against
which the unused tax losses (and unused tax credits) can be
utilised.
Measurement
Deferred tax assets and liabilities are measured at the tax rates
expected to apply to the period when the asset is realised or the
liability is settled, based on tax rates that have been enacted or
substantively enacted by the balance sheet date.
Deferred tax assets and liabilities are not discounted.
Considerations for investment banking: Deferred tax
Deferred tax balance sheet numbers are often removed from

financial analysis. Cases can arise where deferred tax
provisions do not reverse and do not lead to an actual cash
outflow. This is often the case with entities that have aggressive
capital expenditure forecasts. The impact is that the provisions
become bookkeeping entries that do not lead to a cash flow
impact, and merely reduce balance sheet equity. Treating
deferred tax provisions as quasi equity and reinstating the
provision as an equity number is a relatively common
adjustment for analysis using capital employed or equity
numbers.
Pensions
Accounting for company pension schemes is a complex area but

important for bankers to understand, as the numbers can be big
and can have a significant impact on the value of a company.
This section covers the accounting treatments for the two main
types of scheme, defined contribution and defined benefit.
Defined contribution schemes
These are simple schemes where in addition to regular salaries,

the company pays an additional amount (often a percentage of
salary) to the employee, to be invested for the benefit of the
employee when they retire. Essentially the employee has a
personal pension pot which grows over time and helps fund the
retirement years.
From the perspective of the company, this is simply treated as a

little extra benefit paid out to staff, so the accounting for each
payment is a decrease in cash and a corresponding income
statement expense.
Defined benefit schemes
Defined benefit schemes are very different to defined

contribution schemes. A defined benefit scheme is essentially
a promise. The employer promises to pay a pension to the
employee in retirement, the size of which is typically related to
the number of years service and the salary of the employee
during the years of service.
This promise immediately creates an obligation for the company

which needs to be recognised on the balance sheet as a liability.
There are two types of defined benefit scheme:
• Funded: company ring-fences some financial assets to help

settle the obligation in the future
• Unfunded: no ring-fenced assets but usually a regulatory

requirement to take out insurance against company bankruptcy.
The explanations that follow relate to a funded scheme. The

same rules would apply for an unfunded scheme but the
application would be simpler as there would of course be no
pension assets on the balance sheet.
For a funded scheme there would be both a pension asset and a

pension liability on the balance sheet. Understanding the
accounting for these schemes starts with an understanding of
how the asset and the liability move over time and then
considering the dual effect of those movements.
Pension asset
The pension asset on the balance sheet is the fair value of the
pool of assets at the balance sheet date. There are three main
reasons why the pool of financial assets might move over time.
Actual return on assets
The ring-fenced pension assets are essentially a pool of

investments, held for the long-term benefit of the employees.
Those investments, whether they are cash, debt or equity, will

hopefully grow in line with market movements. The pool may
increase when markets are rising, but may also fall in line with a
slump.
Employer contributions
From time to time, or possibly even on a regular basis, the

company may top up the pool of assets with its own cash. This
maybe to fill a deficit and increase the pension asset to bring it
into line with the pension obligation or it may just be a regular
contribution.
The employer is usually prohibited from taking money out of the

pool but this will be governed by the law and regulations that
apply to the scheme.
Payments
There will be regular payments out of the scheme to ex-staff

now in retirement. There may also be one-off payments out to
transfer the value of an individual’s benefit to their next of kin
in the event of death. These payments represent a continual
outflow of assets from the pool.
Movement in pension obligation
The pension obligation is the present value of the future cash

flows that have been earned by the balance sheet date. The
liability is the result of an actuarial calculation with a number of
inputs such as mortality rates, salary rates and other economic
assumptions.
There are four main reasons why the pension obligation might
move over time.
Service cost
The service cost is the increase in the obligation over time as a

result of staff working for the year. Another year worked means
the value of the promise increases as the pension is directly
linked to number of years served.
Interest cost
The company does not actually suffer interest on the liability but
there is a notional interest cost as the discount unwinds as time
passes. Each year, all else being equal, the future cash flows are
discounted over a shorter period (one year less) than the

previous year so the present value will increase.
Changes in actuarial assumptions
If the actuaries change their assumptions for the actuarial

calculation, such as mortality rates, then there will be a change
in the value of the obligation. These changes could increase or
decrease the size of the obligation.
Payments
In the same way that payments to retired people decrease the

pension asset, they will also decrease the pension obligation,
because as soon as a payment is made, that amount is no
longer owed to the individual.
Dual effects and the income statement
So there are seven reasons why the net pension position (asset
minus liability) might move over time. Each of these must have
a dual effect if the balance sheet is to balance. These are
explained below:
Movement Dual effect
Asset
Actual return The full amount of the movement here is

on assets not taken to the income statement as it
could introduce unwanted volatility. A
long term expected return on assets is
taken to the income statement as a gain
(one would never expect to make losses
in long term) and any difference
between expected and actual is treated
as an actuarial gain or loss (see Actuarial
gains and losses)
Employer Company cash falls and the pension

contributions asset increases by the same amount.
These are both balance sheet
movements so no impact on the income
statement
Payments The pension asset falls and the pension

liability falls by the same amount so no
impact on the income statement.
Obligation
Service cost As the obligation increases there is a

matching expense recognised in the
income statement.
Interest cost As the obligation increases there is a

matching expense recognised in the
income statement.
Changes in Treated as an actuarial gain or loss (see

actuarial Actuarial gains and losses)
assumptions
Payments The pension obligation falls and the

pension asset falls by the same amount
so no impact on the income statement.
So the three movements included in the income statement

pension expense are:
Service cost S
Interest cost I
(Expected return on assets) (E)
Pension expense P
Actuarial gains and losses
There are two remaining movements that are not immediately

reflected in the income statement that must be accounted for if
the balance sheet is to balance. The difference between actual
and expected return on assets and the impact of changes in
actuarial assumptions are referred to as actuarial gains and
losses.
There is a choice of how any actuarial gains or losses can be

accounted for. The options are covered here, along with their
applicability to both IFRS and US GAAP.
IRFS? US GAAP?
Option 1: Take any actuarial gains or losses directly to equity. In ✓ x

other words, simply increase or decrease retained earnings
(without passing through the income statement) by the amount of
the gain or loss. This avoids any income statement impact and
results in a balance sheet that shows the true pension position at
the balance sheet date
Option 2: Leave some actuarial gains or losses unrecognised. In ✓ x

other words, pretend they never happened. The rationale for this
being a permitted treatment is that in the long run actuarial gains
will offset any actuarial losses so, in the interests of short term
smoothing, pretending they never occurred in the first place is
acceptable. Actuarial gains/losses can only remain unrecognised
within specified limits (the corridor). Once they exceed these
limits they must be recognised systematically through the income
statement. This avoids any income statement impact but it does
result in a misleading balance sheet position, as the reported
position is the position had the actuarial gain or loss not
happened (even though of course it did happen). The true
pension position can always be determined through a careful
review of the pension note but the balance sheet itself will often
be misleading.
Option 3: As option 2 but recognise all actuarial gains/losses ✓ ✓

eventually through the income statement. In other words, defer
any gains/losses outside the corridor in equity and amortise
systematically through the income statement over time.
Option 4: Recognise all actuarial gains/losses systematically ✓ ✓

thorough the income statement
Presented below is an extract from the pension note of Tesco’s

2008 financial statements. The way that Tesco has presented
the information is useful for the reader, as it is clear where
items have been recorded in the income statement. Service cost
has been charged to operating profit and both expected return
on assets and interest have been recorded in finance income. It
is also possible to see the items recognised outside the income
statement in the statement of recognised income and expense.
Note 24 Post-employed benefits continued
The amounts that have been charged to the Group Income Statement of Recognised
Income and Expense for the year ended 23 February 2008 are set out below:
2008
£m
Analysis of the amount (charged)/credited to operating profit:
Current service cost (461)
Past service gains -
Total charge to operating profit (461)
Analysis of the amount credited/(charged) to finance income:
Expected return on pension schemes’ assets 301
Interest on pension schemes’ liabilities (254)
Net pension finance income (note 5) 47
Total charge to the Group Income Statement (414)
Analysis of the amount recognised in the Group Statement of Recognised Income

and Expenses:
Actual return less expected return on pension schemes’ assets (465)
Experience losses arising on the schemes’ liabilities (21)
Currency gain/(loss) 1
Changes in assumptions underlying the present value of the schemes’ liabilities 672
Total gain/(loss) recognised in the Group Statement of Recognised Income and

187
Expense
Considerations for investment banking: Pensions
Cleaning up the income statement
There are two main income statement issues:
• Some of the pension cost may be in the wrong part of the income statement
• There are some questionable items included in the income statement.
The issues arise with the treatment and location of:
• Interest costs
• Expected gains or losses on plan assets
• Actuarial gains and losses.
An additional problem associated with the income statement impact of pensions is that most
companies preparing their accounts only disclose a detailed breakdown of the income statement
charges in the annual report. It is, therefore, difficult for analysts to examine the income statement
impact of these charges in the quarterly results.
EBIT and EBITDA
The pension service cost represents the present value of the additional pension entitlement
earned by an employee working for another year for his/her organisation.
This is clearly an operating cost and is treated as such by the accounting rules and gets charged to
EBITDA.
The most appropriate approach to adjusting the EBITDA metrics is to strip out all other pension
accounting – interest costs, expected gains/losses on plan assets and actuarial gains and losses
which are financial in nature.
The problem is that the accounting rules don’t specify exactly where in the income statement
these items should be presented. Hence some companies will present all items as part of
operating profit (EBIT) and others may present the interest cost and the expected return on assets
as part of interest (see Tesco example above). Sometimes it is possible to determine how the items
have been presented by carefully studying the pensions note, but is can often be difficult.
The financial items MUST be taken below the EBITDA line
Illustration Income statement $
Unadjusted Adjusted
Interest cost (100) (100) 100 –
Current service cost (130) (130)
Expected return on plan assets 120 (120) –
EBIT(DA) (110) (130)
Interest cost - (100)
Expected return on plan assets - 120
Net financial income - 20
Profit before tax (110) (110)
Cleaning up the balance sheet
As has been explained, the net pension liability recognised on the balance sheet may be distorted by the
accumulation of actuarial gains or losses. These accumulated actuarial gains or losses add no value to the
company and merely distort any analysis of the balance sheet.
Another approach is to ignore the balance sheet number and examine the funding status of the plan, usually
disclosed in the notes to the accounts.
Most analysts will treat a pension deficit as a debt item. Therefore the post-tax pension deficit is often included
in calculations of:
• Adjusted net debt
• Enterprise value
• Total capital employed.
However, when examining a pension asset it is generally inappropriate to treat the asset as a cash item, as
shareholders usually will not have access to the funds.
Adjusting free cash flow
Free cash flow metrics should be net of the pension service charge, as this reflects the normal operating cost of
running the pension. The issue arises as to whether the charge to the free cash flow line is the income statement
service cost or the cash paid.
In most circumstances, analysts will adjust free cash flow with the income statement service cost. Identifying the
cash flow impact of the service cost is likely to be impractical due to the availability of information and the
complexity of the calculation.
Therefore the most common strategy to overcome this issue is to assume over the long run that the service cost
will approximate to the underlying pension contribution.
There will be differences in the numbers used. However, the difference should be immaterial reflecting the time
value impact of the timing of the income statement service cost and the actual contribution.
Ratings agencies’ pension adjustments
Pension
adjustments
General Under-funded pension Deficits in funded plans are Deficits in funded plans
approach schemes treated as debt viewed as debt Liabilities of viewed as debt-like
items unfunded plans are
assessed on a case by case
basis
Debt Post-tax net deficit added Funded schemes: pre-tax Funded schemes: post-tax
adjustment to total debt deficit added to debt deficit added to debt
Unfunded schemes: split
into debt and equity
according to company’s
unadjusted debt / capital
ratio
Income All pension costs, except All pension costs, except for
statement for service costs, are service costs, are added
adjustment added back to EBIT and back to EBIT and EBITDA, if
EBITDA, if reported above reported above the
the operating line operating line
Income statement issues
Many of the areas covered so far have impacted both the

balance sheet and the income statement. There are a small
number of issues that relate primarily to the income statement
only, and they are covered here.
Revenue recognition
The question here is when should revenue (sales) be recognised

in the income statement and how much revenue should be
recognised. For many businesses this is a straightforward
matter. A supermarket recognises a sale at the time the
customer pays for the item at the checkout. However, for more
complex business models, the question is not so simple.
Consider a building company that takes a deposit from

customers before building a property for them. Recognising
revenue in line with cash receipts doesn’t make sense as the
timing of the cash flows may be arbitrary and may not reflect
the performance of the work.
Basic concepts
Revenues are considered to have been earned when the entity

has substantially accomplished what it must do to be entitled to
the benefits represented by the revenues.
In the case of a service provider, revenue should be recognised

to the extent that the service has been provided and the
revenue has been earned.
In the case of the provision of goods, revenue should be

recognised when the customer has assumed the risks and
rewards of ownership.
Long term contracts
Specific guidance is provided where the provision of goods or

services covers a time period greater than one accounting
reference period. In a large-scale construction project such as
that outlined above, the financial statements would be
misleading if no revenue were recognised until the project was
complete. Hence revenue is recognised to the extent that the
project will be profitable and in proportion to the stage of

completion.
Hence where a project is 30% complete, 30% of total revenues

will be recognised and matched to 30% of total expected costs.
Where it becomes apparent that a project may be loss making
then the losses need to be recognised immediately.
Bundling and unbundling
Difficulties arise where the provision of one service is dressed

up to look like separate elements or, alternatively, where the
provision of a number of services is dressed up to look like one
arrangement.
A health club that takes a non-refundable joining fee from the

customer would need to consider what the joining fee
represents. If the upfront fee simply represents a prepayment
for future services then it should not be recognised as revenue
on day 1 but spread over the term of the contract. This would
result in a liability (deferred income) where the cash has been
received but the service not yet provided.
Similarly, a high street retailer that gives out “free” mobile

handsets if the customer signs up to a line rental contract would
need to consider if the provision of the handset on day 1 was an
element that would need to be accounted for separately. This
would result in an asset (accrued income) where the service has
been provided but no cash yet received.
Principal vs. agent
The issue here is one of income statement presentation. A

website might be selling holidays on behalf of a holiday
company. What should the income statement of the website
look like?
Website as principal Website as agent
Sales 100 Sales 40
Cost of sales (60)
Profit 40
The following would be indicators that the intermediary

(website) should be treated as principal:
• Website sets the ultimate selling price
• Website submits fixed amount to holiday company
• Customer deals with website in the event of a problem with

the holiday
• Customer has no direct contact with holiday company.
Although the bottom line profit number is of course the same,

the presentation can have a significant impact on profit margins
and sales multiples.
Illustration
lastminute.com
Memorandum sales
On the face of its income statement lastminute.com discloses

total transaction value of £34.2m. It discloses that this amount
does not represent statutory turnover, but represents the total
price at which goods and services have been sold over the
company’s website, and that, in the majority of transactions,
the company only acts as an agent or cash collector and earns
a commission.
Sales
The income statement also discloses that turnover for

lastminute.com is actually £3.7m.
Considerations for investment banking: Revenue
If the top line is inconsistent …
The revenue recognition policy is a key policy. Where

businesses have different revenue recognition criteria then the
top line, and all subsequent operating numbers, may vary
particularly in times of rapid growth (or decline).
The timing of revenue and cost recognition may vary (and so

will profit metrics) but the cash flows will remain unaffected –
when reconciling from profit to cash flows, the working capital

adjustments are likely to be more significant.
Employee share options
Employees are increasingly being rewarded for their services

through shares and share options in addition to more
traditional methods such as cash. Share option schemes can
vary significantly in nature but the accounting for them is
determined through some basic principles.
A typical share option scheme
A typical share option scheme would have an employer grant

options to staff, that may be exercised at some time in the
future if certain performance targets have been achieved.
For example, on 1 January 2009 (grant date) staff may receive

options to buy shares in the company for €1.00 per share (strike
price, or exercise price) on 31 December 2010 (vesting date) if, at
that time, they are still employed by the company, and the
company share price is greater than €2.00 (performance
conditions). The share price on 1 January 2009 is €1.50.
There is clearly value in the options. On grant date the

difference between the exercise price and the market value of
the share is €0.50. This is referred to as the intrinsic value of the
option. The options also have a fair value, which will be higher
than the intrinsic value as there is the possible upside of share
price rises over the vesting period. The fair value of the option
could be determined with an option pricing model such as
Black-Scholes or binomial and is needed for the accounting.
The accounting treatment for these schemes is separated into

what happens over the vesting period and what happens at the
exercise date. It is important to keep the two separate and not
try to relate them to each other.
They are independent of each other.
Accounting treatment during the vesting period
The accounting rules require an expense to be recognised in the

income statement equal to the fair value on grant date of the
options granted, spread over the vesting period.
Taking the example above, if the fair value of an option was

€1.00 (derived from the option pricing model), then there would
be an expense of €0.50 for each of the next two years.
The dual effect of the expense is an increase in equity (usually

retained earnings) so the overall impact of this cosmetic
expense in the income statement is nil on the balance sheet.
Equity both increases as a result of the direct dual effect and
decreases when the expense flows through to retained
earnings.
The expense may be adjusted over time for non-market

performance conditions such as staff leaving (options lapse) but
is not adjusted for the likelihood of achieving market
performance conditions such as the €2.00 share price target.
The existence of the market conditions are built into the option
pricing model on grant date and are not revisited over the
vesting period.
Accounting treatment at exercise
On exercise, any cash received by the company for the

employee is treated in the same way as cash received when
issuing ordinary shares. This will not impact the income
statement of the company. There are never any gains or losses
reflected in the income statement as a result of transactions in a
company’s own shares.
Cash settled schemes
A cash settled share option scheme works in the same way as a

traditional equity settled scheme (as above) but on exercise date
the employee receives cash, equal to the difference between
exercise price and market value of the share, rather than the
share itself.
The accounting is similar in that an expense is recognised in

the income statement over the vesting period but the dual
effect is a genuine liability, as there is an obligation to pay cash
in the future. The accounting for a cash settled scheme is,
therefore, no different to the accounting for any discretionary
long-term cash bonus. It is expensed in the income statement
as it is earned and the liability extinguished when the cash is
paid.
There are usually many pages of disclosures relating to share

option schemes but it will always be possible to find the income
statement charge for both equity and cash settled schemes.
The Tesco presentation here is typical.
Note 23 Share-based payments
The total Group Income Statement charge for the year

recognised in respect of sharebased payments is £228m (2007 -
£209m), which is made up of share option schemes and share
bonus payments. Of this amount £199m (2007 - £185m) will be
equity-settled and £29m (2007 - £24m) cash settled.
Source: Tesco Annual Report 2008
Considerations for investment banking: Share options
Employee share options can cause difficulties when valuing a

company using DCF techniques. The share option expense in
the income statement is a non-cash charge and should be
added back when determining the free cash flows to be
discounted back to an enterprise value. Hence the EV is larger
than that of an equivalent company that rewards its staff with
cash rather than share options.
However, when adjusting from EV to equity value, in addition to

deducting net debt, an additional deduction will be required in
recognition of the fact that any in-the-money options will need
to be funded somehow, which effectively reduces the value of
the shares of the company. The deduction should be the
difference between the share price at the balance sheet date
and the exercise price of the options.
Post balance sheet events
When events happen after the end of the financial year, but
before the approval of the accounts (post balance sheet events),
the accounting rules require a distinction between those events
that:
• provide additional evidence of conditions that existed at the

balance sheet date (adjusting events)
• are indicative of conditions that arose after the year end (non
adjusting events).
Adjusting events must be adjusted for and the financial

statement numbers will change. Non-adjusting event simply
require disclosure with no changes to the numbers in the
accounts.
Proposed dividends
For a proposed dividend to be recognised as a liability at the

balance sheet date neither the directors nor the shareholders
can have the ability to cancel it. Where dividends are proposed
after the balance sheet date they are not recognised as a
liability.
Cleaning up the income statement
Operating profit and EBIT are not necessarily interchangeable

metrics. Operating profit is an accounting metric, whereas EBIT
is a metric used in analysis and can be adjusted to normalise the
underlying profit.
The types of adjustments made to EBIT are for:
• Exceptional items such as:
• Profit or losses from non-current asset disposals
• Reorganisations/restructuring costs
• Integration costs
• Significant impairments of tangible and intangible non-

current assets
• Operating profits of joint ventures and associates
• Goodwill impairments
• Discontinued operations and/or acquisitions
• Stripping out the non-service cost pension expenses
Depreciation differences are still likely to persist and prove

difficult to identify whilst non-goodwill intangibles (and the
consequent amortisation) are likely to be more conspicuous.
The need for EBITDA still remains.
Additionally, other sector specific metrics may be appropriate

such as EBITDAR (adjusting for rentals) and EBITDARD (adjusting
for research and development) may be necessary to obtain
sector comparability.
The illustration here shows some typical adjustments that may be required when cleaning up
the income statement. 2007 £m
Continuing operations
Revenue (sales excluding VAT) 42,641
Cost of sales -39,401
Pensions adjustment - Finance Act 2006 258
Impairment of the Gerrards Cross site -35
Gross profit 3,463
Administrative expenses -907
Profit arising on property-related items 92
Operating profit 2,648
Share of post-tax profits of joint ventures and associates
106
(including £nil on property-related items (2006/7 - £47m gain)
Profit on sale of investments in associates 25
Finance income 90
Finance costs -216
Profit before tax 2,653
Taxation -772
Profit for the year from continuing operations 1,881
Discontinued operation
Profit for the year from discontinued operation 18
Profit for the year 1,899
Attributable to:
Equity holders of the parent 1,892
Minority interests 7
1,899
Earnings per share from continuing and discontinued operations
Basic 23.84p
Diluted 23.54p
Earnings per share from continuing operations
Basic 23.61p
Diluted 23.31p
Tesco 2007
£m £m £m
Operating profit 2,648
JVs and associates 106
Sale of associates 25
EBIT 2,648 2,779
Pension adjustments (258) (258)
Impairment Gerrards Cross 35 35
Property related items (92) (92)
Recurring EBIT 2,333 2,437
In this way, legitimate cases for EBIT ranging from £2,333 to £2,779 can be made. When making
adjustments to metrics it is vitally important to ensure consistency of definitions when using metrics
in ratio calculations.
For instance, if EBIT has been adjusted to include the operating profit from JVs and associates to be
used in a return on capital employed calculation (or EV multiple), the capital employed (or EV)
definition must include the capital employed (or market value) in relation to the JVs and associates.
Cash flow statements
The cash flow statement is a summary of the cash flows of the

business over a period of time.
Bankers generally prefer cash flow information over income

statement information as it is not subject to the same
differences in accounting policy choices. There is an argument
that the finance director can cosmetically flex profit numbers by
influencing the outcome of, for example, an impairment test;
whereas nothing can be done by the accountants to influence
the cash flows of the business. They are simply a consequence
of the performance of the business.
Cash flow definitions
Cash flows: inflows and outflows of cash and cash equivalents.
Cash: cash on hand and demand deposits.
Cash equivalents: short-term, highly liquid investments that

are readily convertible to known amounts of cash and which are
subject to an insignificant risk of change in value. This includes
overdrafts and cash equivalents with short-term maturities (less
than three months).
Cash flow classification
Cash flows are classified and presented in one of three ways:
Operating
Operating activities are the principal revenue-producing

activities of the entity and other activities that are not investing
or financing activities.
Operating cash flows would typically include the cash flows

associated with sales, purchases and other expenses.
There are two ways of presenting operating cash flows. The

finance director has a free choice between the direct or indirect
presentation.
Direct presentation
Operating cash flows are simply presented as a list of cash

flows; cash in from sales, cash out for purchases, etc. This is a
simple method for presenting operating cash flows, but in
practice it is rarely used. The indirect presentation is much

more common.
Indirect presentation
Profit P
Depreciation D
Amortisation A
Impairment expense I
Change in working capital ΔWC
Change in provisions ΔP
Interest Tax (I)
Tax (T)
Operating cash flow OCF
Operating cash flows are presented as a reconciliation from

profit to cash flow.
The items in this reconciliation are not cash flows but “reasons
why cash flow is different to profit”. Depreciation expense
reduces profit, but has no cash flow impact, hence it is added
back. Similarly if the starting point profit is above interest and
tax in the income statement, then interest and tax cash flows
will need to be deducted if they are to be treated as operating
cash flows.
There is no specific guidance on which profit number should

be used in the reconciliation. Different companies use
operating profit, profit before tax, profit after tax, or net
income. Clearly the exact starting point for the reconciliation
will determine the exact adjustments made to get down to an
operating cash flow number.
Investing
Investing activities are the acquisition and disposal of non-

current assets and other investments not included in cash
equivalents. Investing cash flows would typically include the
cash flows associated with buying or selling property, other non-

current assets, and also financial assets.
Financing
Financing activities are activities that result in changes in the size

and composition of the equity capital and borrowings of the
entity. Financing cash flows would typically include the cash
flows associated with borrowing and repaying bank loans,
issuing and buying back shares. The payment of a dividend is
also usually treated as a financing cash flow.
Interest and tax
IFRS US GAAP
There are two common ways of Interest paid and received

presenting interest in the cash are treated as operating
flow statement. Many companies cash flows.
present both interest received
and interest paid as operating
cash flows. Others treat interest
received as an investing cash
flow and interest paid as a
financing cash flow. The finance
director can choose which way to
do this but it is usually possible
to see which method has been
chosen, simply by looking at the
cash flow statement.
Tax cash flows are usually presented as operating unless they

are specifically associated with investing or financing activities.
Free cash flow
Bankers use different cash flow measures for different

purposes. Free cash flow is a common measure used typically
as an input to a discounted cash flow (DCF) model for valuation
purposes.
Care is needed, however, as free cash flow has no definition as

such and can be calculated and used in different ways.
At firm level
Forecast free cash flow can be discounted (at the weighted

average cost of capital or WACC) to give an enterprise value. Net
debt is then deducted to give an equity value. As free cash flow
here is at the firm level, it must be before interest. So here, free
cash flow means:
Operating cash flow (pre-interest & tax)
Less: tax on operations
Less: capital expenditure (capex)
The capital expenditure number here is the capex required to

maintain non-current assets to the level required to support the
operating cash flow forecasts. This is often taken to be the
annual depreciation expense.
At equity level
Forecast future free cash flow could be discounted at the cost of

equity to give an equity value. Here free cash flow would have
to be after interest.
Operating cash flow (pre-interest & tax)
Less: interest paid
Less: tax paid
Less: capital expenditure (capex)
Accounting and analysis

for mergers and
acquisitions

Introduction
out our online courses As merger and acquisition activity becomes more extensive and
the complexity of the deals increases, it is essential that the
accounting rules provide a robust framework for the financial
reporting of the transactions. A working knowledge of the M&A
accounting rules is an important requirement for investment
bankers who need to:
• Assess the impact of potential transactions on the financial

statements of the acquirer
• Determine whether a potential transaction is EPS accretive or

dilutive
• Construct combination and merger models
• Analyze highly acquisitive companies to understand the extent

of potential creative accounting impacts on the financial
statements
Consolidation: the concept of the group
Most companies and other commercial organisations comprise

a group of separate legal entities, related to each other through
a structure of ownership and influence. A consolidated set of
financial statements reports the performance and position of
the entire group, rather than any particular legal entity within
the group. When accountants “consolidate” the numbers, they
are bringing together the results of all the related entities to
create the group accounts.
Extent of influence
The accounting rules provide different ways of consolidating the

numbers from particular entities depending on the level of
influence exerted by the top parent company on that particular

entity. Consider the group presented here:
Ho
The numbers relating to each of the entities within the group

need to be consolidated, but how? The accounting rules provide
three principal methods for doing this, and which method is
appropriate for each entity depends on the extent of the ability
of the top parent to influence the main operating and financial
activities of the entity. The table here presents a summary of
these three different approaches.
Extent of Insignificant Significant Control

influence
Guideline <20% 20%<x<50% >50%

voting rights
Entity Investment Associate Subsidiary

referred to or financial
as: asset
Method of See separate Equity Acquisition

accounting chapter accounting accounting
IFRS US GAAP
It is important to note that US GAAP has a more rigid set of rules
the guideline voting rights in to determine the most appropriate
the table above are only the method for accounting for entities
starting point when within a group.
determining the extent of There is less emphasis on influence
influence. Other factors that and control, and more on simply the
would need to be considered voting % held. 49% would represent
when determining the level of an associate and 51% would
influence would include: represent a subsidiary, without any
• % equity ownership (often further consideration of the other
the same as % voting rights, indicators of influence. Two
but not necessarily) particular types of entity are singled
• % beneficial interest (often out for specific rules.
the same as % voting rights,
but not necessarily) Qualifying Special Purpose
• Shareholder agreements Entities (QSPEs)
• Power to appoint members
to the board A QSPE is a trust or other legal
• Potential voting rights such vehicle:
as: • which is demonstrably distinct
• Share warrants from the transferor
• Share call options • whose permitted activities are
• Convertible debt significantly limited, were entirely
Hence a situation may arise specified when established and may
where the parent holds only be significantly changed only with
45% of the voting rights but, the approval of a majority of the
because of one of the other beneficial interests held by entities
factors above, is considered other than any transferor, its
to control the company. affiliates or agents
IFRS has additional guidance • which may hold only certain
on the application of the (passive) financial assets, servicing
consolidation criteria rules to rights related to financial assets held
special purpose entities (SPE), and cash
but it is still the idea of • which can only dispose of financial
influence and control that is assets in automatic response to
at the heart of the certain specified events
accounting.
Such vehicles are typically set up to
operate on autopilot to affect a
securitisation arrangement and do
not need to be consolidated.
Variable Interest Entities (VIEs)
VIEs have one or both of the

following characteristics:
• The equity investment at risk is not

sufficient to permit the entity to
finance its activities without
additional subordinated financial
support from other parties, which is
provided through other interests
that will absorb some or all of the
expected losses of the entity
• The equity investors lack one or
more of the following essential
characteristics of a controlling
financial interest:
• The direct or indirect ability
to make decisions about the
entity’s activities through
voting rights or similar rights
• The obligation to absorb
the expected losses of the
entity if they occur which
makes it possible for the
entity to finance its activities
• The right to receive the
expected residual returns of
the entity if they occur which
is the compensation for the
risk of absorbing the
expected losses
The primary beneficiary of a VIE is
the party that absorbs a majority of
the VIE’s expected losses, receives a
majority of its expected residual
returns, or both, as a result of
holding variable interests. The
primary beneficiary of a VIE must
consolidate the entity.
This chapter continues with an explanation of the mechanics

and interpretation of both acquisition accounting for
subsidiaries and equity accounting for associates. Accounting
for investments (financial assets where no influence is exercised)
is covered elsewhere.
Acquisition accounting
The acquisition accounting process
The process required to account for an M&A transaction can be

broken down into a number of steps:
• Identify a business combination
• Identify the acquirer
• Measure the cost of the transaction
• Allocate the cost of a business combination to the identifiable

net assets acquired and goodwill
• Account for goodwill
Identify a business combination
Definition
A business combination is:
“the bringing together of separate entities or businesses

into one reporting entity.”
In most business combinations one entity, the acquirer, obtains

control of one or more other businesses, the acquiree.
A business combination may be structured in a variety of ways

for legal, taxation or other reasons:
• As an equity purchase
• As a purchase of the net assets of another entity
• As the purchase of some of the net assets of another entity

that together form one or more businesses
• By the issue of equity instruments, the transfer of cash, cash

equivalents or other assets, or a combination thereof
• Between the shareholders of the combining entities or

between one entity and the shareholders of another entity; or
• By establishment of a new entity to control the combining

entities or net assets transferred or the restructuring of one or
more of the combining entities
The definition of a business combination should be broad

enough to encompass all transactions or other events in which
separate entities or businesses are brought together into one
economic entity, regardless of the form of the transaction.
The acquisition method views a business combination from the

perspective of the combining entity that is identified as the
acquirer.
The acquirer purchases net assets and recognises the assets

acquired and liabilities and contingent liabilities assumed,
including those not previously recognised by the acquiree.
Identify the acquirer
An acquirer must be identified for all business combinations.

The acquirer is the combining entity that obtains control of the
other combining entities or businesses.
As the acquisition method views a business combination from

the acquirer’s perspective, it assumes that one of the parties to
the transaction can be identified as the acquirer.
Control is the: “power to govern the financial and operating

policies of an entity or business so as to obtain benefits from its
activities.”
A combining entity is presumed to have obtained control of

another combining entity when it acquires more than one half
of that other entity’s voting rights, unless it can be
demonstrated that such ownership does not constitute control.
Although sometimes it may be difficult to identify an acquirer

there are usually indications that one exists. For example:
• If the fair value of one of the combining entities is significantly

greater than that of the other combining entity, the entity with
the greater fair value is likely to be the acquirer
• If the business combination is effected through an exchange

of voting ordinary equity instruments for cash or other assets,
the entity giving up cash or other assets is likely to be the
acquirer; or
• If the business combination results in the management of one

of the combining entities being able to dominate the selection
of the management team of the resulting combined entity, the
entity whose management is able so to dominate is likely to be
the acquirer
In a business combination effected through an exchange of

equity interests, the entity that issues the equity interests is
normally the acquirer.
However, all pertinent facts and circumstances should be

considered to determine which of the combining entities has
the power to govern the financial and operating policies of the
other entity (or entities) so as to obtain benefits from its (or
their) activities.
In some business combinations, commonly referred to as

reverse acquisitions, the acquirer is the entity whose equity
interests have been acquired and the issuing entity is the

acquiree. This might be the case where, for example, a private
entity arranges to have itself ‘acquired’ by a smaller public
entity as a means of obtaining a stock exchange listing.
Although legally the issuing public entity is regarded as the

parent and the private entity is regarded as the subsidiary, the
legal subsidiary is the acquirer if it has the power to govern the
financial and operating policies of the legal parent so as to
obtain benefits from its activities.
Commonly the acquirer is the larger entity; however, the facts

and circumstances surrounding a combination sometimes
indicate that a smaller entity acquires a larger entity.
Measure the cost of the transaction
The acquirer should measure the cost of a business

combination as the aggregate of:
• The fair values, at the date of exchange, of assets given,

liabilities incurred or assumed, and equity instruments
issued by the acquirer, in exchange for control of the
acquiree; plus
• Any costs directly attributable to the business combination.

(Under the new accounting rules – see later – such costs are
treated as expenses)
The acquisition date is the date on which the acquirer

effectively obtains control of the acquiree.
Assets given and liabilities incurred or assumed by the acquirer

in exchange for control of the acquiree are required to be
measured at their fair values at the date of acquisition.
Therefore, when settlement of all or any part of the cost of a

business combination is deferred, the fair value of that
deferred component should be determined by discounting the
amounts payable to their present value at the date of
acquisition, taking into account any premium or discount likely
to be incurred in settlement.
Fair value guidance
The published price at the date of exchange of a quoted equity

instrument provides the best evidence of the instrument’s fair
value and should be used, except in rare circumstances.
Other evidence and valuation methods should be considered

only in the rare circumstances when the acquirer can
demonstrate that the published price at the date of exchange is
an unreliable indicator of fair value and that the other evidence
and valuation methods provide a more reliable measure of the
equity instrument’s fair value.
The published price at the date of exchange is an unreliable

indicator only when it has been affected by the thinness of the
market.
If the published price at the date of exchange is an unreliable

indicator or if a published price does not exist for equity
instruments issued by the acquirer, the fair value of those
instruments could, for example, be estimated by reference to
their proportional interest in the fair value of the acquirer or by
reference to the proportional interest in the fair value of the
acquiree obtained, whichever is the more clearly evident.
Directly attributable costs of the business combination
The cost of a business combination includes any costs directly

attributable to the combination, such as professional fees paid
to:
• Accountants
• Legal advisers
• Valuers and other consultants to effect the combination.
Under the new M&A accounting rules, these costs will be

treated as expenses in the period in which the services are
received. These rules are explained at the end of this chapter.
General administrative costs are recognised as an expense

when incurred.
General administrative costs, including the costs of maintaining

an acquisitions department, and other costs that cannot be
directly attributed to the particular combination being
accounted for are not included in the cost of the combination:
they are recognised as an expense when incurred.
The costs associated with arranging and issuing financial

liabilities are not included in the cost of a business
combination.
These costs should be included in the initial measurement of

the liability. Similarly, the costs of issuing equity instruments
are an integral part of the equity issue transaction, even when
the equity instruments are issued to effect a business
combination, rather than costs directly attributable to the
combination.
Deferred and contingent acquisition costs
As was mentioned earlier, when settlement of all or any part of

the cost of a business combination is deferred, the fair value of
that deferred component should be determined by discounting
the amounts payable to their present value at the date of
exchange, taking into account any premium or discount likely
to be incurred on settlement.
There are circumstances when the costs of the acquisition will

not only be deferred but may also be contingent on future
events. Often this type of acquisition cost is linked to the future
profitability of the acquired business.
If this is the case, the contingency will be included in the cost of

the acquisition if the payment is probable and can be reliably
measured.
Deferred consideration is discounted back to present value to

determine its fair value.
Contingent cost of acquisition
Jenas plc acquires the entire ordinary share capital of Shearer

Ltd. Shearer Ltd has historically been a profitable entity, with
average net income per year of between £2,950,000 and
£3,250,000 over the last 8 years.
Jenas plc has agreed as part of the acquisition cost to pay an

additional £1,000,000 to the previous owners of Shearer Ltd,
if over the next 3 years the average profitability of Shearer Ltd
exceeds £3,000,000 at the net income level.
Given the historical profitability of Shearer Ltd it is probable

that the payment will be made in 3 years time. Therefore the
deferred contingent consideration will be included in the cost
of the acquisition at the acquisition date.
If at any stage there is evidence to suggest that the deferred

contingent payment is unlikely to be paid (not probable), the
cost of the acquisition should be adjusted with a subsequent
amendment made to the goodwill figure.
There are important forthcoming changes to these rules which

are explained at the end of this chapter.
From the shareholders of the acquiree’s perspective, being

acquired with equity issued by the acquirer carries its own
risks. For instance, the acquiree faces the risk that the equity
instruments issued as consideration for the purchase might fall
in value post acquisition. Some acquisitions may be structured
whereby the acquirer agrees to issue additional equity
instruments to the acquiree if the fair value of the equity
instruments given initially as consideration for the purchase
falls below a pre-determined level.
Allocate the cost of a business combination
The acquirer should, at the acquisition date, allocate the cost of

a business combination by recognising the acquiree’s
identifiable assets, liabilities and contingent liabilities that
satisfy the recognition criteria outlined below at their fair
values at that date.
Any difference between the cost of the business combination

and the acquirer’s interest in the net fair value of the
identifiable assets, liabilities and contingent liabilities so
recognised should be accounted for as goodwill.
Sando plc acquires Port of Spain Ltd for £250,000. At the date
of acquisition the assets and liabilities of Port of Spain are as
follows:
Land and buildings 125,000 137,000
PPE 75,000 84,000
Inventories 4,520 4,265
Accounts receivable 12,450 11,205
Cash 7,580 7,580
Accounts payable (12,450) (12,450)
Other payables (12,100) (12,100)
Fair value of net assets acquired 219,500
Total cost of acquisition 250,000
Goodwill 30,500
Sando plc as the acquirer should, at the acquisition date,

allocate the cost of a business combination by recognising the
acquiree’s identifiable assets, liabilities and contingent
liabilities that satisfy the recognition criteria at their fair values

at that date.
For the purpose of allocating the cost of a business

combination, the acquirer should use the following notes to
determine fair value:
Allocation of acquisition cost Fair value determination
Financial instruments traded in active market Current market values
Financial instruments not traded in an active Use estimated values that take into consideration
market features such as price-earnings ratios, dividend
yields and expected growth rates of comparable
instruments of entities with similar characteristics
Receivables, beneficial contracts and other Present values of the amounts to be received,
identifiable assets determined at appropriate current interest rates,
less allowances for uncollectibility and collection
costs, if necessary
Inventories of finished goods and merchandise Selling prices less the sum of the costs of
disposal and a reasonable profit allowance for
the selling effort of the acquirer based on the
profit for similar finished goods and
merchandise
Inventories of work in progress Selling prices of finished goods less the sum of
• Costs to complete
• Costs of disposal
• A reasonable profit allowance for the

completing and selling effort based on profit for
similar finished goods.
Inventories of raw materials Current replacement costs
Land and buildings Market values
Plant and equipment Market values
If there is no market-based evidence of fair value

because of the specialised nature of the item of
plant and equipment and the item is rarely sold,
except as part of a continuing business, an
acquirer may need to estimate fair value using an
income, cash flow or a depreciated replacement
cost approach
Intangible assets Determine fair value:
• By reference to an active market
• If no active market exists, on a basis that

reflects the amounts the acquirer would have
paid for the assets in arm’s length transactions
between knowledgeable willing parties, based on
the best information available
Net employee benefit assets or liabilities for The present value of the defined benefit obligation
defined benefit plans less the fair value of any plan assets
Accounts and notes payable, long-term debt, The present values of amounts to be disbursed in
liabilities, accruals and other claims payable settling the liabilities determined at appropriate
current interest rates.
However, discounting is not required for short-

term liabilities when the difference between the
nominal and discounted amounts is not material
Onerous contracts and other identifiable liabilities The present values of amounts to be disbursed in
settling the obligations determined at appropriate
current interest rates
Contingent liabilities The amounts that a third party would charge to

assume those contingent liabilities. Such an
amount should reflect all expectations about
possible cash flows and not the single most likely
or the expected maximum or minimum cash flow.
Recognition criteria for acquired assets and liabilities
The acquirer should recognise separately the acquiree’s

identifiable assets, liabilities and contingent liabilities at the
acquisition date only if they satisfy the following criteria at that
date:
The acquirer will only recognise the acquiree’s net assets at

the acquisition date if the recognition criteria are met
• In the case of an asset other than an intangible asset, it is

probable that any associated future economic benefits will
flow to the acquirer and its fair value can be measured reliably
• In the case of a liability other than a contingent liability it is

probable that an outflow of resources embodying
economic benefits will be required to settle the obligation
and its fair value can be measured reliably
• In the case of an intangible asset or a contingent liability, its

fair value can be measured reliably.
The acquirer’s income statement should incorporate the

acquiree’s profits and losses after the acquisition date by
including the acquiree’s income and expenses based on the
cost of the business combination to the acquirer.
For example, depreciation expense included after the

acquisition date in the acquirer’s income statement that relates
to the acquiree’s depreciable assets should be based on the fair
values of those depreciable assets at the acquisition date, i.e.
their cost to the acquirer.
Acquiree’s identifiable assets and liabilities
Subject to the recognition criteria outlined above, the acquirer

recognises separately, as part of allocating the cost of the
combination, only the identifiable assets, liabilities and
contingent liabilities of the acquiree that existed at the
acquisition date.
As a result the acquirer:
• Should recognise liabilities for terminating or reducing the

activities of the acquiree as part of allocating the cost of the
combination only when the acquiree has, at the acquisition
date, an existing liability for restructuring recognised in
its accounts
• When allocating the cost of the combination, should not

recognise liabilities for future losses or other costs
expected to be incurred as a result of the business
combination
In the past SPK plc agreed contractually that it would make a

payment to its employees and suppliers in the event that it
was acquired in a business combination. This is a present
obligation of the entity that is regarded as a contingent
liability until it becomes probable that a business combination
will take place.
The contractual obligation is recognised as a liability by the

entity when a business combination becomes probable and
the liability can be measured reliably.
Therefore, when the business combination is effected, the

liability of the acquiree is recognised by the acquirer as part
of allocating the cost of the combination. The liability is
recognised as it is part of the acquiree’s plan prior to the
business combination. (See the following contrasting by the
acquire.
Wavy plc has acquired Beardy Ltd. As part of the business

combination, Wavy plans to restructure the activities of
Beardy Ltd. This will involve the termination of a number of
employee contracts, a renegotiation of the supply chain and a
systems integration exercise.
Wavy plc is unable to recognise the restructuring costs as an

acquired liability as the effects of the plans were not a liability
of the acquiree prior to the business combination. The
restructuring is a post acquisition intention of the acquirer.
Acquiree’s intangible assets
An intangible asset should be recognised at cost on

acquisition. The cost should be determined as part of the fair
value exercise.
An acquirer should recognise separately an intangible asset of

the acquiree at the acquisition date only if it meets the
definition of an intangible asset:
• It is separately identifiable
• It is a resource that is controlled by the entity
• It is a probable source of future economic benefits
• Its fair value can be measured reliably
An asset meets the identifiability criterion in the definition of an

intangible asset if it:
• Is separable, i.e. capable of being separated or divided from

the entity and sold, transferred, licensed, rented or exchanged,
either individually or together with a related contract, asset or
liability; or
• Arises from contractual or other legal rights, regardless of

whether those rights are transferable or separable from the
entity or from other rights and obligations.
For identifiability, separability as well as contractual and legal

rights are taken into account
This development to isolate more of an entity’s intangible asset

value is an attempt to reflect that in a modern economy more
of an entity’s equity value is reflected in its intangible asset
worth.
Under previous accounting rules, the identifiability of separate

net assets relied purely on the ability of the entity to identify an
asset or liability separately and on that item being capable of
separate disposal without curtailing the operations of the
business. Where previously much of an entity’s value could not
be separated, this value became subsumed within the goodwill
figure.
Current accounting rules examine the amount an acquirer is

willing to pay for an acquisition (the cost of acquisition) and
allocate it through a more thorough set of intangible asset
recognition criteria.
When examining the elements of the acquisition, not all items

that are deemed to add value to the entity in question should
be recognised separately. This will usually be because the
entity does not control the resource in question. The
assembled workforce would be an example of this, as the skills
or resource embodied in a particular group of people does not
meet the intangible asset definition as the entity often has
insufficient control over the actions of the group.
Intangible assets recognition issues – illustrative examples
The issue
CGT Ltd acquires PBB Ltd in a business combination on 31st

March 2009.
PBB Ltd has a 3 year service agreement to supply training

services to CTF Ltd. Both CGT and PBB believe that the service
agreement will be renewed at the end of the current contract
which comes to an end on 30th June 2010. The contract has
already been renewed once in the past. The agreement is not
separable in the sense that it is not capable of being separated
or divided from the entity and sold, transferred, licensed,
rented or exchanged, either individually or together with a
related contract, asset or liability.
The conclusion
The agreement to supply training services (a contractual right

that is legally enforceable), irrespective of whether it is
cancellable or not, meets the contractual-legal criterion for
identification as an intangible asset. Therefore the asset will
be recognised separately from goodwill, given that the fair
value of the asset can be measured reliably.
If an entity establishes relationships with its customers

through contracts, those customer relationships arise from
contractual rights.
Therefore, customer contracts and the related customer

relationships acquired in a business combination meet the
contractual-legal criterion for identification as intangible
assets. This will be the case even if confidentiality or other
contractual terms prohibit the sale or transfer of a contract
separately from the acquired entity or business.
Therefore in the case of CGT acquiring PBB, the customer

relationship that PBB has with its customer will be recognised
as a separate intangible asset subject to the fair value being
measured reliably.
The issue
An investment bank decides to acquire a highly successful

training company for the purpose of providing the bank’s
entire in-house and client training services. It seems like a
fantastic idea. The investment bank takes into account a
number of items that are not tangible assets of the
company, when determining the purchase price of the
training company:
• The skills and experience of the trainers working for the

company
• The brand name of the company
• The company’s client list
• The patent the company holds on an investment banking

game it developed
The conclusion
The skills of the trainers and their respective experience

cannot be recognised as a separate intangible asset as the
investment bank does not have sufficient control over the
trainers, their skills and experience to be considered an asset
of the investment bank.
The brand name attached to training services provided by the

company can be recognised subject to the fair value being
reliably measured.
The patent on the investment banking game would be

recognised as a separate intangible asset as it arises from
legally enforceable rights.
In process research and development
IFRS US GAAP
On initial recognition as part Neither past expenditure

of the transaction to acquire a on research nor on
business, the cost of an development is treated as
intangible asset should be a separable asset acquired
measured at the fair value at as part of the acquisition.
the date of acquisition. There Where applicable a value is
can be situations where this assigned to both and that
results in items, that are amount is expensed
ineligible for recognition in through the group income
the books of the acquiree, statement on the date of
being recognised separately the acquisition.
on acquisition in the books of
the acquiring company.
In-process research and

development (IPRD) is a
common example of this
particular situation.
Expenditure during the

research phase (the search
for new knowledge – pure
research – and the
noncommercial
development of existing
knowledge – applied
research) of an IPRD
project must be expensed.
However, subsequent
expenditure during the
development phase of a
project (the commercial
development of existing
research knowledge) can be
capitalised post acquisition if
the entity can demonstrate
the features highlighted in

the previous chapter.
These criteria have the

objective of determining
whether a reliable economic
benefit can be attached to the
IPRD project in question.
Pharma plc is a UK based

pharmaceutical company. It
has just completed the
acquisition of a
pharmaceutical research
company. The research
company has two major
research projects. Project
Ache is a development project
taking a proven cure and
developing it into a
commercial product. Project
Interest is a research project
to examine and refine a
potential medical cure for
stupidity.
On acquisition the projects are

measured at their fair values
and are recognised as assets
acquired as part of the
business combination.
After the acquisition, any

expenditure on Project Ache
(the development project) can
be capitalised if the project
satisfies the recognition
requirements outlined above.
The subsequent expenditure
incurred on Project Interest,
because it is a research project
and its future economic
benefits are uncertain, will be
written off immediately, until
such time as the project can be

classified as a development
project that satisfies the
criteria outlined above.
Examples of separately recognised intangible assets
Marketing related intangibles
• Trademarks
• Brands
• Trade names
• Internet domain names
• Newspaper mastheads
• Non-compete agreements
Customer related
• Customer lists
• Order or production backlogs
• Customer contracts and related relationships
Contract based
• Licensing
• Royalty and standstill agreements
• Lease agreements
• Construction permits
• Franchise agreements
• Operating and broadcasting rights
• Employment contracts
Technology based
• Patented technology
• Computer software
• Unpatented technology
• Databases
• Trade secrets
Accounting for goodwill
On the date of acquisition, the goodwill arising from the

business combination should be recognised in the balance
sheet of the acquirer as an intangible asset. The asset will be
measured as the excess of the acquisition cost over the
acquirer’s interest in the fair value of the assets acquired and
the liabilities assumed.
A detailed summary of the goodwill calculation is illustrated

below:
Goodwill
Fair value of consideration
Cash 300,000 Fair value
Ordinary shares of acquirer 675,000 Fair value
Debt 1,560,000 Fair value
Acquisition costs 23,350 Included in the acquisition cost if directly attributable to

the cost of the acquisition
2,560,350
Fair value of net assets acquired
Book value of target 1,180,000 Per balance sheet of target
Fair value adjustments 12,000 Adjustment to bring book values in line with fair values
Intangible assets 175,000 Recognition of intangible asset not recognized on target’s

balance sheet
1,380,500
75% of target acquired 1,035,375 % of target acquired in business combination
Goodwill arising on the acquisition of

target
1,524,975 Goodwill arising (subsuming net assets not
identifiable/separable as part of the business
combination)
Alternatively, this could be presented as:
Goodwill
Fair value of consideration
Cash 300,000 Fair value
Ordinary shares of acquirer 675,000 Fair value
Debt 1,560,000 Fair value
Acquisition costs 23,350 Currently included in the acquisition cost if directly

attributable to the cost of the acquisition
2,560,350
Minority interests: 25% x 1,380,500 345,125
2,905,475
Fair value of net assets acquired
Book value of target 1,180,000 Per balance sheet of target
Intangible assets 175,000 Recognition of intangible asset not recognized on target’s

balance sheet
1,380,500
Goodwill arising on the acquisition of

target
1,524,975 Goodwill arising (subsuming net assets not identifiable
as part of the business combination)
This presentation is useful in understanding the new M&A

accounting rules presented at the end of this chapter.
The goodwill arising will sit as an intangible non-current asset

on the balance sheet of the acquiring group. It is not amortised
over its useful economic life, but tested for impairment on an
annual basis.
Discounts on acquisitions (previously referred to as negative

goodwill)
Negative goodwill arises when the acquisition cost of a

business combination is less than the fair value of the net
assets acquired. Consider the illustration below – the
acquisition cost is significantly smaller than the fair value of the
net assets acquired in the business combination.
Book value Fair

value
Land and buildings 125,000 137,000
PPE 75,000 84,000
Inventories 4,520 4,265
Accounts receivable 12,450 11,205
Cash 7,580 7,580
Accounts payable (12,450) (12,450)
Other creditors (12,100) (12,100)
Fair value of net assets 219,500

acquired
180,000
Total cost of acquisition
(39,500)
Goodwill
The first step required is to reassess the goodwill

calculation, as discounts on acquisitions are rare and
often negative outcomes are mistakes in the calculations
rather than being a reflection of the actual goodwill
position.
If after reassessing the goodwill calculation, the outcome

is negative, the remaining negative excess is recognised
immediately in profit or loss for the period. Given the
information in the above example, if the initial calculation
of the goodwill was deemed appropriate, the negative
goodwill would be written off and a gain would be

recognised in the income statement.
Negative excess is recognised immediately in profit or loss

for the period.
Minority interest
A minority interest is that portion of the profit or loss and net

assets of a subsidiary attributable to equity interests that are
not owned, directly or indirectly through subsidiaries, by the
parent.
There are important forthcoming changes to these rules which

are explained at the end of this chapter.
The group structure below illustrates a very straightforward

minority interest. The parent company owns 75% of the equity
voting share capital of the subsidiary. The rest of the voting
share capital of the subsidiary is owned by parties external to
the group shareholders.
Parent
The minority interest in the income statement represents the

appropriation of profit that is owned by parties outside the
group shareholder structure. The minority interest accounting
arises because purchase accounting focuses on accounting for
control in the income statement between the sales and profit
after tax lines.
With group structures where the parent owns less than 100% of
the voting share capital of the subsidiary, purchase accounting
will consolidate 100% of the subsidiary results between sales
and profit after tax, irrespective of the degree of ownership,
thereby demonstrating control. However, this does overstate
the degree to which the group has ownership of the profits or
losses consolidated. The minority interest appropriation is
therefore required to strip out the element of profit or loss the
group does not own.
Group income statement (minority interest illustration)
Sales X P+S (100%)
Cost of sales (X) P+S (100%)
Operating expenses (X) P+S (100%)
Operating profit X
Interest (X) P+S (100%)
Profit before tax X
Tax (X) P+S (100%)
Profit after tax X
Minority interest (X) 25% X Net Income of S
Net income X P+75% X S
X/(X) Income and expenses under control of the parent
X/(X) Net income owned by the group after appropriating ownership to the MI
The same argument can be applied to the balance sheet as purchase accounting
demonstrates control by consolidating 100% of the net assets of the subsidiary into the
group accounts. With structures where the parent owns less than 100% of the voting
share capital of the subsidiary, a minority interest adjustment is required to appropriate
this ownership.
Group balance sheet (minority interest illustration)
Goodwill X
Tangible assets X P+S (100%)
Intangible asses X P+S (100%)
Inventories X P+S (100%) Net assets under the

control Cash X P+S
Receivables X P+S (100%)
(100%) of the group
Cash X P+S (100%) (100%)
Total assets X
Liabilities < 1 year X P+S (100%)
Liabilities > 1 year X P+S (100%)
Minority interest X 25% X net assets of S MI appropriation of group net asset

ownership
Share capital X P Residual claim on the

net assets of the group
Share premium X P
(75%)
Retained earnings X P+75%XS(post acqn)
Total liabilities &

shareholders equity
X
X/(X) Assets and liabilities under the control of the parent
X/(X) Net assets owned by the group after appropriating ownership to the MI
Comprehensive example
Mango plc is to acquire 100% of the shares of Steen plc. The

consideration will comprise either:
• 2,700m in cash
• £3,100m of shares in Mango plc (comprising 1,525m shares

with a fair value of 2031⁄2p each); or
• £2,250m of shares in Mango plc (comprising 1,107m shares

with a fair value of 2031⁄2p each) and £750m in cash
• Both companies have the same year-end. The balance sheet of

Steen reflects fair values. Goodwill is not to be amortised but is
to be reviewed annually for impairment
Assume interest at 6% and corporation tax at 30%.
Forecast results for year following the transaction (₤m)
Mango Steen
Sales 4,384 8,969
Operating costs, excl dep’n (4,017) (8,336)
EBITDA 367 633
Depreciation (109) (190)
EBIT 258 443
Interest 14 (65)
Tax (97) (117)
Net income 175 261
Number of shares 1720m
EPS 10.2p
Accounting for associates and joint ventures
Significant influence
An associate is an entity, including an unincorporated entity

such as a partnership, over which the investor has significant
influence and that is neither a subsidiary nor an interest in a
joint venture.
If an investor holds, directly or indirectly (e.g. through

subsidiaries), 20 per cent or more of the voting power of the
investee, it is presumed that the investor has significant
influence, unless it can be clearly demonstrated that this is not
the case.
The existence of significant influence by an investor is usually

evidenced in one or more of the following ways:
• Representation on the board of directors or equivalent

governing body of the investee
• Participation in policy-making processes, including

participation in decisions about dividends or other distributions
• Material transactions between the investor and the investee
• Interchange of managerial personnel
• Provision of essential technical information
Parent
Equity accounting
Under the equity method the investment in an associate is:
• Initially recognised at cost
• Increased or decreased to recognise the investor’s share

of the profit or loss of the investee after the date of
acquisition
The investor’s share of the profit or loss of the investee is

recognised in the investor’s profit or loss.
Distributions received from an investee reduce the carrying

amount of the investment.
When potential voting rights exist, the investor’s share of profit

or loss of the investee and of changes in the investee’s equity is
determined on the basis of present ownership interests and
does not reflect the possible exercise or conversion of potential
voting rights.
Goodwill can arise on the acquisition of an interest in an

associate investment in the same way as in the acquisition of a
subsidiary.
Considerations for investment banking
Equity accounting and the implications for adjusted net debt

calculations
The standard net debt calculation only includes the borrowings of the
parent and its subsidiaries. Normally, lenders to an associate have no
legal recourse to the group in respect of its debt and therefore there is
an argument that the debt in the associate should be left outside the
calculation.
However, for some companies their associates are so strategically

important to the overall well being of the group, that if their associates
did default on their debt (even if there was no recourse to the group)
the consequences could call into question the financial position of the
group. Therefore in some situations it may be necessary to adjust the
net debt calculation to bring in the debt exposure embedded in the
associates.
This is a situation Coca Cola Inc is exposed to. Below is an extract from
their 10K:
“As of December 31, our long-term debt was rated ‘‘A+’’ by Standard &
Poor’s and ‘‘Aa3’’ by Moody’s, and our commercial paper program was
rated ‘‘A-1’’ and ‘‘P-1’’ by Standard & Poor’s and Moody’s, respectively.
In assessing our credit strength, both Standard & Poor’s and

Moody’s consider our capital structure and financial policies as well
as aggregated balance sheet and other financial information for the
Company and certain bottlers including Coca-Cola Enterprises Inc.
(‘‘CCE’’) and Coca-Cola Hellenic Bottling Company S.A. (‘‘CCHBC’’).
While the Company has no legal obligation for the debt of these
bottlers, the rating agencies believe the strategic importance of
the bottlers to the Company’s business model provides the Company
with an incentive to keep these bottlers viable. “
Source: Coca Cola 10K
[“CCE” and “CCHBC” are both equity accounted investments of Coca

Cola Inc]
Accounting for joint ventures
A joint venture is defined as a contractual arrangement

whereby two or more parties undertake an economic activity
that is subject to joint control, where joint control is the
contractually agreed sharing of control over an economic
activity.
Joint ventures take many different forms and structures.
• Jointly controlled operations
• Jointly controlled assets
• Jointly controlled entities
A venturer should recognise its interest in a jointly controlled

entity using either:
• Proportionate consolidation; or
• Equity accounting
Joint ventures are normally accounted for in the same manner

as associates; equity accounting. There is an alternative which is
occasionally used; proportional consolidation. An illustration of
proportional consolidation is presented here.
The example below is an illustration of how a 50% joint venture would be proportionally consolidated
into the group accounts. The joint venture is brought into the group accounts on a proportionate line
by line basis between sales and net income
€’000s Sven plc Yard Ltd Joint Prop Consol Sven plc
venture Yard Ltd Group
50.00%
(A) (B) (B) X 50% = (C) (A) + (C)
Sales 15,000 8,000 4,000 19,000
Cost of sales (6,000) (3,200) (1,600) (7,600)
Operating expenses (1,200) (640) (320) (1,520)
Operating profit 7,800 4,160 2,080 9,880
Interest (1,560) (1,664) (832) (2,392)
Profit before tax (1,560) (1,664) (832) (2,392)
Tax (1,640) (646) (323) (1,963)
Net income (3,200) (2,310) (1,155) (4,355)
Interest cover 5.00x 2.50x 4.13x
Considerations for investment banking
Value will be harder to prove
Entities completing business combinations (accounted for as

purchases) will look very different following the transaction.
New assets and liabilities will be recognised on the combined
balance sheet. Some existing assets and liabilities may be
measured according to different conventions. It is possible
that balance sheet items recognised prior to the acquisition
may be derecognised in the post acquisition accounts.
These changes to the recognition and measurement

requirements will make it a harder exercise to justify the
accretion of post acquisition earnings.
Goodwill
The accounting rules force acquirers to work hard to identify all

of the assets they are acquiring, both tangible and intangible.
As goodwill is the residual of these identifiable net assets, the
goodwill number is often lower than would otherwise have
been.
The impact of goodwill impairment calculations on EBIT,

EBITA and EBITDA calculations
In the past, the systematic amortisation of goodwill arising on

the purchase of subsidiaries used to be charged in arriving at
EBIT.
The removal of this amortisation charge will therefore increase

EBIT numbers for companies with significant goodwill
balances.
The impairment of goodwill, although not a systematic charge

to EBIT, will be charged in arriving at the EBIT figure.
EBITA and EBITDA figures should still include adjustments for

goodwill impairment charges and the amortisation of other
intangible assets in arriving at the metric.
EBIT earnings volatility could increase as a result of the non-

amortisation of goodwill. Previously, the systematic
amortisation of goodwill provided a consistent charge to the
income statement with respect to the consumption of the

economic benefit. Now with the introduction of impairment
testing of goodwill, there is no regular charge to the income
statement for goodwill. This could result in irregular income
statement charges as and when impairments materialise.
More amortisation
Goodwill amortisation has been replaced with the impairment

model. This will have an earnings accretive impact. However,
impairments of goodwill can still arise giving a more
unpredictable dilutive impact to earnings. This is especially a
concern for companies that made acquisitions at the top of
the bull market. Companies with significant goodwill balances
arising from acquisitions made during the mid 2000s bull run
should assess the potential impact of the goodwill impairment
reviews. Any significant goodwill impairments should be
quantified and communicated to the market in order to
manage any potential share price impact.
More intangible assets will be measured and recognised as

part of the business combination. These intangible assets will
be subject to the normal intangible asset amortisation rules.
This may result in more amortisation in future years,
mitigating the earnings accretion arising from the non-
amortisation of goodwill.
Tax deductibility of goodwill
As a general rule, goodwill is not considered tax deductible

within most countries. The reason for this is that goodwill
arising on the acquisition of equity is a group accounting
adjustment and therefore only appears in the accounts at the
group level. Tax is in most countries calculated at the single
entity level, with the group tax charge merely reflecting the
addition of the individual tax charges of individual group
members. Thus goodwill adjustments / impacts rarely appear
in the taxable profit calculation of a single tax reporting entity.
The exception to this basic rule relates to goodwill arising on

the acquisition of an entity’s net assets rather than its equity.
Goodwill arising from this type of business acquisition will

appear in the accounts of an individual single entity. In some
countries, amortisation of this goodwill is deductible for tax
purposes.
Restructuring costs and the impact on post acquisition

performance
Unless the target entity was already committed to a

restructuring prior to the acquisition, restructuring provisions
are excluded from the goodwill calculation and must be
charged directly to net income post acquisition. Under the old
rules, there was more scope to include restructuring provisions
in the goodwill calculation (as part of the allocated cost of an
acquisition).
This will make it harder to demonstrate post acquisition

earnings accretion.
Net debt implications
The basic definition of net debt is detailed in the introductory

accounting chapters. A basic definition of net debt =
Borrowings - (Cash + Liquid Resources)
Given the nature of purchase accounting outlined in the

previous pages, it is important to appreciate that the net debt
calculation contained within an annual report includes
borrowings, cash and liquid resources for the parent and its
subsidiaries. It is important to realise that the standard net
debt calculation does not include the debt exposure included in
joint ventures and associates.
Past deals
With the introduction of the goodwill impairment model, there

may be significant write offs of goodwill required in respect of
past deals. Consideration will have to be given as to how this
information is communicated to the market. There is always
the worry of an AOL-Time Warner situation where there was a
$53bn impairment write down on the intangible assets.
Comprehensive example
New M&A accounting rules
In 2008 a revised set of rules for accounting for business

combinations was published. The new rules provide a better
reflection of the economics of business combinations and
should provide the users of financial statements with more
relevant information. When companies start using the new
rules for the first time there will be a significant impact on the
way transactions are reported and an early understanding of
the new rules is useful for any investment banker.
Application date
The new rules must be applied for accounting periods

beginning on or after 1st July 2009. For companies with
December year ends, the first accounting period when the new
rules will apply will be the year ending 31st December 2010.
However, companies can choose to apply the new rules early if
they want to, so it is important to be aware of the changes as
soon as possible.
The most important changes to the rules are explained here.
Non-controlling interest and goodwill
The terminology is changing, in particular the concept of

minority interest, which will be referred to in the future as
non-controlling interest. There is a change to the way in which
non-controlling interest can be measured, but in order to
understand this, it is better to first consider the changes that
are happening to goodwill.
There is no fundamental change to the way that goodwill is

calculated (see earlier in chapter), however a slightly different
approach will be required to calculate goodwill. Goodwill will
be seen as:
Price paid plus PP
Non-controlling interest NCI
(Fair value of 100% of separable net assets (FV)

acquired)
Goodwill GW
The calculation is effectively the same as the traditional

goodwill calculation, but grossed up on both sides by the non-
controlling interest, resulting in the same answer as in the past.
IFRS US GAAP
The real change comes in the way non-controlling The non-controlling interest must be measured at its
interest is measured. The new rules allow full acquisition date fair value and not simply the
noncontrolling interest to measured either as noncontrolling share of the fair value of the separable
noncontrolling share of identifiable net assets net assets.
(traditional approach), or at its full acquisition date
The fair value of non-controlling interest should be
fair value. The full acquisition date fair value of non-
measured on the basis of market prices for equity
controlling interest will generally be higher than the
shares not held by the acquirer or, if not available, by
share of net assets, as it will include any goodwill
using a valuation technique such as discounted cash
attributable to the non-controlling interest.
flows. This will not necessarily be the price paid for
If the choice is made to measure non-controlling the acquisition, extrapolated across the non-
interest at fair value, then the post-transaction group controlling interest, as this will often not represent the
balance sheet will be grossed up, as both the true fair value of those shares.
noncontrolling interest and the goodwill number will
be higher than otherwise would have been. The two
numbers will be increased by the same amount so, of
course, the balance sheet will still balance.
If the Finance Director chooses to present the

noncontrolling interest at fair value, then the question
of the best way to measure that fair value becomes
important. The new rules state that the fair value of
non-controlling interest should be measured on the
basis of market prices for equity shares not held by
the acquirer or, if not available, by using a valuation
technique such as discounted cash flows. This will
not necessarily be the price paid for the acquisition,
extrapolated across the non-controlling interest, as
this will often not represent the true fair value of
those shares.
Where there is the intention to buy up the

noncontrolling interest in the future, it makes sense
to value non-controlling interest at its fair value. This
will result in a balance sheet that better represents
the future intention to buy up the remainder of the
subsidiary and when this does eventually happen,
there will be less of a negative impact on group net
assets. However, the downside is the extra effort that
may be required to value the non-controlling interest,
particularly where there is no market for the shares.
Bankers who are trying to model a particular

transaction will need to be careful when applying the
new rules. The selection of one of the methods for
measuring the non-controlling interest should, in
theory, have no impact on the value of the target but

it will impact the post acquisition balance sheet.
Merger models may need to incorporate a switch that

enables both options to be modeled. Clearly the
choice shouldn’t impact the extent to which the deal is
earnings accretive or dilutive but the size and shape of
the group balance sheet may well be quite different
depending on how the non-controlling interest is
measured and this may impact the financing
arrangements or related covenants.
Contingent consideration
Many M&A transactions include an element of contingent

consideration; a future adjustment to the price, often
dependent on the performance of the acquired business. For
a number of years after the acquisition there may be
payments, either in cash or shares between buyer and seller
to affect any “earn out”. Existing accounting rules have
required annual adjustments for changes in expectations of
payments, with a corresponding adjustment to goodwill.
The new rules require that the adjustment be to the group

income statement rather than goodwill. So volatility may be
introduced to the group income statement in the years
following the transaction as a result of changes in the
estimates of the contingent consideration.
The most important implication of this rules change is that the

post acquisition group income statement may be more volatile
than before as the changes to the estimates of the contingent
consideration move profits rather than goodwill. It will not be
possible to eradicate this volatility altogether, but more care at
the time of the first determination of the value will help reduce
the extent of it. This additional complexity will also make the
jobs of the bankers more difficult, and again the merger
models will need to be adapted to be able to handle sensitivity
analysis around the value of the contingent consideration.
The bankers will need to focus more effort on forecasting the
post acquisition performance of the target as the impact of
their forecasts will be much more visible as a consequence of
the new rules.
Acquisition related costs
Existing accounting rules require that any costs directly

associated with the acquisition are treated as part of the cost
of the acquisition, in other words capitalised on the balance
sheet as an increase in goodwill. These directly attributable
costs would typically include the cost of investigating and
valuing the target, any due diligence required, auditing the
completion accounts, negotiating the price, and completing
the deal.
The new rules require that such costs be expensed through the
income statement in the same period the services are received,
which will typically be around the transaction date.
Obvious implications of this rule change are lower goodwill

numbers and lower group profits in the year of the acquisition.
Bankers responsible for modeling the transaction will need to
remember that these costs can no longer be capitalised as part
of the purchase price and amend their models accordingly.
Note that there is no change to the accounting treatment of

costs associated with raising finance for the transaction.
These costs will continue to be deducted from the fair value of
the instruments issued and amortised over the life of the
instrument as part of the effective interest rate.
Other changes
There are a number of other changes to the rules that are

beyond the scope of this chapter but are mentioned here for
completeness. The new rules cover the following areas:
1. Re-classification and re-designation of financial

arrangements for accounting purposes on a business
combination
2. Determination of what exactly is part of the exchange

transaction as opposed to transactions that should be
accounted for separately
3. Step acquisitions, where an existing stake is already held
4. Changes in ownership interest with no loss of control
PART 02
Valuation
Discounted cash flow

techniques
Discounting fundamentals
out our online courses Discounted Cash Flow (DCF) valuations are founded on the
premise that:
Company value =
value of the future cash flows generated by the company

discounted at the required rate of return demanded by the
investors
A number of questions need to be answered:
• What is the cash flow?
• What is free cash flow (FCF)? How does it relate to FCF to firm
and FCF to equity?
• How is the cash flow derived?
• What drives cash flow?
• How many years of cash flow forecasts must be produced to

complete a valuation?
Understanding the structure of DCF valuations
Realistically, it is difficult to forecast the entire cash flow profile

of any company because of issues such as uncertainty:
• We do not know how long the company will exist and hence
how many years to include in our cash flow forecast
• Forecasting is estimation. The further we predict into the

future, the more prone to error our estimates become.
To address these issues many DCF models, whether estimating

equity or firm value, will follow a two-stage approach to the
forecasting of cash flows. The stages of a company’s cash flow
profile are split on the basis of:
• A visible forecast cash flow period
• A continuing period.
The two-stage approach to DCF valuations
The two-stage approach to DCF valuations is a common

solution to the problem of how we forecast the cash flow
profile of a company. The approach is to forecast the cash
flows of a company over a finite period of time, usually
between 5 and 10 years. Analysts for some industrial groups
(utilities and mining) may extend this period as far as 25 years,
where cash flows tend to be contractual.
After this initial period of more detailed forecasting the

remaining value of the company is captured by a terminal
value, using either a perpetuity or multiple calculation (see
above diagram – the continuing period value).
The valuation of the cash flows after the initial detailed

forecasting period is often seen as a significant estimate or
guess in the valuation process. The value estimated through
the terminal value calculation can also be significant, relative
to the full company valuation, and is very sensitive to its
inputs.
However, the terminal value can be reviewed for

reasonableness with respect to peers (cross sectional
comparison) and the performance of the business itself (time
series comparison).
The argument for using the terminal value calculation to

capture the company’s value post the visible forecast period is
based on the premise that the company will hit a stage of
maturity. Beyond this point, cash inflows to the company may
grow with the rest of the economy and can be viewed as
indefinite, if there is the necessary level of reinvestment back
into the business. Capital expenditure, working capital and
research and development will all have to be sustained to
maintain the company’s existing position.
The obvious benefit of the terminal value calculation is that we

do not have to forecast cash flows forever. However, blind
reliance on the terminal value calculation is a danger and is
naïve.
The competitive advantage period (CAP)
The CAP is the time period during which it is believed that the
company is expected to generate returns on incremental
investments in excess of the cost of capital.
Economic theories of the firm state that the generation of

returns in excess of the cost of capital will attract competition.
This competition will enter the market, providing barriers to
entry are sufficiently low, and eventually force returns towards
the cost of capital.
The issue for valuation lies in estimating the CAP to determine

the visible forecast period. This is because the CAP will
establish the length over which cash flows need to be
estimated prior to the reliance on a terminal value calculation.
A number of strategic approaches have been developed to

assist in determining the length of the CAP. Examples of such
techniques are noted below:
• Porter’s 5 forces
• Value chain analysis
• Product life cycle.
Using a combination of these tools, an estimate of the CAP can

be determined. Generally, analysts will forecast between 5 and
10 years’ cash flows before relying on a terminal value
calculation to capture post CAP cash flows.
The determination of an appropriate CAP is obviously crucial

for the valuation process, as it defines the use of the terminal
value calculation and its impact.
Estimating free cash flow for valuation purposes
We need cash flows to discount, in order to arrive at a

valuation. We now have an idea of how we estimate a
company’s cash flow profile – we split the model into 2 stages –
a visible forecast period and a terminal value period. We
estimate cash flows during the visible forecast period and then
capture subsequent future cash flows through a terminal value
calculation.
Why discount cash flows?
It seems obvious that a DCF valuation should focus on cash

flows. However, there is clear reasoning why we focus on cash.
The alternative to using cash is to focus on some sort of

earnings measure (as a number of the comps valuation
techniques will do). The downside to an earnings measure is
that it uses an earnings figure. Earnings can be manipulated
in terms of revenue and cost recognition; it is affected by
nonrecurring items and changes in accounting policy. Much
of the work with comps valuation is spent trying to “clean” the
earnings information prior to it being used in the valuation
process.
At the end of the day….
“Cash is fact – profit is an opinion”
The Economist 2nd August 1997
A focus on earnings will also ignore a number of key

considerations for the valuation process – such as:
• Risk considerations are ignored in accounting earnings
• Reinvestment needs are ignored
• The time value of money is ignored
• Earnings are historic, valuation is forward looking.
Cash flow is the energy of a business. Earnings do not pay bills,

invest in capital expenditure or recruit new human resource –
cash is required to partake in any of these activities. Hence a
focus on cash flow is a focus on where a company generates
future value for shareholders.
This statement that cash flow generates value to support

shareholder returns finds support with empirical evidence.
There has been a significant amount of economic research that
has found that there is a weak statistical link between
accounting based earnings and shareholder returns. However,
the same types of studies presented using cash flow based
measures have produced much stronger relationships between
cash flow and shareholder returns.
Which cash flows do we use?
Cash flow is a generic term and can refer to a number of

different definitions.
The illustration below demonstrates the derivation of operating

cash flow for accounting purposes:
Derivation of cash flow
₤’000s
Sales X
Operating costs (X)
EBIT/Operating profit X
Depreciation X
Amortisation X
EBITDA X
Changes in working capital X/(X)
Operating cash flow X/(X)
This operating cash flow however does not go far enough

for valuation purposes.
The illustration below outlines the basic derivation of cash flow:
Derivation of accounting operating cash flow
Sales 125,000
Operating costs 75,000
Increase in debtors (receivables) 12,000
Decrease in stocks (inventories) 9,000
Increase in creditors (payables) 7,500
Depreciation (included in operating costs) 2,300
Amortisation (included in operating costs) 750
Derivation of accounting operating cash flow
Sales 125,000
Operating costs (75,000)
EBIT/Operating profit 50,000
Depreciation 2,300
Amortisation 750
EBITDA 53,050
Decrease in stocks (inventories) 9,000
Increase in debtors (receivables) (12,000)
Increase in creditors (payables) 7,500
Operating cash flow 57,550
A major difference between accounting operating cash flow

and the cash flow required for valuation purposes is that the
latter will take into account the investment required to
maintain existing cash flows and to support future cash flows.
FCF to firm vs. FCF to equity
DCF valuation techniques focus on free cash flow (FCF). A basic

definition of Free Cash Flow to the Firm (FCFF) is:
“the amount of cash that a company has left over after it has
paid all of its expenses, but before any payments or receipts of
interest or dividends, before any payments to or from
providers of capital and adjusting tax paid to what it would
have been if the company had no cash or debt” .
The nature of the FCF measure will depend on the type of DCF
valuation that is being performed. A FCF valuation which
values the whole company (firm value) will focus on a different
FCF to that which produces an equity valuation.
The FCF required to perform a valuation of equity is the

potential cash claim equity shareholders will have after all
expenses have been paid. This is known as the free cash flow
to equity (FCFE).
The “cash left over” for a FCF valuation of the entire company
(the firm value) will be the potential cash claims all providers of
finance will have after all expenses have been paid. This is
known as the free cash flow to firm (FCFF) and is defined above.
The main difference between FCFE and FCFF is the interest paid
(net of tax) to debt finance providers. FCFF is before interest.
FCFE is also after the cash flows arising from debt repayments;
one reason why it is difficult to use in practice.
The illustration below details the full breakdown of the

accounting operating cash flow down to the FCFF and FCFE
levels:
Derivation of cash flow
₤’000s
Sales X
Operating costs (X)
EBIT/Operating profit X
Depreciation X
Amortisation X
EBITDA X
Changes in working capital X/(X)
Operating cash flow X
Tax paid (calculated on EBIT) (X)
CAPEX (X)
Free cash flow (to firm) X/(X)
Interest paid (net of tax) (X)
Free cash flow (to equity) X/(X)
Note: the tax paid figure above should be a pre interest figure
(unlevered) – calculated on EBIT or EBITA.
A FCFF DCF valuation will involve forecasting these cash flows

over the visible cash flow period; cash flows post the visible
cash flow period will be captured through a terminal value
calculation.
The above breakdown of FCF gives an indication of how cash

flows will be driven during the forecast visible cash flow period.
The key value drivers of cash flow
Having examined the derivation of FCF at the equity and firm

level, we can examine how we forecast and drive these cash
flows. In order to forecast the cash flows of a company we
need to have a sound understanding of the company’s
business model, its strategies and the markets the company
operates in. Much of this knowledge can be analyzed using the
strategic analysis tools we used in estimating the length of the
visible cash flow period. However, there is no substitute for
sector knowledge and experience.
The key drivers of FCFF cash flows are:
• Sales growth rates
• EBITDA margins
• Cash tax rates
• Fixed capital investment or capital expenditure
• Working capital requirements.
We shall examine in turn the influence each factor has on FCFF:
Sales growth rates
The first driver of cash flow growth – without sales there is no

company, no business, and therefore no cash. Obviously this is
a crucial forecast driver.
The starting point of the sales analysis will be current sales

activity. Consideration can then be given to recent investment
activity at the capital expenditure and working capital levels to
see if there is any foundation for future growth. Any
expectations based on this level of analysis will have to be
adjusted for:
• Market information
• Strategic considerations
• Pricing policy decisions
• Economic considerations
• Current and prospective competition (and barriers to entry).
EBIT and EBITDA margins
Margins are useful for driving cash flow as they reflect the
earnings after taking into consideration the normal costs of
operations.
It is important to note that margins will depend on the nature

of the business and the sales it makes. Commercially, the
higher the capital expenditure and working capital
requirements, the higher the margins must be to maintain a
viable business.
When forecasting cash flows, margins allow valuation models

to make an efficient jump from pure sales forecasts to profit
figures.
Cash tax rate
If a company is generating positive EBIT, it is likely that tax will

have to be paid. The forecasting of tax to be paid is a more
specialist area than forecasting sales. Consideration must be
given to the tax legislation, the possibility of claiming relief for
previously incurred tax losses and the impact of deferred
taxation.
To circumvent unnecessary complications in the forecasting

process, cash tax rates will generally be used and driven
through EBIT or EBITA (treating the depreciation charge as an
approximation to the allowed tax depreciation deduction),
with effective cash tax rates adjusting for all other tax
adjustments.
Fixed and working capital requirements
As mentioned earlier the main difference between operating

cash flow and cash flows for valuation purposes, is the
investment necessary to maintain existing cash flows and
support future cash flows.
Working capital requirements support current operations as

well as supporting future growth. For instance, holding stocks
(inventories) will satisfy current demand, as well as supporting
future demand. For most business models, as sales grow,
working capital investment will grow too.
Fixed capital requirements can be split into two elements:
• Maintenance capital expenditure – the replacement of the

existing capital base, in order to satisfy existing demand and
requirements
• Investment capital expenditure – the investment in new

assets to meet forecast growth projections.
If a business model is forecasting growth, this growth must

have a source. The source of longer term growth will be
investment capital expenditure.
Higher capital expenditure should be reflected in higher sales

growth in the short to medium term. As the company expands,
working capital requirements should also expand in response.
Calculating the terminal value
Earlier we introduced the structure of the standard DCF

valuation – that is a two-stage valuation approach. Cash flows
are forecasted during the visible cash flow period, with post
visible cash flow period cash flows captured through a terminal
value calculation. Most DCF valuation models will use a visible
cash flow period between 5 and 10 years. This period would
have been estimated using the strategic analysis tools
mentioned earlier.
Some business models (for instance mining and utilities) will

have visible cash flow period in excess of 20 years. Under
these circumstances, the calculation of a terminal value at the
end of a 20 year cash flow stream is often insignificant due to
the impact of the time value of money and the residual value
left in the business after 20 years. For this reason, DCF
valuations with extended visible cash flow periods will often
not calculate a terminal value as its impact on the total
valuation is deemed to be immaterial.
For shorter visible cash flow period DCF valuations, the

calculation of the terminal value is a crucial and sensitive
element.
There are a number of steps required in order to calculate a

terminal value:
• Select a terminal value calculation method
• Estimate the relevant parameters for the terminal value

calculation
• Calculate the terminal value
• Convert the terminal value into present value terms.
DCF method Comps Asset valuation
The two most widely employed methods used to calculate a

terminal value are:
• DCF method (cash flow perpetuity method)
• Comps.
DCF method (Cash flow perpetuity method)
Initially we will concentrate on the FCFF valuation techniques.

Subsequently we will compare and contrast FCFF vs. FCFE.
The DCF method for a FCFF terminal valuation works on the

assumption that by the end of the visible cash flow period, FCFF
will reach maturity and behave as a perpetuity. These
perpetuities can assume no growth, constant positive growth
or constant negative growth.
A simple DCF terminal value cash flow perpetuity calculation

may assume zero cash flow growth. For a FCFF valuation this
would involve dividing the terminal year FCFF by the WACC.
𝐶𝐹11
TV =
𝑊𝐴𝐶𝐶
Where:
CF11 The cash flow in period 11 (where year 10 is the

last year of the visible cash flow period)
WACC The weighted average cost of capital
𝐶𝐹11
TV =
𝑊𝐴𝐶𝐶
$125,000
TV =
10%
TV = $1,250,000

=$125,000
WACC The weighted average cost of capital = 10%
Note: this terminal value calculation is expressed in

time period 10 terms and will still required
discounting back into present value terms.
A simple DCF cash flow perpetuity calculation, assuming no

growth:
This method assumes there is no growth in the post visible

cash flow period.
Most companies would argue that they would still grow during
the post visible cash flow period, even if it was only at a low
rate.
For terminal values calculated with an implied element of

growth, the simple DCF cash flow perpetuity calculation must
be modified.
𝐶𝐹10 (1+𝑔)
TV =
𝑊𝐴𝐶𝐶−𝑔
Where:

g The perpetuity growth rate (expressed as a %

age)
A DCF cash flow perpetuity calculation, assuming 2% growth:
𝐶𝐹10 (1+𝑔)
TV =
$125,000(1+2%)
TV =
(10%−2%)
TV = $1,593,750

=$125,000
g The perpetuity growth rate = 2%
WACC The weighted average cost of capital = 10%
Note: This terminal value calculation is expressed in time

period 10 terms and will still require discounting back
into present value terms.
As you can see the introduction of a 2% growth rate into

the perpetuity equation has a significant impact on the
terminal value calculation. The terminal value is very
sensitive to the growth rate applied to the perpetuity

calculation.
Note also we must take great care when changing growth

rates. Growth does not come from thin air. We must
consider the capital injections required to create this
growth and the impact of these capital injections on
previous years’ free cash flow.
The DCF cash flow perpetuity calculation must be used with

caution because of the huge impact the growth rate
assumption can have on the overall valuation. Estimating what
the growth rate of a company will be in 5 or 10 years’ time is
tricky. Simple reality checks can prevent serious errors.
Such reality checks could be considering what sales would be in

20 years if the growth rate is applied to current sales. Can the
market absorb this level of growth? What is the total market
potential? What would competitive pressures be? At what rate
is the economy growing? Is the growth rate sustainable? – All
questions that need to be answered!
Key considerations when using the DCF method (cash flow

perpetuity method)
There are a number of issues to consider:
• The DCF method relies on the cash flow estimated in the final
year of the visible cash flow period. Therefore, to use the DCF
method, you must have faith in the visible cash flow period
numbers and assumptions
• The reliance on the terminal value calculation as the main

contributor to the overall valuation can be managed by
extending the visible cash flow period. The benefit of this
option is that the proportion the terminal value contributes to
overall value will be lowered. The cost will be the increased
speculation involved in forecasting cash flows over longer
periods
• Be realistic when estimating the growth rate. Companies are

not going to grow at 8% in perpetuity, when the GDP of the
economy is growing at 2%.
The DCF cash flow perpetuity calculation is one option for

terminal value calculations. Many practitioners will calculate
the terminal value using several methods, as each method
will give a unique insight into the terminal value.
Value driver methodology
The problem with the above method is that it does not link the
growth rate to capex or changes in working capital. For higher
growth these will need to increase with a consequent fall in
FCF.
For most valuations with a steady state GDP growth rate this is
not critical, but as higher growth rates are incorporated into the
model the problem can become more acute and the valuation
is likely to be overstated.
The value driver formula below addresses the issue:

𝑔
𝐸𝐵𝐼𝐴𝑇∗(1−𝑅𝑂𝑁𝐼)
TV =
TV= Terminal value
EBIAT = Earnings before interest after tax
g = growth rate
RONI = return on new investment
WACC = weighted average cost of capital
1,500
TV = =₤30,000
0.08−0.03
EBIAT is ₤2,000
g = 3%
RONI is 12%
Based on the rb model (RONI X proportion of funds reinvested X growth)
b (proportion of funds reinvested) = g/RONI = 3/12 = 25%
So ₤2,000 X 75% can be paid out
In the FCF model we would have exactly the same result using
£1,500 as the free cash flow.
However if we increase the growth rate to 3.5% the value driver

model will reduce the EBIAT to be distributed to £2,000 * (1 -
3.5/12) whereas the FCF flow model will not automatically
adjust for this.
In practice good sensitivity analysis should always triangulate

results taking account of returns, proportions reinvested and
growth rates.
Comps method of computing the terminal value
In this approach the terminal value is calculated by applying a

multiple to a consistent profit metric forecast as part of the
DCF valuation. In a FCFF DCF valuation, we are attempting to
estimate the terminal value at the firm level for the post
visible cash flow period. Therefore the most appropriate
multiples used are Firm Value (FV) multiples as these multiples
will give a firm or firm level terminal value.
The attraction of this approach is its simplicity.
EBITDA (Terminal year t=10) £125,000
EV/EBITDA multiple 10.00x
Terminal value in t=10 terms £1,250,000
The terminal value in this example is calculated using an

EV/EBITDA multiple. This multiple will be applied to the
EBITDA in the last year (the terminal year) of the visible cash
flow period. The estimated terminal value of £1,250,000 is
expressed in time period 10 terms and will still need to be
discounted back to present value.
Using an appropriate multiple
The multiple used in the terminal value calculation has a

significant effect on the final valuation and the choice of
multiple used is a critical decision to be made. The main issue
is how to arrive at an appropriate multiple.
The process focuses on maintaining a comparable universe of

similar companies. The assumption underlying comps
valuation is that the market on average prices companies
fairly. Using the comparable universe information, applied to
the company to be valued, should yield a suitable valuation.
Ideally the comps used should be from companies currently

experiencing the growth pattern that our valuation target will
be experiencing at the end of its visible forecast period.
For example fixed line operators were used as exit multiples

when valuing the mobile phone companies (i.e. Telecom Italia
reflects Orange as Orange will be in 15 years’ time).
The use of multiples to compute a terminal value has the

benefit of being able to ‘reality check’ the estimate against the
rest of the comparable universe. However, some will argue
that this contradicts the very nature of DCF valuation
techniques – that DCF is an estimate of intrinsic value. Using
comps to estimate the terminal value introduces a dangerous
mix of relative or comparable valuation into an intrinsic
valuation technique. Such inconsistency, some will argue,
should be avoided.
Another issue of using comps determined terminal values is

that all terminal values have an implied growth rate embodied
in their calculation. The issue with comps is that the implied
growth rate is not a transparent element of the terminal value
calculation, whereas the growth rate (g) forms part of the DCF
cash flow perpetuity calculation. It is reasonably easy to use
an inappropriate multiple embodying an excessive growth
rate.
For cyclical companies, the terminal EBITDA and cash flow

number should always be cycle average numbers (rather than
taking a cycle peak or trough), on which we apply a cycle
average multiple.
It is of course also very difficult to forecast the EV/EBITDA

multiple for a peer group 10/15 years into the future.
Backing the implied growth rate out of the multiple
The issue of using an inappropriate multiple embodying an

excessive growth rate can be resolved by backing out the
implied growth rate from the multiple used in the terminal
value calculation. The implied growth rate can then be
reviewed for reasonableness.
Backing out the implied growth rate from a multiple-calculated

terminal value uses a rearrangement of the DCF cash flow
perpetuity equation. Substitute the known variables of the TV,

WACC and CF10 and solve for the implied growth (g).
𝐶𝐹10 (1+𝑔)
TV =
TV(WACC-g) = CF10(1+g)
TVWACC – TVg = CF10 + CF10g
TVWACC – CF10 = TVg + CF10g
TVWACC – CF10 = g(TV + CF10)
𝑇𝑉𝑊𝐴𝐶𝐶− 𝐶𝐹10
g=
(𝑇𝑉+ 𝐶𝐹10 )
TV Terminal value calculated using a multiple

g The perpetuity growth rate (implied)
An illustration of backing out the implied growth rate from a

terminal value calculation using multiples:
Backing out implied growth rates from TV multiples
EBITDA (t=10) 159,375
EBITDA multiple 10.00x
Terminal value (using EV/EBITDA) 1,593,750
Cash flow (t=10) 125,000
WACC 10%
Implied growth rate 2.00%
𝑇𝑉𝑊𝐴𝐶𝐶− 𝐶𝐹10
g=
(𝑇𝑉+ 𝐶𝐹10 )
1,593,750 𝑋 10%−125,000
g=
(1,593,750+125,000)
Putting it all together – DCF with terminal value

calculation
This does seem a great deal to take on board. However,

remember the fundamental structure of this DCF valuation.
We are attempting to value a company at the firm level. To do
this we have split the cash flow profile of the company into two
sections:
• The visible cash flow period
• The terminal value period.
For the visible cash flow period we estimated the FCFF. As we

mentioned most analysts will forecast a visible cash flow period
over 5 to 10 years. In order to forecast the FCFF during the
visible cash flow period, a clear understanding of the
company’s business model and key drivers of cash flow is a
prerequisite.
Beyond the visible cash flow period, the value of the company
was captured using a terminal value calculation (using either a
DCF cash flow perpetuity or comps calculation). The terminal
value calculation expresses the value of cash flows post the
visible cash flow period in value terms of the terminal year.
The terminal value will still require discounting back to present
value.
For a DCF FCFF valuation all cash flows are pre finance costs
(debt and equity) and post tax. These FCFF are discounted back
to present value using an appropriate weighted average cost of
capital (WACC). The present value of the FCFF discounted at
the WACC will yield the implied firm value of the company
(treated as a cash generating asset financed by debt and
equity).
The entire procedure is founded on the original tenet that:
Company value =
value of the future cash flows generated by the company

discounted at the required rate of return demanded by
the investors
The following summary illustrates the general steps performed

to present a full two-stage DCF FCFF valuation.
DCF summary (FCFF valuation)
Illustration
The following illustration is an extract from a formal DCF FCFF

financial model. The model is estimating the equity value per
share for Tesco plc.
Note the format of the FCFF derivation, the calculation of the

terminal value, the discounting of the FCFF using a WACC and
the calculation of the implied firm value.
Breakdown of firm value to equity value
The above illustration shows the full formal DCF FCFF valuation.
The valuation produces an implied firm value of the

company. However, for analysis purposes, it is the equity
value analysts will often be more interested in.
The firm value is the value of the entire firm and all its claims.
Equity shareholders are but one claim on the entire value of
the firm. Therefore to identify the element of the firm value
which equity has a claim on, we need to adjust the firm value
for non-equity claims.
The DCF FCFF extract below shows a typical implied

equity value breakdown:
The firm value of £21,508m is the present value of the FCFF

generated by the company. 34% of this value has come from
the visible cash flow period and is represented by the present
value of the visible cash flows of £7,268m. The remaining
£14,240m (66%) of the firm value is represented by the present
value of the terminal value calculation.
Implied value at 1 November 2003
Present value of visible cash flows (£m) 34% 7,268
Present value of terminal value (£m) 66% 14,240
Implied enterprise value (£m) 21,508
Net (debt) / cash (4,737)
(Minority value) (43)
Joint ventures/associates 343
Implied total equity value (£m) 17,071
Number of shares outstanding 7,237,609,183
Implied equity value per share (p) 236
To break down the firm value to an equity value the following

adjustments are made:
• Net debt is usually a significant claim on the firm value of a

company. Debt should be deducted at market value. When a
company is in financial distress or there are significant
differences between book and market value, debt instruments
should be marked to market
• If there is no market value, its market value can be estimated

by discounting the cash flows at the current refinancing rate
(like valuing a bond). An estimate of the cash flows can be
obtained from the accounts. The refinancing costs can be
obtained by talking to bankers who know the sector
• Market value information can be found for traded debt in the

annual report in some jurisdictions. For example, in the UK,
under FRS 13 Derivatives and Other Financial Instruments
Disclosures, market values should be disclosed for all financial
instruments. This will be the value as at the last balance sheet
date which will need to be updated for current valuations
• Minority interest represents, from an accounting viewpoint,

an outside ownership interest in a subsidiary that is
consolidated with the parent for financial reporting purposes.
Equity shareholders have no claim over this element of firm
value as it is owned by parties outside the group structure. As
the FCFF forecasts include the minority interest element,
minority interests must be removed in the breakdown to equity
value
• Firm value is measured at the market value of all its

components. Minorities are a constituent part of firm value
and should, when representing significant value, be valued at
market value; otherwise they should be included at book value
• If the subsidiary, where the minority interest arises, is quoted,

the market value of the minority can be derived. Practical
difficulties in arriving at the market value of minorities exist
where the subsidiary is unquoted. Unquoted minorities will
have to be valued on a separate basis (using either DCF or
comps)
• Due to the accounting rules for the inclusion of joint ventures

and associates in the group accounts, (that is, they are
generally accounted for below the EBIT or operating profit line
in the income statement), the cash flow contribution of these
entities has been ignored in the DCF FCFF valuation
• Equity shareholders have an ownership claim on joint

ventures and associates. The DCF FCFF valuation does not
include cash flows generated by joint ventures and
associates, as FCFF drives cash flow from financial
information above the EBIT line
• As for minority interests, a market value adjustment

(usually an addition) to equity value would be preferable in
order to calculate the implied equity value. However, due to
practical constraints the book value of joint ventures and
associates is often used as a proxy for market value. If the
value is a material and significant part of the valuation, a
market value should be used.
Unfunded pension liability
The calculation of the FCF will only take account of the ongoing
wage related element of the pension payment. The final firm
value will need to be adjusted to account for the pension deficit
at the time of the valuation. This is in effect an additional
source of ‘debt type’ funding.
The deficit should be deducted when establishing the

warranted equity value of the firm.
The post tax unfunded pension liability should be deducted as

ultimately the payments will save corporate tax at the normal
rate.
For simplicity it is generally assumed that the deficit will

eventually be funded in the same ratio of debt to equity as is
currently used in the WACC formula thereby negating the need
to adjust the WACC.
Comparison of FCFE and FCFF DCF valuations
The analysis has focussed on the FCFF DCF valuation. The main
reason for this is that the FCFF DCF valuation is the most
commonly used method for valuation purposes. Secondly, if
the mechanics are understood for the FCFF valuation the FCFE
valuation is straightforward.
The main differences are outlined in the table below:
DCF firm valuation DCF equity

valuation
Cash flow Unlevered cash Levered cash flow

to be flow (residual cash
(residual cash flow
discounted flow after paying for
after paying for all
all the operating
the operating
expenses, capital
expenses, capital
reinvestment and
reinvestment and
taxes, but prior to
taxes, but prior to
making any
making any
payments to the
payments to the
providers of
providers of equity
finance)
finance)
Appropriate Weighted average Cost of equity

cost of cost of capital
capital
Valuation Firm value Equity value
The main issue with the differences between the two methods
is the issue of consistency. The most common error is
discounting cash flows with inconsistent discount rates:
DCF firm valuation DCF equity

valuation
Cash flow Unlevered cash Levered cash flow

to be flow
discounted
Appropriate Cost of equity Weighted average

cost of cost of capital
capital
Valuation Wrong Wrong
DCF FCFE valuations use a cash flow prior to distributions to

providers of equity finance to determine the equity valuation of
company. The risk borne by the equity providers is factored
into the calculation by discounting the anticipated future cash
flows by an equity cost of capital. This consistency of ensuring
that the appropriate cash flow is discounted by an appropriate
cost of capital is a central tenet of valuation.
The same thinking applies to DCF FCFF valuations. This

technique values the entire firm, both debt and equity
components. Hence the cash flow estimated prior to
discounting is before all cash payments to providers of finance
– an unlevered cash flow. The cost of finance for all providers
is included in the appropriate weighted average discount rate.
Cost of Capital
An introduction to risk
out our online courses From an investor’s perspective, risk can be defined as the
variability of the actual return generated by an investment
relative to what the investor expected. An investor in a risk free
asset would receive an actual return equal to the expected
return.
However, most investments will not generate an actual return

exactly in line with expectations. This deviation (risk) in returns
around the expected return can be measured by variance and
standard deviation calculations.
Types of risk
There are a number of reasons why the actual return on an

investment does not equal the expected return – or why an
investment carries an element of risk. However, the reasons
can be grouped into two broad categories of risk:
• Firm-specific risk (unsystematic)
• Market risk (systematic).
Firm-specific risks may affect a single investment or possibly a

small group of investments. Market risk may impact many or
all of the investments in a market. Understanding the different
types of risk is a crucial foundation to understanding how
investors will get compensated for risk.
Firm-specific vs. market risk
Firm specific risk is risk that affects single or small groups of

investments. This category of risk can be sub-divided into:
• Project risk
• The risk that a firm may have misjudged its product

demand
• Tesco may purchase a significant number of game

consoles for the Christmas season. They later find out
that this year’s must-have Christmas gift is remote
controlled cars. This type of misjudgement would have

an impact on the company’s earnings
• Competitive risk
• The risk arising from the impact of the performance of

the competition.
• Competition taking market share due to an inventive

new marketing strategy will affect earnings. The launch
of on-line retailing for Tesco plc has seen an impact on its
earnings, as well as the earnings of Tesco’s competitors
• Sector risk
• Risks affecting the entire sector, but restricted to that

sector.
• For instance the government decides to increase the

corporation tax rate levied on food retailers. The direct
impact is felt mainly in this sector.
Some risks can affect one sector, but some can affect all sectors
of the economy. The UK economy experienced very low
interest rates through 2001 to 2003. However, in late 2003
interest rates started to increase. Though the impact of
increasing interest rates will be felt to differing degrees
throughout the economy, the impact is widespread.
This type of risk is known as market (systematic) risk.
Risk diversification
An investor has $1,000 and initially chooses to invest it entirely

in AT&T Inc shares. In doing this the investor is exposed to the
firm specific risks (project, competitive and sector risks)
affecting AT&T Inc, as well as the market risk. An excellent
position to be in if the risk is entirely upside, not so good if the
risk is downside.
If the investor was to choose to reallocate part of her portfolio

out of Telecoms into other sectors, she would be reducing her
exposure to firm specific risk. She would be diversifying his
risk.
Why does this reallocation reduce firm specific risk?
The first reason is based on the old adage of “…not having all
your eggs in one basket…”
Thinking of the initial asset allocation – all of the $1,000

invested in AT&T shares. All the eggs are in one basket. The
telecoms sector sees a significant downturn – the current
portfolio bears the full brunt of the downturn as it is fully
exposed to the firm specific risk of AT&T.
Shifting some of the “eggs” into another basket, let’s say, food
retail, may have reduced some of this exposure to AT&T’s firm-
specific risk when the sector took the downturn. Hence the
downturn affects a smaller percentage of the overall portfolio
of investments.
The more “baskets” a portfolio has, the more the exposure to

firm-specific risk will be reduced.
Empirical research has found that having around 20 to 25

different “baskets” or stocks should be sufficient to eliminate
firm specific risk. Because firm specific risk can be diversified
away, it is also known as diversifiable risk.
Holding an appropriate number of assets within a portfolio,

with all the firm specific risk diversified away, does not make a
portfolio risk free. The portfolio is still affected by market risks
or non-diversifiable / systematic / non specific risks.
Key risk assumptions in models
Most models that estimate the level of rewards required to

compensate for various levels of risk are based on two factors:
• The investor is deemed to be the marginal investor
• The marginal investor is assumed to be well diversified. That

is, the marginal investor is only exposed to the influence of
non-diversifiable risk.
Thus the only risk a well diversified marginal investor is

exposed to is market risk.
Risk terminology
The table below shows the various terms accorded to market

and firm specific risks:
Market risk Firm specific risk
Systematic risk Unsystematic risk
Non-specific risk Specific risk
Non-diversifiable risk Diversifiable risk
Risk and the cost of equity
Given the above analysis of risk, the marginal well-diversified

investor will be exposed to market risks, with all other firm-
specific risk being diversified away. Therefore, the rational
marginal investor will demand a return (compensation) for the
level of market risk he faces.
From a valuation perspective, equity investors provide a cash

investment to a company. The initial investment is given in
return for future deferred cash flows and value. This return
must be sufficient to compensate for the risks embodied in the
future cash flows.
The return demanded by the equity investors of a company is

called the equity cost of capital. It is the reward to equity
investors for the market risks their investment is exposed to.
There are a number of ways to calculate the equity cost of

capital:
• Capital asset pricing model (CAPM)
• Arbitrage pricing theory (APT)
• Multi factor model (MFM).
Given that CAPM is the equity cost of capital model favoured by

most banks, our analysis will focus on this model. CAPM will
then be contrasted with the other risk / reward models.
Capital asset pricing model (CAPM)
CAPM is the preferred model for calculating the cost of equity

for a number of banks. It has the longest history of use and it
is the most widely used risk / return model. The added bonus
is that it is mathematically easy to apply.
The CAPM is a risk / reward model that assumes that investors

holding a risky asset will demand compensation in excess of
the return they would receive from a risk free asset and that
the additional return demanded (risk premium) is proportional
to the market risks they are exposed to.
Overview
The CAPM calculates the cost of equity for a company.
In fact it calculates the required return to the shareholder (this

is the cost to the company, ke).
It is an academic model with many practical applications and its

component parts are later examined in detail as they can have
a significant impact on the outcome of valuation.
In essence the model can be simply stated as:
Ke = Risk free rate + (Beta) X Equity Market Premium
The required return is based on the return from a risk free

asset plus a premium for risk.
The Equity Market Premium (EMP) is the excess of the expected

return on the market portfolio over the risk free rate.
The β measures the level of risk in a particular share relative to

the level of risk in the market overall.
If a share is less risky than the market average it will have a β

of less than 1.
So if the risk free rate is 5% and the stock market is returning

12% the Equity Market Premium is 7% (12% - 5%).
If we have a low risk share with β of 0.6, an investor would

require a return from this share of:
5% (the risk free rate) + a premium for risk (as the share has a
b of 0.6 the premium required will be less than 7%, in fact it
will be 0.6 X 7%) 4.2%
The required return will be 9.2%. This will be used as K e (the

company’s cost of equity).
CAPM and its components will now be examined in more

detail.
Assumptions
CAPM has a number of assumptions embodied in its model.
We have already discussed the benefits of diversification.

Diversification however does have its costs, such as transaction
and investment monitoring costs. Hence there will come a
time where the marginal diversification costs exceed the
marginal diversification benefits. At this stage diversification
should cease.
CAPM makes a number of other simplifying assumptions:
• There are no transactions costs
• Investments are infinitely divisible
• Investors have access to full information.
The consequence of such assumptions is that there are no

additional costs of diversification. Therefore investors will keep
diversifying until their portfolios hold all traded assets in the
market. That is, investors hold the market portfolio.
The existence of a market portfolio may seem theoretically

abstract. However, it is possible to think of it as a large and
very well diversified investment or mutual fund.
Further assumptions within CAPM are:
• There are risk-free assets, where the expected return is

known with certainty
• Investors can borrow and lend at the risk-free rate. Lending

at the risk free rate is achievable through government gilts and
bonds. However, borrowing at the risk free rate may be an
issue within CAPM.
These assumptions have been relaxed in further developments

of the CAPM. However, the conclusions are still broadly
consistent with the CAPM.
Meaning of risk under CAPM
The assumptions above are used to illustrate how individual

investors demonstrate their individual risk preferences. Each
investor will hold a combination of the risk free asset and the
market portfolio. Risk averse investors will hold a greater
proportion of their wealth in the risk free asset. Investors with
a greater desire to expose themselves to risk will allocate a
greater proportion of their wealth to the market portfolio.
In our CAPM world, the risk of an individual asset is the risk

that the asset brings to the market portfolio. If the risk of the
asset is firm specific, the impact will be diversified away. On
the other hand if the asset moves with the market portfolio, it
will add to the risk of the market portfolio. This relationship
between how the asset moves in relation to the market can be
measured using the covariance of the asset with the market
portfolio.
The risk of the market portfolio is measured as the variance in

the returns on the market portfolio σ2m. This is the variance
prior to adding a new asset to the portfolio. The variance of
the asset that is going to be added to the portfolio is σ2i.
Therefore:
Pre asset inclusion portfolio variance = σ2m
Post asset inclusion portfolio variance = wi2σ2i + (1-wi)2 σ2m + 2wi(1-wi) σim
Where:
wi = market value weight of the new asset introduced to the portfolio
σ2m = variance of the individual asset introduced to the portfolio
σim = the covariance of the asset’s return with the market portfolio’s return
The weighting of the market portfolio, w, should be very small.

Therefore,
• The 1st term, wi2 σi2 should be nearing zero
• The 2nd term, (1-wi)2 σ2m should be pretty much the variance
of the portfolio, σ2m.
• This should leave the 3rd term, 2wi(1-wi)sσim, in the equation

representing the additional risk added to the portfolio due to
the introduction of the new asset.
The result of a covariance calculation is a percentage term.

Assessing the relative risk of an asset in relation to the portfolio
is difficult when dealing with percentage terms. If you were
told that the covariance of AT & T Inc shares in relation to the
market was 67, you would be none the wiser of how risky this
asset was in relation to other assets.
The covariance, σim, can be standardised in relation to the

market by dividing it by the variance of the market portfolio.
This equation gives us the beta of the asset, that is, a relative
measure of the risk of an asset in relation to the market.
σ𝑖𝑚
=
σ2
𝑚
Where:
σ𝑖𝑚 = the covariance of the asset’s return with the market

portfolio’s return
σ2𝑚 = the variance of the market portfolios return
The covariance of the market portfolio with itself is its variance.

Therefore the beta of the market portfolio’s return will be equal
to 1. Individual assets that are riskier than the average will
have betas greater than 1. Likewise, individual assets that are
less risky than average will have betas less than 1.
Hence the beta is a standardised method of isolating the

additional risk introduced by adding an asset to the market
portfolio.
Understanding the CAPM equation
The next step in the CAPM process is to derive the linear

relationship between expected return on an asset and its beta.
The standard CAPM equation is:
E(Ri) = Rf + βi[E(Rm) – Rf]
Where:
E(Ri) =Expected (or required) return on an asset
Rf =Risk free rate
E(Rm) =Expected return on the market portfolio

σ𝑖𝑚
βi =Beta of the asset =
σ2
𝑚
The CAPM equation calculates the required return as a

premium over the risk free rate. The premium is defined by
the risk of the asset in relation to the behaviour of the
market. Assets which are perceived to be more risky than
the market average will attract a higher beta and hence a
higher demanded premium over the risk free rate.
For an equity investor the CAPM equation will give a cost of

equity for an individual asset.
Using CAPM in a practical context
To use the CAPM three inputs are required:
• The risk free rate
• The beta of the asset
• The equity risk premium [E(Rm) - Rf].
Risk free rates
The risk free rate represents the rate of return available from
an asset or portfolio that has no risk. The expected return on
the asset equals the actual return on the asset.
This definition rules out the use of corporate bonds to provide

a risk free rate, as there is a risk that the corporate may default
on its interest or principal payments.
For this reason, most users of CAPM will refer to government

bonds to provide a risk free rate. If governments run the risk of
default, they are in the position to print more money to service
their debt obligations. Strictly, while the government bonds of
the US, UK and most countries are free from default risk, they
are not risk free. Government bonds will be exposed to
reinvestment risk as interest rates move after the interest rates

on the bonds have been fixed.
It is impossible to get a truly risk free rate. For this reason,

analysts will use the yield on government gilts or bonds. This
information is very easy to obtain through information
providers, such as Bloomberg or Reuters. 10 year UK
government gilt rates are published by the FT, appearing in
the Companies and Markets section of the paper.
The gilts benchmarks and most liquid bond issues are shown in bold.
It is preferable to use medium to long dated government gilts

as these rates will come closest to matching the pattern of the
cash flows of the company under valuation. Shorter term
bonds (< 10 years) will not achieve this consistency.
The highlighted rate of 5.06% approximates a 10 year UK

government gilt yield in 2003 – an appropriate proxy for the
risk free rate to be used in the CAPM equation.
Beta
There are a number of approaches to calculating a beta:
• Use historical information and perform linear regression

(historical market betas)
• Estimate the beta from company fundamentals (fundamental

betas)
• Estimate the beta from accounting data (accounting betas).
Historic market betas
The regression of historic investment returns against the

returns of the market is the standard method of producing
beta estimates for firms that are established and have traded
for a sufficient length of time.
The theory is that the investment returns of the individual asset

will be related to the returns of the market, and hence
mathematical analysis will produce the beta for the asset.
The standard procedure is to run a regression analysis of the

individual investment returns against the market returns, using
a market index as a proxy to the market portfolio (FTSE 100,
S&P 500, etc.)
Regression estimate for beta:
Ri = a+ bRm
Where:
Ri =Individual stock returns
Rm =Market returns
a =Regression intercept
σ𝑖𝑚
b =Slope of the regression= =beta
σ2
𝑚
The following page includes an example of an historic

regression beta calculation. The regression was performed
using the Microsoft Excel data analysis tool. The investment
and market returns are hypothetical.
A rearrangement of the CAPM equation can provide a

comparison of the asset’s investment return relative to that
expected by the CAPM equation:
The standard CAPM equation:
Ri = Rf + β(Rm – Rf)
Rearranged through multiplying the brackets out:
Ri = Rf + βRm – βRf
Ri = Rf (1-b) + βRm
This discloses the CAPM equation in terms of an intercept

Rf (1-β) and a line gradient β.
The rearranged CAPM equation and its expected return

can now be compared to the regression equation of the
historic returns from the market and the individual asset:
Ri = Rf (1-β) + βRm
Ri = a + bRm
Hence:
The intercept, a, can be compared with Rf(1-β), giving a

measure of the asset’s performance relative to the CAPM.
The difference (known as Jensen’s alpha) is a measure of
whether the actual return of the asset was greater or less
than the required (or expected) return given market
performance and risk demonstrated by CAPM.
Jensen’s alpha Asset performance
a > Rf(1 - β) Asset performance better

than expected during the
regression period
A = Rf(1 - β) Asset performance as

expected during the
regression period
a < Rf(1 - β) Asset performance worse

than expected during the
regression period
Using service betas
Running a historic regression analysis every time we need a

beta for our cost of equity calculations will be time consuming.
It is for this reason that most analysts will use a beta provided
by an information service provider such as Bloomberg, Barra,
LBS or S&P.
Using service betas has its own issues.
In performing the previous regressed beta calculation a

number of decisions were made prior to the running of the
regression:
• What is the length of the estimation period?
• What is the frequency of the historic observations?
• Which index will be used as a proxy to the return on the

market portfolio?
Each information service will make these decisions as defaults

in their regression calculations. Hence, a beta for Safeway plc
produced by LBS will differ from the beta provided by
Bloomberg.
These decisions have important implications for the beta

estimation:
• Length of the estimation period:
• The trade-off is straightforward. A longer estimation

period will yield more observations. However, over time
a firm’s risk characteristics can change, as the firm
evolves, possibly into new markets or new products.
Introducing inappropriate observations in to the
regression analysis can introduce bias into the
estimation.
• Frequency of the historic observations:
• A shorter time frequency – more observations
• Shorter time frequencies of observations can introduce

non-trading bias into the beta estimation. Non-trading
bias arises when a stock does not trade and hence its
price remains static, but the market still moves. This
effect will reduce the correlation between market and

individual asset returns
• Non trading bias is certainly more of an issue for

smaller, less liquid firms
• The issue can be managed by choosing a frequency

interval that is not too short, but still yields a sufficient
number of observations for the chosen estimation
period. Most analysts will have a frequency period using
weekly or monthly returns.
• Market portfolio proxies:
• The standard practice of the information service

providers is to use the index of the market that the stock
is traded in
• In estimating a beta for Tesco plc, the FTSE 100 would

be a sensible market portfolio proxy. For US stocks, the
NYSE or S&P 500 would be appropriate proxies.
Bloomberg is one of the few service providers to reveal the

estimation techniques used in its beta calculations.
A typical Bloomberg screen is shown below.
Note: Bloomberg issues two beta estimations – a raw beta and

an adjusted beta. The raw beta is the beta estimation from the
basic regression estimation – i.e. the gradient of the line of best
fit. The adjusted beta is calculated using the equation:
Adjusted beta = (0.67) X RAWβ + (0.33) X 1.00
The adjusted beta calculation will weight a raw beta towards 1.
The argument is that over time betas trend towards 1, as firms

diversify and get bigger.
Fundamental beta calculations
Estimating betas using regression techniques relies on the

availability of historic investment returns. This will pose
problems for private companies, newly listed companies and
firms which have recently seen its risk characteristics change.
An alternative method of calculating betas, without relying on
historic information, is to derive the beta from fundamentals.
Bottom-up betas
The technique of calculating bottom up betas is founded on the

idea that the beta of a company is dependent on two factors:
• The business it operates in
• The beta measures the risk of the company relative to

the market risk. The more sensitive the business
operations are to market conditions, the higher the beta
will be
• The degree of financial leverage
• A company with high gearing will have high financial

leverage, as fixed interest payments will result in
proportionately higher returns during upturns and
proportionately lower returns during downturns
• Hence the variance of earnings for firms with debt in

their capital structure will be higher than for unlevered
firms. Intuitively, this higher risk to equity investors will
result in a higher beta.
Given that regressed betas rely on the availability of

appropriate historic information, bottom up betas provide a
beta estimation technique that is less reliant on historic
information. Bottom up beta calculations use these factors to
estimate betas from comparable information.
Fundamental betas (Bottom up beta calculations)
There are a number of steps required to perform a bottom up

beta calculation:
• Identify comparable publicly traded firms and regress their

historic information to obtain beta estimations
• Defining the comparable set (universe) of firms can be

difficult. If we define a comparable firm as one which
demonstrates very similar characteristics to the firm we
are trying to estimate a bottom up beta for, it can result
in a very small comparable universe, as very few
companies will be directly comparable. However,
loosening the definition of a comparable firm may
introduce firms that may not share the necessary
characteristics.
Comparability can be defined with reference to

characteristics such as:
• Sector
• Size
• Geographical location
• Growth method (acquisition vs. organic) and growth
rates
• Gearing.
The betas for these comparable firms will be influenced
by the financial leverage particular to each firm’s capital
structure. As we mentioned earlier, higher financial
leverage will lead to a higher variance (risk) on earnings,
hence a higher beta.
This relationship is demonstrated by the equation:

𝐷
βlevered = βunlevered[1 + (1 - t) ( )]
𝐸
Where:
βlevered =Beta of a levered firm
βunlevered =Beta of an equivalent unlevered firm
tc =Corporate tax rate

𝐷
( ) =Debt to equity ratio at market value
𝐸
• As gearing increases, measured by the debt to equity

ratio, the company’s equity investors will bear a higher
amount of market risk, thus resulting in a higher beta
factor. The tax deductibility of interest payments is
represented by (1-tc)
• This equation assumes that all of the firm’s risk is borne

by the equity investors, that is, the debt has a beta of
zero.
• The next step in the bottom up beta approach is to create a

level playing field to analyze the beta. This involves stripping
the impact of financial leverage out of the comparable beta
calculations – deleveraging the comparable betas – a simple
rearrangement of the above equation is shown in the
illustration below:
β𝑙𝑒𝑣𝑒𝑟𝑒𝑑
βunlevered = 𝐷
[1 + (1 − t) ( )]
𝐸
Where:
βlevered =Beta of a levered firm
βunlevered =Beta of an equivalent unlevered firm
tc =Corporate tax rate

𝐷
( ) =Debt to equity ratio at market value
𝐸
• The comparable betas are all now unleveraged betas,

free from the influence of financial leverage. A decision
must be made to identify what beta will be used to
provide the basis of the target beta estimation. This
could be a simple or weighted average of the comparable
betas, or a subjective judgement
• Once an appropriate unlevered comparable beta has

been isolated, it will then be leveraged for the gearing of
the target beta company using the equation.
𝐷𝑡𝑎𝑟𝑔𝑒𝑡
βlevered - target = βunlevered - comparable[1 + (1 – tc-target) ( )]
𝐸𝑡𝑎𝑟𝑔𝑒𝑡
Where:
βlevered - target =Beta of a levered firm
βunlevered - comparable =Beta of an equivalent unlevered firm
tc - target =Corporate tax rate
(
) =Debt to equity ratio at market value
The illustration below outlines a bottom up beta calculation,

using the comparable levered betas of 10 comparable
companies. Market D/E and tax rates are given for each
company. This allows each comparable levered beta to be
deleveraged for the financial leverage reflected in its capital
structure.
Comparable Levered Market Tax Rate Unlevered

universe beta beta*
D/E
Company 1 1.30 35.00% 38.00% 1.07
Company 2 0.54 102.00% 37.00% 0.33
Company 3 1.26 25.00% 43.00% 1.10
Company 4 0.86 250.00% 12.00% 0.27
Company 5 0.23 52.00% 25.00% 0.17
Company 6 0.73 46.00% 32.00% 0.56
Company 7 0.84 45.00% 42.00% 0.67
Company 8 1.52 62.00% 35.00% 1.08
Company 9 0.64 54.00% 34.00% 0.47
Company 10 0.65 58.00% 34.00% 0.47
Average 0.857 0.729 0.342 0.619
Median 0.785 0.530 0.350 0.512
Minimum 0.230 0.250 0.120 0.172
Maximum 1.520 2.500 0.430 1.103
Unlevered comparable beta applied to bottom up beta
Simple average of comparable betas chosen 0.619
Market D/E of target beta company 54.90%

Tax rate of target company 30.00%
** Comparable beta leveraged for target company market 0.857

D/E
β𝑙𝑒𝑣𝑒𝑟𝑒𝑑
* βunlevered = 𝐷
[1 + (1 − t) ( )]
𝐸
**βlevered - target = βunlevered - comparable[1 + (1 – tc-target) ( )]
A bottom up beta is calculated for the target using a

comparable unlevered beta as the foundation. (In this case the
simple average of the unlevered comparable betas of 0.619
was used).
The bottom up beta is then leveraged for the market D/E of

the target beta company, thus producing a bottom up beta of
0.857 derived from comparable company analysis.
As we mentioned earlier bottom up betas are useful as they get

away from the dependence on historic information necessary
for regressed beta calculations. This is especially useful for
private and newly listed companies, as well as for companies
that have seen a recent change in their risk profile.
There are further advantages to the bottom up beta approach:
• The comparable betas do not have to be sourced through

regression calculations. They can be sourced from
information service providers. Remember, when using
service betas the estimation techniques and parameters of
the beta calculations will differ between service providers.
Try to remain loyal to one service provider and make sure
that the parameters are consistent through the comparable
universe. Using service betas will obviously save a great deal
of time on the preparation of the analysis
• Bottom up betas can be easily modified for changes in the

business model of the target beta company. For instance,
changes in the target company’s market D/E ratio can be
factored into the leveraged beta calculation. Likewise, if
there are structural changes in the company due to the
financing impact of acquisitions or changes in business
strategy, this can be factored into the beta
• Factoring these changes into the beta can be ex-ante or ex-

post. That is, anticipated changes can be introduced to the
method, to analyze how business changes can impact the
company’s beta
Accounting beta calculations
An accounting beta is estimated by comparing market

performance against company earnings.
You should have a gut feeling that this method is not the best.
The reason is founded on the ease with which accounting
information can be manipulated. Calculating betas based on
information that can be easily manipulated cannot yield a
reliable beta.
Beta terminology
Leveraged beta Unleveraged beta
Published beta Asset beta
Equity beta Earnings beta
Dividend beta
β𝐿
𝐷𝑡𝑎𝑟𝑔𝑒𝑡 βU =
βL = βU[1 + (1 – tc-target) ( )] 𝐷
[1 + (1 − t) ( )]
𝐸𝑡𝑎𝑟𝑔𝑒𝑡 𝐸
Equity risk premium [E(Rm)- Rf]
This is the final step in order to put the CAPM into practice.
In our initial discussions of risk we concluded that equity

investors will demand a higher return to compensate them
for the increased exposure to risk.
CAPM estimates this risk premium from a well diversified

marginal investor’s perspective. Therefore given CAPM’s
assertions, the marginal investor will only be rewarded for the
additional market risk exposure, as it is market risk that cannot
be diversified.
The beta we have discussed measures relatively how much the

individual asset’s returns move in relation to the market
portfolio (the individual asset’s relative exposure to market risk)
and factors this into the required equity return.
Beta is a relative measure. The CAPM equation needs to know

how the market portfolio has performed in relation to the
benchmark risk free rate. This is given by the [E(Rm) - Rf] part of
the CAPM equation. The CAPM will take this absolute
performance and, through the beta, quantifies the relative
impact for the individual asset and hence an estimate of the

required risk premium.
Estimating the risk premium (historic risk premium analysis)
This is an intuitively straightforward method of risk premium

estimation. The premium is estimated by analysing the historic
return on stocks over the historic return on a risk free security.
The difference between the two returns yields the historic risk
premium.
The historic risk premium is a widely used approach. However,

the results from the approach can vary widely (between 4% and
12%) dependent on the parameters used in the analysis.
There are a number of reasons for the divergence in the

historic risk premium results:
• Ibbotson Associates provide the industry standard source of

historic risk premium information. Their data goes back to
1926. The decision on how much of this data should be used in
the historic analysis varies from analyst to analyst
• Using data from back in the 1920s and 1930s can

obviously be argued to be a little old, as investors’ risk
perceptions have changed. However, concentrating on
more recent information will reduce the sample size in
the analysis, making the analysis more open to noise or a
higher standard error. For instance, the standard error
using a 5-year analysis of historic risk premiums is 8.94%.
This could outweigh the size of the actual historic risk
premium
• Generally, analysts feel that the benefits of

concentrating on a recent sample of historic risk
premiums are outweighed by the associated cost of the
increasing standard error (or the increasing noise in the
estimate)
• There are a number of risk free proxies that could be used for
the historic risk premium analysis (US T-bills, US T-bonds, short
and long dated UK gilts). There is generally a positive
relationship between the yield on bonds and their maturity.
This relationship is illustrated through yield curves. A standard
upward sloping yield curve is shown below
• The yield curve below is for government bonds (US or

UK)
• The point being made is that over the term structure of

the bonds, the yield or risk free rate increases as the
maturity or the term increases
• Hence the choice of bond maturity chosen will affect the

proxy risk free rate and hence alter the risk premium.
With an upward sloping yield curve, a long dated bond
with a higher risk free rate will produce a smaller risk
premium.
• Generally, analysts will use US Treasuries (for US based

calculations) or UK long dated government bonds (for UK
based calculations) as the risk free benchmark. Although
the default risk on these bonds is low, the bonds are
more sensitive to interest rate changes and inflationary
pressure. However, the long dated bond prices reflect
future interest rate expectations, which is appropriate if
the cost of capital being estimated is being used for long
term forecasting (i.e. DCF)
• Using the historic risk premium method requires an average

calculation to be applied over an extended time period. The
method of calculating this average can have a significant
impact on the size of the risk premium. The historic risk
premium can be calculated using an arithmetic or geometric
average
• The geometric average calculation produces an annually

compounded return
• The arithmetic average calculation gives a simple

average return
• A simple example of the difference:
• A share (non dividend paying) has a price of €10

on 1/1/2000, €20 on 1/1/2001 and falls back to
€10 on 1/1/2002
• The arithmetic average return would be 25%
• The geometric average return would be 0%

(equating the beginning and end values)
• There are strong arguments for and against both

methods. Analysts will take a view on which averaging
calculation to apply. But be aware of the issues.
The historic risk premium analysis is used as a proxy for the

prospective risk premium to be used in the cost of equity
calculation to be applied to future cash flows.
A summary of risk / return models
There are a number of ways to calculate the equity cost of

capital:
• Capital asset pricing model (CAPM)
• Arbitrage pricing theory (APT)
• Multi factor model (MFM).
The key differences between the three models are outlined

below:
CAPM APT MFM
Summary Assuming no The market has Market risk

transaction costs no arbitrage affects all
and full opportunities. investments (or
information, the Therefore the at least most of
marginal investor market risk of any them). Therefore
will be fully asset must be market risk must
diversified – captured by betas be the result of
therefore every relative to factors macro economic
asset is included that affect all variables
in a market investments
portfolio
Market The risk added by Market risk Market risk

risk any investment reflects the reflects the
included in the exposure to exposure to macro
market portfolio market factors economic
variables
Beta Single share A number of single A number of betas

levered beta share levered related to macro
relative to the betas related to economic factors
market portfolio unspecified
market factors
The cost of debt and WACC
Introduction
Debt holders require compensation for their investment.
Debt investors when investing in a company will have a debt

agreement or indenture. This will set up the repayment
schedule, the debt maturity, the call options and debt
covenants, amongst other things. This type of agreement very
much defines the debt investor’s return and contingencies for
repayment. For most forms of debt, there is no access to the
upside potential of the company they have invested in.
Likewise, the debt agreement will limit the downside potential
faced by the investor through the use of debt security and
covenants.
In summary, the risk faced by the debt investors should in all

commercial situations be lower than the equity investors.
Hence the compensation demanded by this group of investors
will be lower too.
The cost of debt
The cost of debt measures the current cost of financing faced

by the firm from borrowed funds. It is a common
misconception amongst naïve investors that debt financing is
risk free and that the risk free rate should be an appropriate
proxy for a company’s cost of debt.
Corporate lending will suffer default risk. If a corporate cannot

service its debt obligations it cannot print some more money
to satisfy its debt investors. The very fact that a corporate
does not have control over the money supply means that all
corporates have an element of default risk – no matter how
well the company is doing or however remote default could
be.
Therefore debt investors lending to corporates will demand a

return that includes a premium over the risk free rate. The
premium acts as compensation for the additional risk of
default faced by a corporate lender. The size of the premium
(default spread) will reflect the debt investors’ perception of
default risk. Higher risk, higher demanded premium.
Debt finance has the general advantage that it is a cheaper

source of finance relative to equity. It has the additional
benefit that interest payments are tax deductible. That is, a
company with a pre tax cost of debt of 6% and a tax rate of
30%, will effectively pay 4.2% [6%X(1-30%)]. As tax rates
increase, the tax benefit of debt will increase.
Post tax cost of debt = (Risk free rate + default risk premium) X (1 - tax rate)
Remember, the risk free rate is the yield on the

Government Bond, not the coupon.
Estimating the default risk spread
The estimation of the cost of debt, and therefore the implied

default risk spread, is very easy if the company’s debt is widely
traded in a liquid market and the maturity is known. From this
information the yield can be calculated and used as a cost of
debt.
However, most company debt is not traded.
Nevertheless, a debt issuing company will have its debt rated

by rating agencies such as S&P, Moody’s and Fitch. Using these
debt ratings and their associated published default risk
spreads, the cost of debt can be estimated using an
appropriate risk free rate.
A diagrammatic outline of the S&P ratings process is given

below.
•
•
Issues start to arise for companies that do not have rated debt,
for example, small companies or companies based in emerging
markets. The default risk premium must then be estimated.
There are two default risk estimation options:
• Examine the recent borrowing history
• Whether or not a company is rated, it will probably still

issue debt. Examining the history of recent debt issues
and the associated borrowing rates will provide a guide
to an appropriate cost of debt.
• Estimate a synthetic rating
• Perform the role of rating agencies and produce a rating

on the basis of financial credit analysis
• A starting point will be to assess the financial credit

analysis of comparable firms which are credit rated to
determine the financial characteristics associated with
each rating class. Financial credit analysis can then be
performed on the unrated firm and compared to that of
the rated firms
• Standard & Poor’s 2003 Corporate Ratings Criteria

provides a detailed insight into their rating process and
the financial analysis they use. An extract from the S&P
report is included below, illustrating the key financial
ratios they use in their rating process.
Source: Standard & Poor’s Corporate Ratings Criteria
Once the default risk premium has been estimated it is added

to an appropriate risk free rate. This will yield a pre-tax cost of
debt. However, the appropriate cost of debt for the WACC and
the valuation process is a post tax cost of debt. The pre tax
cost of debt is converted to post tax by multiplying by (1-Tax
rate).
Full cost of debt
The cost of debt discussed so far reflects the various costs of

the issued debt instruments. These debt instruments will be
reflected on the balance sheet of the company and will be easy
to identify.
The problem arises when the definition of a debt item is

expanded. Debt is a liability of a company:
A liability is an obligation resulting from a past transaction

that leads to a probable future outflow of economic
benefit.
Debt instruments are instruments issued as a means of

raising finance other than those classified in/as
shareholders funds.
The main issue that arises is: are all financing obligations
accounted for in the WACC calculation? The list below
identifies a sample of areas where debt can be positioned off
balance sheet due to accounting rules and therefore may be
omitted from the WACC calculation.
• Operating leases
• Special purpose vehicles
• Joint ventures and associates
• Net pension deficits.
The weighted average cost of capital (WACC)
The components of WACC are the individual costs of capital for

each provider of finance to the company, weighted by the
relative size of their contribution to the pool of finance.
There are a few issues to consider:
• Have all the costs of finance been calculated?
• How should the WACC be weighted – book or market values

of finance?
WACC weighting – book or market value weightings
The WACC is the weighted average cost of capital. The

weighting should reflect the instruments’ contributions to the
company’s capital structure. The issue is whether to use book
values of debt and equity to perform the weighting or to use
market values.
One of the major weaknesses of the balance sheet is that it is

historic, out of date and based on accounting rules. Therefore
a strong argument against using book values is that they are
out of date and do not reflect current market conditions. Some
would argue this is an advantage as book values eliminate the
volatility of the market – agreed but they are still historic, out of
date and based on accounting rules.
The majority of firms who use WACC use the market value
weighting approach; however there are a number of
possibilities:
Weighting proportions
Current market value
• This has the advantage of being empirically correct
• However the current position may be atypical. Also if the

WACC is being used to calculate a market value there is a
degree of circularity in basing one of the inputs on current
market value
• When using a WACC (based on current market values) to

calculate an implied firm value it would make sense to deduct
the current market value of the net debt when moving from
firm to equity value.
Optimum leverage ratio
• Using either Modigliani & Miller or an empirical model, it is

possible to derive the optimal capital structure for the firm’s
WACC. This capital structure can then be used to create the
WACC
• Obviously this assumes that the company can and will move
towards this optimum position (or is already at its optimum).
Target leverage ratio
• The Board may have stated targets for their long-term

leverage. If these are publicly stated and deemed attainable,
then it would make sense to use this ratio in creating the
WACC.
Industry average
• In certain circumstances (IPO for example) there may be a lack

of available data
• In these instances it can be assumed that the company will

tend toward the industry average debt to equity ratio.
Bottom up
• If the WACC is itself partly built up from an unleveraged and

releveraged cost of equity, then the weighting used in the
WACC model should be consistent with the weightings used
when releveraging the unleveraged beta.
The weighted average cost of capital calculation
WACC = Cost of equity X (1-D/D+e) + Cost of debt X (D/D+E)
Comparable company
analysis (Comps)
Why do we do comps?
out our online courses Analysing the operating and equity market valuation
characteristics of a set of comparable companies with similar
operating, financial and ownership profiles provides a useful
understanding of:
1. The important operating and financial statistics about the

target’s industry group (e.g. growth rates, margin trends,
capital spending requirements).
This information can be helpful in developing
assumptions for a discounted cash flow analysis.
2. The relative valuation of publicly listed companies.
The resulting multiples guide the user as to the market’s
perception of the growth and profitability prospects of
the companies making up the group. Consequently,
comps can be used to gauge if a publicly traded company
is over or undervalued relative to its peers.
3. A benchmark valuation for target entities.
Comps valuations are based on:
• Metrics of target company (e.g. EBITDA)
• Multiples of similar quoted company(ies) (e.g. EV /
EBITDA).
Valuation multiples from comparable companies may be

applied to the financials of the target entity to be valued to
give a theoretical value of the target business.
For example:
Metric of target earnings $10.0m
Multiple of similar quoted company p/e 18.0
Theoretical equity value of target $10.0m x 18.0 =$180.0m
4. An indicative market price for a company which is to be

floated on the stock market
5. The validity of terminal DCF assumptions
6. Investment returns for financial buyers acquiring assets
with the intention of monetising the investment in the
public equity market in an IPO.
Example
Tesco Sainsbury
Share price (p) 261.5 376.0
Equity value (£m) 18,127 7,260
Enterprise value (£m) 20,967 8,172
Enterprise value / Sales
2003 (Curr.) 0.86x 0.48x
2004 (Prosp.) 0.74x 0.47x
EBITDA
2003 (Curr.) 10.8x 7.6x
2004 (Prosp.) 9.4x 6.6x
EBIT
2003 (Curr.) 15.5x 12.4x
2004 (Prosp.) 13.5x 10.4x
Equity Value / Earnings
2003 (Curr.) 20.8x 17.9x
2004 (Prosp.) 18.5x 15.5x
Comparable universe
Being a numerically easy exercise, multiples valuation requires

in-depth understanding of the target company and its peers.
The relative valuation multiples are only useful if the companies
are a comparable peer group. Similarly, comps valuations are
based on applying the valuation multiples of one company (or a
group of companies) to value the target business.
As no two companies are exactly the same the most similar

companies are sought. The companies (both target and
comparable) should have similar:
• Business activities – industry, products and distribution

channels
• Size
• Growth profiles (including seasonality and cyclicality)
• M&A profiles
• Profitability profiles
• Accounting policies
• Market liquidity of securities
• Breadth of research coverage.
Additionally, if equity level comps are to be used, similar capital

structures are essential.
In conclusion
Select the universe of comparable companies carefully – more

is not necessarily better.
Sources of information
Information Source
List of Sector brokers’ reports
comparable Bloomberg
companies Hoovers
Prospectuses (often have a “Competition”
section)
Share price Datastream or Bloomberg
Shares Most recent annual report (or interim
outstanding results or 10Q) updated for any subsequent
changes – for UK companies see Regulatory
News Service (RNS) for changes
Bloomberg
Options Most recent annual report (or, unusually,
outstanding interim results or 10Q) updated for any
and exercise subsequent changes reported
price of Companies reporting under US GAAP will
options disclose the weighted average exercise
price
Debt and Most recent annual report or more recent
cash interim results or 10Q
Preference Most recent annual report or more recent
shares interim results or 10Q
Minority Most recent annual report or more recent
interests interim results or 10Q
Income Most recent annual report (or more recent
statement interim results or
information 10Q if last 12 months [LTM] analysis is to be
done)
Forecast Broker research
financials I/B/E/S database (the median of all
estimates)
General Extel cards and Datastream 101A
information
Note:
• All source documentation should be marked to show where

information has been extracted from with both a Post-it
showing the page and a highlighter showing the numbers used
• When choosing a broker, make sure the numbers are sanity

checked with Global Estimates to make sure the analyst’s
projections are in line with peers
• Footnotes should be used for all assumptions and points of

interest.
From Equity Value to Enterprise Value
Enterprise value (*) = Equity Value (**) + Net Debt (***) + Minority Interest
1. Example continued – Enterprise value
Tesco
Share price (p) 261.5
Number of Shares (m) 6,932
Equity Value (£m) 18,127 [A]
ST Debt 1,413 [B]
LT Debt 1,925 [C]
Cash & cash equivalents
(liquid resources) (534)
[D]
Net Debt 2,804 [E]=[B+C+D]
Minority Interest 36 [F]
Enterprise value (£m) 20,967 [A +E + F]
Enterprise value (EV)
Enterprise value is also referred to as:
• Total enterprise value (TEV)
• Entity value (EV)
• Gross value (GV)
• Total capitalisation
• Firm value (FV)
• Aggregate value
• Leveraged market capitalisation (LMC).
The terms are used loosely and generally interchangeable. If

used in a critical context we should define exactly what is
meant by them.
Equity value (Eq.V)
Equity value (Eq.V) is also referred to as:
• Market capitalisation (MC).
Net debt
Net debt components may be spread around the balance sheet

in:
• Liabilities due after more than 1 year
• Liabilities due within 1 year
• Cash at bank and in hand
• Investments or marketable securities (held as current assets).
UK companies must disclose an analysis of their net debt

(typically in a note to the accounts).
Preference share capital
Despite falling outside the above definition, preference

share capital may be included within net debt for analysis
purposes as it has many of the attributes of borrowings
without meeting the definitional and legal requirements of
borrowings.
The enterprise value is made up of different elements of the

capital structure adopted by a company. The way this EV is
used in comps is independent of this capital structure. For
example, a company may have an enterprise value of $1bn; this
could be made up as follows:
When to use Equity Value vs. Enterprise Value
Impact of capital structures on multiples
Company A Company B
Capital structure
Equity 200 500
Net debt 300 –
Minority interest – –
P&L
Sales 150 150
EBIT 35 35
Net interest (25) –
PBT 10 35
Earnings 7 25
Multiples
Enterprise value / Sales 3.3x 3.3x
EBIT 14.3x 14.3x
Equity value / PBT 20.0x 14.3x
Earnings 28.6x 20.0x
2. Example continued – the multiples
Tesco
(£m – except per share)
Enterprise value 20,967
Share price (p) 261.5
2001A 2002E 2003E
Sales 20,988 24,306 28,212
Enterprise Value / Sales 1.00x 0.86x 0.74x
EBITDA 1,663 1,950 2,230
Enterprise Value / EBITDA 12.6x 10.8x 9.4x
EBIT 1,187 1,352 1,556
Enterprise Value / EBIT 17.7x 15.5x 13.5x
EPS (p) 11.5 12.6 14.1
P/E (Equity Value / Earnings) 22.7x 20.8x 18.5x
Which multiple?
The relevance of the different valuation benchmarks changes

over time as business models evolve. Consequently, two key
questions must be asked when selecting multiples:
• What is the development stage of the target company relative

to comps?
• What is the appropriate comps universe trading on?
Pros Cons
EV/Sales • Suitable for companies with similar • Does not take into account varying
business model / development stage revenue growth rates
• May be the only performance related • Does not address the quality of
multiple available for companies with revenues
negative EBITDA
• Does not address profitability issues
• Sectors where operating margins are
• Inconsistency of treatment within
broadly similar between companies
sales of joint venture in different
• Companies whose profits have reporting environments
collapsed
• Different revenue recognition rules
• Sectors where market share is between companies
important
• Limited exposure to accounting

differences
EV/EBITDA • Incorporates profitability • Ignores depreciation / capex
• Most businesses are EBITDA positive • Ignores tax regimes and tax
so widening the universe profiles
• Ignores the most significant accounting • Does not take into account varying
differences arising from goodwill EBITDA growth rates
• Relatively limited exposure to • Inconsistency of treatment within

accounting differences EBITDA of joint venture and other
unconsolidated affiliates within
different reporting environments
• Other accounting differences such as

revenue recognition, capitalisation
policies, finance vs. operating leases
EV/EBIT • Incorporates profitability • Depreciation / amortisation policies

may differ
• Useful for capital intensive businesses
where depreciation is a true economic • Ignores tax regimes and tax profiles
cost
• Does not take into account varying
• Good for companies within the same EBIT growth rates
reporting environment where
• Inconsistency of treatment within EBIT
accounting differences are minimised
of joint venture and other
unconsolidated affiliates within
different reporting environments
• Other accounting differences such as

revenue recognition, capitalisation
policies, finance vs. operating leases
P/E • Widely used in traditional industries • Depends on corporate structure

with high visibility of earnings
• Accounting policies have a significant
• Widely understood impact on earnings
• Quick and easy calculation
• Useful to check DCF exit assumptions
In conclusion
By understanding the industry through reading analyst reports

and news stories it will become clear:
• What are the most important performance ratios and market

multiples to focus on?
• Are there any industry specific statistics (e.g. hotels – price per
room)?
Using comps
Illustration
Company X is to be valued using Company Y as a comparable

company.
Company X Company Y
Capital structure
Equity value ? 1,000
Net debt 200 –
Enterprise value ? 1,000
P&L
EBITDA 170.0 170.0
Depreciation & amortisation (22.0) (22.0)
Operating profit 148.0 148.0
Net interest (20.0) -
PBT 128.0 148.0
Tax at effective rate of 30% (38.4) (44.4)
Earnings 89.6 103.6
Multiples
Enterprise value / EBITDA ? 5.88
Equity value / earnings ? 9.65
Valuing Target – Company X
At equity level
Metric of target earnings of X 89.6
Multiple of similar quoted company p/e of Y 9.65x
Theoretical equity value of target 89.6 X 9.65= 865

(Company X)
At enterprise level
Metric of target ebitda of X 170
Multiple of similar quoted company ev/ebitda of Y 5.88x
Theoretical enterprise value of 170X5.88= 1,000

target
Less: net debt & minorities of (200)

target
Theoretical equity value of target 800

(Company X)
How to use Comps
Comparables Company Entity Value Net Debt Equity Value
Companies Financials (£m) & MI (£m)
Multiples (£m) (£m)
Ranges
Sales Curr. 0.50x–0.85x 100 50–85 10 40–75
Prosp. 0.47x–0.75x 106 50–80 10 40–70
EBITDA Curr. 7.5x–10.5x 7.3 55–77 10 45–67
Prosp. 6.5x–9.5x 7.9 51–75 10 41–65
EBIT Curr. 12.5x–15.5x 5.1 64–79 10 54–69
Prosp. 10.5x–13.5x 5.5 58–74 10 48–64
Earnings Curr. 18.0x–21.0x 3.0 – – 54–63
Prosp. 15.5x–18.5x 3.3 – – 51–61
High 75
Low 40
Average 57
Median 58
Estimated Equity 55-60

Value (£m)
Special situations
Adjustments may be needed to the metrics and/or the

resulting equity or enterprise value when the following
issues arise in the target and / or the comparable company:
1. Currency
2. Annualisation
3. LTM (last twelve months)
4. Exceptional items
5. Dilution
6. Convertible debt
7. Mezzanine finance
8. Market value of debt and / or preference shares
9. Associates and JVs
10. Minorities
11. Pro forma: disposal, acquisition.
The over-riding idea behind Comps is to ensure that there are

like-for-like comparisons. Consequently, if one of the
companies in the Comps group has significant associates whilst
its peers do not, then an inconsistency exists amongst the
group. The metrics of the company with the associate need to
be adjusted to remove the inconsistency and maintain the idea
of comparable companies.
Currency
Multiples (e.g. EV/EBIT) are independent of currency provided

that both numerator (e.g. EV in $m) and denominator e.g. (EBIT
in $m) are in the same currency. Consequently, keep financials
and market capitalisation in the (same) local currency – there is
no need to translate to target’s currency.
For the Euro-zone incorporated companies, convert financials

into Euros as the exchange rates have been fixed and the
stocks are already trading in Euros.
Always use the share price traded on the primary exchange

(Bloomberg: RELS).
Annualisation
Financials should be adjusted for:
• Different year-ends
• Seasonality of business
• Growing / declining activity.
e.g. to annualise to December a company with a March

financial year-end
Alternatively, the annualisation can be done using quarterly or

monthly accounts if these are available. For companies quoted
in the US, published quarterly information will enable this.
LTM
LTM (Last Twelve Months) numbers are useful where the profits
of the comparable businesses are growing (or declining)
significantly and/or are seasonal. In these situations,
annualising numbers (by pro-rating on a time basis) may be an
over-simplification of the profits generated in a particular time
period and may not be indicative of the companies’ most recent
trading performances.
Where companies have produced quarterly or half-yearly

accounts, more upto-date profit figures can be generated. For
example, a US company with a year end of 30 November, may
have just produced its quarterly results (10Q) for the 3rd
quarter to 31 August 2006. Therefore, to find the most recent
trading performance, LTM to 31 August 2006 would be
calculated and compared with the LTMs (not necessarily all to
31 August) of comparable businesses. The LTM would be
calculated as:
Exceptional / extraordinary items
Exceptional and extraordinary items are characterised by:
• Their unusual nature (unrelated to ordinary business

activities)
• The infrequency of occurrence (i.e. not expected to happen

again).
The rules vary in different countries as to what should be

classified as exceptional or extraordinary. For example, in the
UK it is not possible to have extraordinary items, whilst in
France, certain items must be classified as extraordinary.
Additionally, companies would prefer losses and charges to

be classified as exceptional in order that underlying profits (ie
valuation metrics) are unaffected by such bad news.
Consequently, the notes to the accounts should be examined
to determine which items are true exceptionals /
extraordinaries and worthy of exclusion.
Exceptional / extraordinary items include:
• Restructuring charges
• Profits and losses on disposals
• Financing one-offs (e.g. debt redemption above book value,

etc.)
• A share in unconsolidated affiliates’ exceptional items.
True exceptional and extraordinary items should be stripped

out.
Where adjusting net income (for equity level comps) refer to

the tax notes in the accounts to find the tax effect of
exceptionals. If not available use the effective or marginal tax
rate.
Example
Compco Adjustments Pro forma
Sales 100 - 100
Exceptional (20) 20 -
EBIT 5 20 25
Net interest (2) - (2)
PBT 3 20 23
Tax (*) (1) (6) (7)
Earnings 2 14 16
Notes: (*) Tax rate on exceptional items is assumed to be 30%.
Not all exceptionals / extraordinaries will have a tax effect. Additionally, the tax effect
of like items will be different in different countries. For example:
• Reorganisation / redundancy provisions
• In the UK it is unlikely that tax relief will arise
• In Germany it is likely that tax relief will be received
• Property write-downs / impairments
• In the UK tax relief will not arise
• In Germany it is likely that tax relief will be received.
Associates and JVs
Earnings from associates / joint ventures are not always directly

comparable. For example, income from associates is reported:
• In the US, as share of profit after tax (as one line)
• On the Continent, often as share of profit before tax (although

could be share of profit after tax) – as one line
• In the UK, as share of EBIT and proportionally consolidated for

the post EBIT P&L.
Additionally, income from joint ventures is reported:
• In the US, as per associates in one line
• In the UK, as per associates but with additional disclosure

about sales of the joint venture
• On the Continent, may be proportionally consolidated or as

per associates depending on jurisdiction.
When material, Associates and JVs should either be:
• Consolidated in proportion (including debt); or
• Excluded and valued on a separate basis
When not material, Associates and JVs may just be included in

EBIT.
Illustration
CompCo has a 40% stake in AssocCo.
CompCo AssocCo
Market value of equity 90 55
Net debt 30 10
Sales 100 50
Operating profit 20 12.5
Associate 5
EBIT 25
Consolidate in proportion (including

debt)
This method is used if:
• A joint venture is proportionally consolidated (i.e. the

proforma numbers are already presented in the consolidated
accounts); and / or
• The associate / joint venture has similar activities and growth

prospects to the CompCo so that it is appropriate to apply the
same multiples to both parts of the business.
CompCo Adjustment Pro forma
Sales 100 20 120
EBIT 20 5 25
Equity value 90 – 90
Net debt 30 4 34
Enterprise 120 4 124

value
EV / Sales 1.03
EV / EBIT 4.96
The equity value of CompCo includes the market value of

its stake in AssocCo.
Exclude and value on a separate basis
The market has valued CompCo’s equity value to include that of

the associate / joint venture whereas the P&L metrics do not
include the associate / joint venture. Where the two companies
have different activities or growth prospects the resulting
metrics are not appropriate for all parts of the business.
This method is appropriate where the associate / joint venture

has different activities or growth prospects to the CompCo.
The multiples that are derived are the multiples of CompCo’s
business only.
CompCo Adjustment Pro forma
Sales 100 – 100
EBIT 20 – 20
Equity value 90 (22) 68
Net debt 30 – 30
Enterprise 120 (22) 98

value
EV / Sales 0.98
EV / EBIT 4.90
Minorities
Enterprise value is measured at the market value of all its

components. Minorities are a constituent part of enterprise
value and should, when representing significant value, be
valued at market value. Otherwise they should be included at
book value.
Where the subsidiary in which the minority arises is quoted the

market value of the minority can be derived.
Practical difficulties in arriving at the market value of minorities

exist where the subsidiary in which the minority arises is
unquoted. Unquoted minorities will have to be valued on a
separate basis.
Illustration
CompCo has a 75% stake

in SubsidiCo.
CompCo SubsidiCo
Market value of equity 80 70
Net debt 40 25
Shareholders’ funds 30
Minority interest in 7.5

SubsidiCo
Sales 100 60
EBIT 20 12
PBT 16 10
PAT 11 6
Minority interest (1.5) –
Net income 9.5 6
Using book Using market

value value
Equity value 80 80
Net debt 40 40
Minority interest 7.5 17.5 (25%x70)
Enterprise value 127.5 137.5
EV / Sales 1.28x 1.38x
EV / EBIT 6.4x 6.9x
Equity value / net income 8.4x 8.4x
Finance and operating leases
To acquire the use of an asset such as an aeroplane, a

business may buy the asset or lease the asset. This leads to
three distinct ways in which the financing of the operating
assets of a business is accounted for:
Illustration
3 airlines have acquired the use of a plane with a cash price of

€95m.
Company A has bought the plane (10 year life) using cash on
which it was earning a 4.0% return.
Company B has leased the plane on an 8 year lease paying

€16m per annum (the implicit interest rate on the lease is
7.15%) – this will be treated as a finance/capital lease.
Company C has leased the plane on a 3 year lease paying €18m

per annum – this will be treated as an operating lease.
After one year the impact on the financial statements of the

acquisition of the asset would be:
Company A Company B Company C
(borrow to) buy Lease
Finance / capital Operating
Income statement
EBITDAR – – –
Rental expense – – (18.0)
EBITDA – – (18.0)
Depreciation (9.5) (11.9) –
EBIT (9.5) (11.9) (18.0)
Interest expense (3.8) (6.8) –
Pre-tax profit (13.3) (18.7) (18.0)
Balance sheet
PPE 85.5 83.1 –
Cash (98.8) (16.0) (18.0)
Debt – (85.8) –
Retained earnings (13.3) (18.7) (18.0)
Balance sheet
Operating – – (18.0)
Interest paid (3.8) (6.8) –
Capex (95.0) – –
Debt repaid – (9.2) –
Cash flow (98.8) (16.0) (18.0)
Consistency of metrics
For comps purposes, the above example illustrates that where

comparable businesses finance their operational assets using
different financing arrangements, the impact on the profit
metrics can be significantly different. For example, for airlines,
the comparability of EBIT or even EBITDA is limited. EBITDAR
should be the metric of choice where comparing the underlying
trading performances of the business.
Alternatively, the operating leases could be converted

(mathematically) into finance leases. For example, in the above
illustration, the breakdown of the finance lease charge in the
income statement is approximately 1/3 interest and 2/3
depreciation. This rule of thumb has been identified by the
credit rating agencies and so adjusted metrics (e.g. EBIT) can be
calculated.
Using Company C in the illustration, the rental expense is

removed (and so standardises EBITDA) and replaced with a new
depreciation charge of 12 (18 X 2/3) and interest of 6 (18 X 1/3). If
this simplifying assumption is accepted, then the result is that
EBIT and all subsequent multiples are similarly standardised no
matter how the operating assets have been financed.
Adjusting EV
If EBITDAR is the metric of choice (or the adjusted EBITDA),

then EV / EBITDAR should be the multiple. However, EBITDAR
(by definition before rentals, depreciation and interest) is
independent of the method of finance of the asset. Where the
asset has been acquired outright or has been finance leased,
the net debt (a component of EV) has been increased whilst
the operating lease obligation remains off-balance sheet.
For consistency between EV and EBITDAR, operating leases

should be converted into finance leases, by calculating the
present value of the minimum lease commitments. A schedule
of payments and the appropriate discount rate are needed to
do this – neither of which is likely to be presented in financial
statements.
Illustration
A company has a corporate borrowing rate of 7.5% and a

disclosed schedule of operating lease payments:
Discount 7.50%
rate
Year 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Op lease 75 72 65 60 58 58 51 46 45 45 30 30 18 12 10
payments
Present 70 62 53 45 40 38 31 26 23 22 14 13 7 4 3
value
PV of lease
payments
(capitalised 451
operating
leases)
The illustration would be difficult to recreate in practice due to

a lack of disclosed information. Additionally, the derived value
of €451m is very sensitive to the length of the leases and the
discount rate:
• The longer the lease terms, the higher the present value of
the lease payments
• The lower the discount rate, the higher the present value of
the lease payments.
For example, if a company’s corporate borrowing rate is

assumed to be the applicable rate for refinancing the operating
leases then the present value of these commitments will be
higher than if the WACC was used.
Additionally, as the leases end they may need to be replaced

and so the lease terms may be indefinite.
As a result, credit rating agencies and analysts simply capitalise

operating leases into net debt by multiplying the annual
operating lease charge by a factor. This factor varies between

5.5 and 8.5 depending on the sector (due to typical length of
leases and discount rates). This factor approximates to an
appropriate annuity factor.
Unfunded pension obligations
Where a business has guaranteed a minimum pension to

employees on retirement, it must make payments into the
pension scheme to meet these future obligations – a defined
benefit scheme. These payments will be invested by the
pension scheme with the intention of meeting the future
pension requirements when they fall due. As time moves on,
employees within the scheme will be getting closer to
pensionable age and may also be entitled to greater pension
payouts as they continue to work for the business.
As a result, it is possible to calculate the pension deficit – the

difference between the market value of scheme assets and the
present value of liabilities to scheme members.
Scheme value of assets 3,921
Present value of scheme liabilities (5,760)
Net pension scheme deficit (1,839)
In simple terms, if a business has not made sufficient payments

to the pension scheme, then the scheme is likely to be in deficit.
Comparable companies which have historically made sufficient
cash payments into the scheme (no deficit) will consequently
have different net debts to companies with deficits.
The accounting issues
The accounting for defined benefit pension schemes is

notoriously varied depending on which accounting regime is
followed.
Adjusting net debt
As defined above, the net pension scheme deficit of €1,839 is

unlikely to be recognised on the balance sheet (although some
variant of the calculation may be). However, when using either
US GAAP, UK GAAP or IFRS, this figure is disclosed in the

accounts and so international comparability can be achieved.
As payments into pension schemes are tax deductible, any

payments made to reduce this deficit will reduce taxes payable.
Consequently, assuming a corporate tax rate of 30%, the
adjustment to net debt would be an extra €1,287 [€1,839 X (1-
30%] of “debt” to make it comparable to a business which has
already made up any deficit.
Adjusting profit
As with the accounting (or non-accounting) in the balance

sheet, internationally the income statement effects will vary.
Once more, US GAAP, UK GAAP and IFRS disclose (though don’t
necessarily recognise) similar figures.
Where EBIT or EBITDA is the metric of choice, the most relevant

element is the current service cost – being the increase in the
projected benefit obligation (present value of scheme liabilities)
due to employees working for the company during the period.
Consequently, to calculate EBIT or EBITDA, the existing

accounting for pensions in the income statement (which
may well have significant international variation) should be
removed and replaced with the current service cost (as an
operating expense).
Illustration
A company with an EBITDA of €553m and net debt of €1,938m,

and which suffers corporate tax at the rate of 30%, has a
provision in its balance sheet for pensions of €57m and a
pension charge in operating expenses of €64m.
Disclosed in the notes to the accounts is the following

information:
Net pension scheme deficit €1,839m
Current service cost €92m
Pension contributions paid to scheme €88m
Revised net debt
Net debt as originally stated €1,938m
Net pension deficit (post tax) [1,839 X (1– €1,287m

30%)]
Adjusted net debt €3,225m
Revised EBITDA
EBITDA as originally stated €553m
Add: original pension charge €64m
Less: current service cost (€92m)
Adjusted EBITDA €525m
Note
Due to international tax complexities, the tax treatment of the

existing and revised accounting may be substantially different
and so adjusting post tax profits will prove onerous.
Consequently, EPS adjustments are likely to be intricate.
Keys to success
1. Understand the industry by reading analyst reports and

news stories
• What are the industry specific statistics (sales /
employee etc.)?
• What are the most important performance ratios?
• What are the most important market multiples?
2. Select the universe of comparable companies carefully –
more is not necessarily better.
3. Use the most recent published financials
• Check the web site and the financial calendar of the
individual companies to ensure that the most recent
published financial information is used
4. Use only the most appropriate broker
• Ensure that the research is recent and subsequent to
any company result announcements
• Ensure that the forecast numbers are similar to global
estimates
5. All source documentation should be marked to show where
showing the page and a highlighter showing the numbers
used
6. Use footnotes
• To disclose adjustments made to the numbers
• To explain unusual operating and financial trends
7. Always reconcile the broker historicals to the published
historicals – this will help to understand how the broker has
defined key metrics, e.g. EBIT and EPS, so that the historics
and the forecasts can be input using the same adjustments
8. Ensure that the numbers are comparable – potentially, the
more adjustments made for special situations (true
exceptionals / non-recurring items, dilution, associates
etc.), the more comparable, but:
• The more time to input the comps
• The less likely that all the desired adjustments will be
visible in the brokers’ research forecasts
• The more chance of errors
9. Keep the comps analysis up to date
• Check the web site and the financial calendar of the
individual companies to ensure that the most recent
published financial information is used
• Update share prices

• Update exchange rates
10. Check your work
• Double check for data entry or other processing mistakes
• Step back and look at the finished product – do the results
make sense?
• Get someone else to check your work
11. Understand the results of the analysis and be prepared to
discuss them.
Precedent transactions
analysis
Introduction
out our online courses Precedent transactions, also known as comparable
transactions, comptrans, transaction comps or premium paid
analysis, are used to derive an implied market valuation for a
company, either public or private, in an acquisition context.
Precedent transactions reflect the market value of a target’s

income stream in a takeover situation.
Precedent transactions look at recent acquisitions in the

relevant sector from which valuation multiples can be derived
by dividing the transaction value by the target company’s
financials. These valuation multiples are applied to the
company being valued in order to give a theoretical value of the
business.
Relevant transactions
Precedent transactions look at recent acquisitions in the

relevant sector. Comparable transactions are selected to
include corporate activity of companies with similar business
activities and ideally operating in the same geographical areas.
As no two companies or transactions are exactly the same the

most similar companies and transactions are sought. The
target companies (both precedent and intended target)
should have similar profiles, i.e.
• Business activities – industry, products and distribution

channels
• Size
• Growth profiles (including seasonality and cyclicality)
• Profitability profiles
• Accounting policies
• Public vs. private.
Additionally, the transactions should, ideally:
• Be for similar acquisition proportions
• The premia for a 30% stake will be lower than for a

100%
• Be for similar considerations (cash vs. debt vs. equity)
• It is likely that a 100% cash offer will be at a lower price

than a 100% equity offer
• Involve similar bidder companies (trading vs. private equity)
• Private equity acquirers do not value synergies in their

offer price
• Arise during similar equity market conditions – recent

transactions are:
• A more accurate reflection of the values buyers

currently are willing to pay since the public equity
markets and the availability of acquisition finance can
change dramatically in a short time period
• More relevant than older transactions because more

recent transactions are more indicative of the current
market environment. However, historical transactions
can be used to highlight trends in a particular industry
• Have similar transaction profiles (recommended offer vs.

hostile bid vs. contested).
Consequently, it is better to use a small number of relevant

comps rather than a large amount of less relevant ones.
Mechanics
Summary transaction
information
Data Description
Date Announcement and/or closing date

of transaction
Bidder Bidder name including parent

name if bidder is a subsidiary
Target Target name including parent

name if target is a subsidiary
Target - business Very short description of target’s

description business activity
Local currency Currency in which the transaction

took place
Acquired stake % of the target being acquired

(usually 100%)
Equity value Equity consideration to be paid by

the bidder
Grossed-up equity The equity value adjusted when the

value acquired stake is less than 100%, to
reflect the equity value for 100% of
the target
Net debt acquired Typically, the net debt of the target.

However, special arrangements are
possible whereby the acquisition is
debt-free or the bidder agrees to
take on only part of the target’s
debt
Implied enterprise Grossed-up equity value plus net

value debt acquired
Sources of information
Information Source
List of sector SDC

corporate activity
M&A Monitor
Sector brokers’ reports
When target is a public company
Offer details Offer documents
Reuters articles
Regulatory News Service (RNS) for

UK companies
Historic target Annual report and offer document

data – last P&L
Annual report or interim results –

last BS
Forecast target Broker research

data
When target is a private company / division /

subsidiary
Historic target Parent annual report – last P&L

data
Press articles and RNS (for UK
companies) – sales & profit
Note:
1. Historic and forecast data for the target company should be

extracted from the most recent relevant research immediately
prior to the transaction being announced – the transaction was
negotiated based on these numbers and the current
transaction will be based on comparable research
2. All source documentation should be marked to show where

showing the page and a highlighter showing the numbers used
3. When choosing a broker, make sure the numbers are sanity

checked with Global Estimates to make sure the analyst’s
projections are in line with peers
4. Footnotes should be used for all assumptions and points of

interest.
Exchange rates
Always make sure you are using the same currency in both
numerator and denominator:
• P&L historic – use average exchange rates for the period
• P&L forecast – use most recent exchange rate
• B/S – use the exchange rate at the date of the BS
Deferred payments
When acquiring a business, a company may defer part of the

consideration it offers, or hold back a proportion of the
transaction value. This may arise:
• Where the management of the target company hold

significant stakes in the business, thereby ensuring they
continue to work for the company post-acquisition
• Where the consideration is withheld and is payable upon the

acquired company meeting or exceeding the projections
contained within its business plans
• Tax restructuring reasons.
When calculating multiples for a transaction in which there is

deferred consideration, ensure the terms of how it has been
created are noted. Include both values and the range of
multiples if possible.
Equity value vs. enterprise value
The equity and enterprise values are always for 100% of the
target company. If Bidder buys 50% of Target, the equity and
enterprise values are the implied values for the entire
company.
If Bidder buys less than 100%, the amount paid represents a

portion of the equity value. Enterprise value is calculated by
grossing up the equity value to 100% and adding net debt.
However, if Bidder buys all of Target, Bidder will also assume all
of Target’s liabilities, and what is described as “amount paid”
might or might not include the debt. It is important to
understand what the amount paid represents to avoid
calculating incorrect transaction multiples.
Share options and convertible debt
In-the-money share options (and all Long Term Incentive Plans,

LTIPs) will be exercisable upon the acquisition and so should be
converted (using the treasury method – i.e. after accounting for
exercise price) when calculating the equity and enterprise
values.
Similarly, convertible debt may be convertible into shares.

Equity and enterprise value must be adjusted commensurately.
The multiples
Examples of multiples
Sales multiple Enterprise Value / Sales
EBITDA multiple Enterprise Value / EBITDA
EBITA multiple Enterprise Value / EBITA
EBIT multiple Enterprise Value / EBIT
Price / Earnings multiple Equity Value / net income
Net assets multiple (Equity Value + Minority

Interests) / Net Assets
Growth ratios
(Yr0 metric / Yr1 metric) –1
Margins
Profit metric / Sales
Private transaction multiples
By looking at historic precedent transactions, valuation

multiples can be derived by dividing the transaction value by
the target company’s financials.
𝑐𝑎𝑠ℎ 𝑝𝑎𝑖𝑑 + 𝑑𝑒𝑏𝑡 𝑎𝑠𝑠𝑢𝑚𝑒𝑑 (𝑖𝑓 𝑎𝑛𝑦)

𝑚𝑒𝑡𝑟𝑖𝑐
Public transaction multiples
As for private transactions, by looking at historic precedent

transactions, valuation multiples can be derived by dividing
the transaction value by the target company’s financials (or
other metric such as subscribers, square feet, etc.).
(𝑜𝑓𝑓𝑒𝑟 𝑝𝑟𝑖𝑐𝑒 𝑋 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠) + 𝑑𝑒𝑏𝑡 𝑎𝑠𝑠𝑢𝑚𝑒𝑑 (𝑖𝑓 𝑎𝑛𝑦)

𝑚𝑒𝑡𝑟𝑖𝑐
For a public company transaction, the premium paid alludes to

the fact that a bidder will typically pay a premium above the
market valuation to obtain control over the target.
Valuing the target
The valuation multiples calculated from precedent transaction

are applied to the relevant metric of the target company being
valued in order to give a theoretical value of the target
business.
There are a number of different ways to select the appropriate

transaction multiple from the transaction database:
• Average / median of the transactions
• Average excluding outliers
• Range around the average
• Identify highest and lowest likely prices.
The best method will depend on:
• The quality of the information going into the precedent

transactions database
• Who is the audience?
• What is the situation?
Comparable Company Enterprise Net Debt Equity Value

(£m)
Transactions Financials Value (£m) & Minority
Multiples (£m) Interest
Range (£m)
hist. 0.90x – 1.20x 100 90 – 120 10 80 – 110

curr.
Sales 0.80x – 1.10x 115 92 – 127 10 82 – 117
prosp.
0.70x – 1.00x 125 88 – 125 10 78 – 115
hist. 10.0x – 16.0x 7.0 70– 112 10 60– 102

curr.
EBITDA 9.5x – 15.5x 7.5 71– 116 10 61– 106
prosp.
9.0x – 15.0x 8.0 72– 120 10 62– 110
hist. 14.0x – 20.0x 5.0 70 – 100 10 60 – 90

curr.
EBIT 13.0x – 19.0x 5.5 72 – 105 10 62 – 95
prosp.
12.0x – 18.0x 6.0 72 – 108 10 62 – 98
hist. 25.0x – 28.0x 3.0 75 – 84 – 75 – 84

Net curr.
24.0x – 27.0x 3.5 84 – 95 – 84 – 95
Income prosp.
23.0x – 26.0x 4.0 92 – 104 – 92 – 104
High 117
Low 60
Average 84
Estimated Equity 80 – 85
Value (£m)
Checking
• Always check your work – use a calculator
• Comparable multiples should be checked with the broker to

see if they are in line
• The completed sheet should be checked by eye to make sure

there are no obvious mistakes
• Footnotes should be used for all assumptions and points of

interest.
Valuation football field
Control premia
Typically, acquisitions in the UK are made at c. 30% premium to

the company’s quoted value, representing a “premium for
control” – in certain industries, e.g. technology, this may not be
the case.
The ability to control a company has a value:
• Complete control (majority)
• Partial control (minority, significant influence, joint control).
A block of shares providing some level of control may be worth

more than the sum of the values of the single shares
i.e. 51 shares > 51 X 1 share
Consequently, transaction multiples are higher than the trading

multiples of the company.
It is theoretically not correct to compare an acquisition of 5% of

a company with a full take-over since, in the latter case, the
Bidder would have to pay a larger premium to gain control.
Consequently, purchases of small stakes, i.e. less than 25%, are
likely to be excluded from the analysis.
Why pay a premium?
The ability to control a company has a value, but value in a

corporate sense must be represented by future cash flows.
When the equity markets value a company, they are assessing
the PV of its future cash flows.
Synergies
The control premium must be justified by higher future cash

flows to the new owner. These arise through synergies:
How much additional cash can the bidder earn from the target
which is not available to:
• The market; or
• The current owner (in a private transaction)?
Synergies mean that cash flows discounted by bidders are

higher than the cash flows being discounted by the market (or
current owner). This, therefore, sets a limit on how much the
bidder can pay. If the acquisition is going to add any value to

the bidder, then the amount actually paid is generally less than
this maximum.
Consequently, precedent transaction multiples are impacted by

the split of value of synergies between target and bidder.
Drivers of equity return in an LBO
An investor in an LBO deal does not acquire with the target

the benefits of synergies as the target will continue to
operate in isolation. Consequently, the LBO team must see
different benefits from paying a premium for the target.
Benefits of leverage
• Tax savings from interest
• Downside limited to equity capital injected
• Potentially very high upside for equity holders.
Problems with precedent transactions
Relative to public comparables, it is more difficult to conduct a

valuation based on precedent transactions. It is usually difficult
to get a large enough set of transactions to calculate a
meaningful average because:
• Valuation multiples tend to be widely dispersed between

transactions
• Timing differences between transactions and the different

market conditions – recent transactions are a more accurate
reflection of the values buyers currently are willing to pay since
the public equity markets and the availability of acquisition
finance can change dramatically in a short time period
• Differing stakes (minority vs. control acquisitions)
• Access to information / quality of information
• The standard of reporting is different in different markets
• Press reports are generally inaccurate
• Inclusion of assumed debt
• Acquisition of minority stakes
• Volatility of public markets
• Calculating premia to pre-bid share price - getting the

most appropriate pre-bid price
• Had the market already moved on rumours?
• Use pre-transaction or post-transaction estimates – must

compare like with like.
PART 03
Financial modeling
Guide to the financial modeling section
These chapters lay out best practice and functionality for users
to make the most out of financial modeling using Excel 2016.
Tricks and shortcuts for Excel can be found in the Appendix to

Best practice financial modeling.
Best practice financial

modeling
Introduction
out our online courses
This chapter sets out how Excel can be controlled and exploited
to enable:
• Faster and more efficient use of Excel tools
• Better understanding of model design principles
• Reliable, robust and flexible models to be built
• Improved efficiency in identifying inconsistencies when

auditing financial models
It will also introduce the tools to better analyze and assess the
sensitivity of financial models. The aim is to provide the
practical skills to build, modify and audit an integrated and
flexible financial model.
Meeting user needs
The most common complaint about spreadsheet models is that

they cannot be understood. The lack of understanding could
be a problem for users other than the model preparer, or even
the preparer of the model when the model is revisited.
This complaint arises because models:
• Are rarely documented
• Include cumbersome formulae (difficult to understand, check

and modify)
• Include wide and / or long spreadsheets
• Are made up of purely numbers (a chart can quickly highlight

results)
• Have no consistent format
• Mix the assumptions, other inputs, workings and outputs.
Useful models are those that can be picked up and easily and
quickly understood by a reviewer. The more logical, consistent
and rigorous the model, the more confidence will be
engendered in the results.
These notes should help ensure that models are not only
logical, but can also be reviewed by others with the minimum
of effort.
Excel vs. modeling
Excel is a particularly powerful application which can be used to

generate, analyze and present both simple and complex data.
Like any sophisticated tool, when used properly, it can be
harnessed to create highly efficient, interactive and robust
financial spreadsheets.
The skills introduced by financial modeling harness the

functionality of Excel within a methodical and rigorous financial
framework which can be applied to a large number of different
applications.
Financial modeling, therefore, combines:
1. Financial skills
• The strategy of the business or project
• The product, project or industry competitive dynamics and

their value-drivers and key sensitivities
• Accounting, analysis, forecasting, structuring and / or

valuation techniques.
2. Excel functionality
• Knowledge of the mechanics of functions and tools
• How to practically apply the functions and tools
• Practical limitations of the functions and tools.
3. Robust spreadsheet modeling techniques
• Design principles
• Modularity
• Quality controls and diagnostics
• Version control
• Formulae conventions
• Format conventions
• Logical thought
• Data analysis and sensitivity.
The golden rules of modeling
The following modeling rules have been developed to:
• Enhance the quality of models
• Ensure that flexibility can be easily added
• Make models robust
• Enhance the efficiency of calculations within models
• Ensure internal consistency
• Make models easier to review.
The magic numbers
A financial model is different from a calculator. In a calculator,

arguments are input and an answer results:
• The calculator will have limited functionality
• The cumulative effects of a number of calculations are difficult

to assess
• There is limited scope to flex the inputs without doing the

calculation again
• The inter-relationships between each input / calculation

cannot easily be evaluated
Often Excel is used like a calculator but Excel has enormous

functionality which can be harnessed to create cumulative
calculations which can be flexed and enable inter-relationships
to be examined. Consequently, to use Excel efficiently for
financial modeling:
data must only ever be entered once
Therefore all dates, currencies, numbers, labels etc will be

entered once and if used in other places in the model will refer
back to this first input cell.
For example, the current year end is often the only date that is
entered. All other year ends are related back (via formulae) to
this cell. Consequently, if the date is changed, then only one
cell needs to be changed and the remainder of the model
updates automatically.
Never use hard-wired (input) numbers within formulae.

Permitted exceptions are:
Number Justification
0 Often defines start period or used to define

whether a number is positive or negative
(as part of a logical test);also used to denote
false as a flag (multiply by 0 if a logical test
is failed)
1 Often defines the first period or used to

define true as flag (multiply by 1 if a logical
test is true); starting point for and
increment for row and column counters
12 (and 7) Number of months in a year (days in a

week) – i.e. a fact
100 p in £, c in v and $ etc – i.e. a fact
365 (or 360 Number of days in a year – i.e. a fact

or similar)
All formulae should therefore only be made up of cell

references and the above 5 numbers.
Presentation issues
• Stick to consistent color-coding, e.g. inputs blue, workings

black (see Colors, size and number formats later)
• Format consistency: consistent number styles (see Styles

later) and sheet set-up (see Sheet consistency later) enables
quick interpretation of the results
• Shade areas in different colors for ease of navigation (some

sheets may be large)
• Develop a consistent sign convention across all workings, e.g.

all numbers are positive unless unusual
• Never hide columns or rows. If data is to be hidden, group

the data (see Group outline later). It is then obvious to the user
Formula construction
• Always refer back to the original reference unless it becomes

onerous to do so. For example, if EBITDA is used in many
different places, the cell where it was first calculated / input
should always be the reference for all other cells. This will
speed up calculation and reduce the file size
• The rule of two-thirds: if the formula takes up more than 2/3

of the formula bar, then it is too long
• The worksheet is 256 cells wide and 65,536 cells deep -

over 16.7 million cells to play with per sheet
• Breaking down long formulae into several steps makes

them easier to understand and edit
• Where possible, use logical operators (AND, OR, etc.)

rather than nested IF functions
• Use flags (e.g. for dates, event triggers) where possible

to shorten formulae
• Avoid the macho
• The shortest formula is often, though not always, the

best. ‘=MAX(0,D16)’ and ‘=IF(D16<0,0,D16)’ do exactly the
same thing. However, the first belongs to the macho
school of modeling (adopt a clever formula whenever
possible), whilst the second is widely understood
• Do not create circular references
• They slow down calculations and may cause Excel to

crash
• Results depend on Excel settings (in the Tools; Options;

Calculations menu), i.e., maximum iterations and
maximum change
• Once a circular reference has been created, it is very

easy to add further circular references without being
aware of it
• They can almost always be avoided with more careful

formulation or automated goal seeks. However, in the
interests of time you may be able to tolerate it if you
close the circularity whilst editing the model (for example
by having some sort of switch) (see later)
• Row consistency: where possible, avoid changing formulae

across a single row (see F5-Special later)
• Try to keep to one row / one formula
• If unavoidable, highlight the non-standard cells
• A reviewer needs to be confident that there are no

hidden fixes in individual cells
Other best practice modeling rules
• Only name those ranges/cells that will be used away from the
near vicinity (see Names later)
• Insert notes/comments where it may not be obvious what the

logic is (for easy review)
• When deleting data at the end (either vertically or

horizontally) of a sheet, use Edit, Clear All across the whole area
– this will re-set the size of the sheet in the memory, making it
easier to identify the reference of the bottom-right of the active
sheet: (short cut - Ctrl-End) and may significantly reduce the
size of the file
• Make all check digits positive for ease of use in subsequent

conditional statements (see Common problems with IF
statements and some simple solutions later)
• Use the mouse as little as possible – keyboard shortcuts will

make you faster, more efficient and less prone to errors when
using Excel. If possible cut down your toolbars to the bare
minimum and organize them so that the ones which are
onerous to access without using the mouse are at either ends
of the toolbars for easy access using Alt; Ctrl-Tab
Introducing the Ribbon

Above is a screen shot of the typical workbook layout. This
menu and toolbar layout is called the Ribbon. The Ribbon icons
are within the menu functions, making it better for navigation
for those who prefer using a mouse. Most modellers however,
are more efficient and accurate without the mouse. Menus can
still be accessed via the keyboard by using the Alt button
followed by the relevant letter(s) that has been allocated to
each button.
Pressing Alt once reveals the keyboard letters required to

access the main menus.
Pressing W on the keyboard reveals the ‘View’ icons.
See the table below for an overview of what is contained within

each Ribbon Tab.
There is enhanced grouping and extra menus.
The commands available in the Ribbon vary depending on

which tab has been selected. As a quick overview the main
elements of the Ribbon are:
Tip: Look out for underlined letters to help navigate using the
keyboard.
Ribbon tab Overview Short cut to

access
Home This contains the basic Alt-H

formatting tools, cut,
copy and paste as well
conditional formatting
Insert Used for inserting graphs, Alt-N

pivot tables, illustrations
and text
Page layout Includes the Alt-P

functionality for
altering the look of the
workbook and printing
requirements
Formulas Includes the Excel formula Alt-M

tools and the naming
functionality and
management
Data Data related commands Alt-A
Review Includes all the proofing, Alt-R

track changes and comment
management
View Management of windows, Alt-W

view options and zooming
Developer Macro functionality Alt-L (see

and the switch (VBA) below)
tools used for scenario
management building
Developer
The developer menu does not appear as standard but can be
added easily. Left click on the Office Button (Alt-F), select Excel
Options (Alt-I) and then select “Show Developer tab in the
Ribbon” (Alt–D).
All commands can be added to customise the Quick Access

Toolbar.
To hide or display the Ribbon use Ctrl-F1 or right click on the

Ribbon and select ‘Minimise the Ribbon’.
Quick Access Toolbar
This toolbar can be set up to include any commands that are

useful, so the user can access them quickly with the keyboard.
Typical buttons that are useful and repeatedly used by financial

modellers would be:
• Font colors
• Fill cell
• Borders
• Cell Style (replaces style dropdown box)
• Camera
The Customize menu is located on the left side of the

navigation area. Alternatively, you can access the Customize
menu using the mouse; right click on the Ribbon and select
“Customize Quick Access Toolbar…” from the dialog box, or
use keyboard shortcut Alt-right mouse key (if you have one on
your keyboard).
Tip: Look out for underlined letters to help navigate using the
keyboard.
Individual commands can also be added to the Quick Access

Toolbar direct from the Ribbon. Select the icon, right-click;
select Add to Quick Access Toolbar.
Once in the Customize menu, commands can be chosen and

added to the QAT. Every command is included in the ‘Choose
commands from’ menu.
The QAT can be customised for an individual workbook or for

all documents using the dropdown menu below ‘Customize the
Quick Access Toolbar’ in the top right hand corner of the menu.
Once the QAT has been customised, the buttons can be

navigated easily by entering Alt and the appropriate number:
In the above example the QAT has been setup with five
commands and each can be accessed by pressing Alt and the
corresponding number:
1. Autosave (Alt-1)
2. Save (Alt-2)
3. Undo (Alt-3)
4. Redo (Alt-4)
You can choose to display the QAT either above or below the
Ribbon, (rightclick the QAT or check the box within the
Customize menu.
Page Layout menu
The Page Layout menu contains all of the page setup

requirements. If all sheets are grouped (still with the shortcut
Ctrl-shift page down), the page setup can be completed for all
sheets at the same time.
See the appendix for Ribbon shortcuts.
View menu
Excel has a menu dedicated to organising the way Excel

worksheets can be viewed. Alt-W or a mouse click will give the
user access to the View menu.
This menu will allow the user to change the workbook views
between:
• Normal
• Page layout
• Page break preview
• Custom view
The Normal view is the standard workbook view.
The Page Layout view (Alt-W-P) provides an editable print

preview option. This view will usually be used to create and
format headers and footers. Below illustrates the appearance
of the Page Layout view. The view demonstrates what the
spreadsheet will look like when printed out given the current
page set up for the workbook.
Headers and footers

To edit headers or footers, the model should be in Page Layout
view. Click into the bottom right-hand corner of Page Setup
and the click the Header/Footer tab and click Custom
Header or Custom Footer.
A new Design tab will appear,
Zoom
If a user wishes to zoom in on a part of the workbook there are
several options. You may hold Ctrl and Scroll up on your
mouse to zoom-in or hold Scroll down on your mouse to zoom-
out. Or you may use the icon on the bottom right of the sheet.
View multiple windows

A very useful tool when modeling is the ability to view more
than one window in an active workbook. Modellers can make
changes in one window, whilst viewing the impact in another.
The View menu New Window (Alt–W–N) opens a new window,

Arrange All (Alt– W–A) allows the windows to be arranged as
before.
Watch Window
The Watch Window function is found in Formulas Menu, in the
Formula Auditing grouping (Alt-M-W).
Excel Options
The Excel Options menu is:
Sub-menu Sub menu used to:
Popular Alter default fonts, sizes, number of sheet

tabs, set up live preview and mini toolbars
Formulas Set calculations, switch on iterations,

background error checking
Proofing Set the spelling check parameters
Save Set the auto save parameters and the back

up save locations
Advanced Set detailed excel options – for instance,

after pressing enter setting excel to move
the cursor downwards
Customise Customising the quick access toolbar (see

below)
Add-ins Adds in additional functionality. For

instance, the analysis tool pack add-in will
add statistical data analysis tools into the
excel workbook. For example, this would
be required for users wishing to regress
their own betas using the excel regression
tool
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Model set up
Excel set up for efficient modeling
In order to use Excel efficiently, it is worth ensuring the profile

(where possible) has been amended for the following:
Autosave
Autosave will automatically run in the background and so no

action is needed. If it is not it must be added in. To do this,
select File, Options, Save and the following dialogue box will
appear. (This may require the programme disks.)
Check the “Save AutoRecover information every” box, choose

time in minutes and press OK.
To change the settings for Autosave or switch it off, click on File,

Options, Save and the dialogue box will appear again.
Autosave, like many Microsoft innovations, is controversial

amongst modellers and a double edged sword. If you follow
the saving procedure, then Autosave is a useful tool. Crashes
will not worry you and you will not worry either about saving,
only to realise that you accidentally deleted a sheet 10
minutes ago. The worst position you will be in will be to lose a
morning’s work. Most of the time, you will only lose 5-10
minutes.
Analysis ToolPak
The standard set-up of Excel is fine for most users. However, in

some financial models, some more advanced statistical tools
and / or date functions are needed. These tools and functions
are within the Analysis ToolPak, which must be added in the
same way as Autosave:
File; Options; Select Analysis ToolPak; OK
Note 1: If you are logged into the network at the time of doing
this, your profile will be updated so that these advanced
functions are available for all future sessions.
Note 2: If the model is to be sent to others, they may not have

incorporated this add-in and so some of the calculated
formulae may appear as #NAME?. It may be necessary to
indicate that the user must go through the add-in routine to
ensure the model works effectively.
Calculation settings
File; Options; Formulas tab
1. Ensure the Enable Iterative calculation box is not selected
If the Iteration box is selected, Excel will iterate any

circularities created within the model. Circularities make
models slower to calculate, unstable and more likely to
crash. Often circularities within models are created in error
or are unnecessary. Whilst the iteration option remains off,
any circularities will be flagged (and can be eliminated).
Note: if a circularity exists and the iteration option remains off,

the calculated numbers in the model cannot be trusted.
2. Select Automatic except tables
The model will calculate automatically as the model is modified,

but F9 must be pressed whenever Data Tables are to be
calculated (see Data Tables later).
Grey background
Following this procedure Excel (together with all other

applications) will appear on screen with a grey background. It
is merely the screen color that has changed – the document will
continue to print out and be viewed by other users in the same
way as before the change.
The benefit of such a change is to allow white text to be used in

the model – this can be read on the screen (against the grey
background) but will print out as white (probably on white
paper) and so be invisible. This can be used for row / column
counters, checks etc. which may otherwise confuse the reader
of the printed model.
To set the profile to grey:
Files; Options; General; “Under Default view for

new sheets”; Select “Page Break Preview”; Open
new Spreadsheet
To undo this, select “Normal View”
Design
Time spent on design is never wasted and will be recouped

many times over while building a model. Clear design
objectives at the start (which do not change) will enable a
simple and straightforward model to be built, which should
also be transparent in structure, making it easy to use and
easier to find any mistakes.
The first step is to scope out the model. The following

questionnaire aims to help uncover the key issues which will
drive the way the model is structured and which will also
determine the user friendliness and flexibility that is required.
The questionnaire is for modellers to gather responses from

the potential users and consumers of the results (these may be
different people).
Scope questionnaire
1. Who is the customer? Who wants the outputs and why?

What are detailed questions the model will be used to
answer? What are the important outputs? Is there a
mandatory or preferred format for them? What are the key
decisions which need to be made based on the outputs?
2. What is the nature and form of the input data? How
detailed and high quality will it be? Can you set the format,
or get a commitment to format from the input data’s

author?
3. What is the legal entity or group being modeled? Is this
uncertain or likely to change?
4. Will the model be published in printed form in a prospectus
or similar? Will it be issued to third parties in electronic
form?
5. Will the model be formally audited by a third party?
6. What will the role of the model ultimately be? For example:
• A “one off” piece of analysis as part of a larger study
• A standard model to be used as a template for analysis
• The main forecasting tool to establish the structure and
amount of a public finance raising.
7. What are the critical value drivers which will need to be
flexed into the model, and what are the key operating links,
e.g. working capital / sales?
8. What is the range of structures of company or transaction
which will need to be examined by the model?
9. Are timing assumptions likely to change in the model, e.g.
do you plan to still be using the model in a year’s time when
all forecasts will need to start a year later? Is the timing of
events in the model likely to change, e.g. an acquisition, a
divestment, the start of operation of a project? If in doubt
assume the worst.
10. What detailed questions will the model answer?
• Valuation
• Financing structure optimisation
• Liquidity planning.
11. Will borrowing or holding assets in foreign currencies need
to be modeled?
12. Will there be large changes in the level of debt?
13. Will there be significant seasonality in cash flows or
revenues?
14. What will be the inflationary environment of the company
being modeled; will real and nominal forecasts be
required?
The answers should enable the modeller to do the job clearly

understanding the levels of usability and professional polish
that the model requires.
Questions 7-14 are particularly important because they are the

typical issues of “detail” that may not be discussed at an early
stage, but which will have a fundamental impact on design

approach. It will be difficult to bring these issues into a model
which is already well developed. Again, planning and providing
for a particular development from the start will make a model
easier to work with throughout its life.
Standard models
A model is inevitably a very specific answer to a set of very

specific questions. A line of thought that occurs at some stage
to anyone involved regularly in modeling is: “A good standard
model will simplify my life and instead of building models I can
focus on analysis.”
This is perfectly reasonable but this strategy has practical

shortcomings. Creating a standard model will constrain
analysis. The standard model will always make the same
implicit assumptions; treat companies / projects / data in the
same way; and make the same approximations.
Because it is not always appropriate to look at companies /

transactions in the same way or because some companies /
transactions are very different, standard models tend to
develop in two ways:
1. They become very simple.

The result being that the analysis is largely outside the
model and only a small number of key variables are used
to get results.
If the model only performs limited analysis, it will only help
in a limited way with decision-making. What a good model
should do is give integrated and consistent analysis from
which decisions can be made.
2. They become complex with lots of flexibility, alternative

inputs and calculation sections which can be used as
necessary.
Large, complex models can become unwieldy and, if the
users are not trained or do not regularly use all parts,
sections fall into disuse because people do not understand
them, do not trust them or just do not know what they do.
Most modeling groups have one of these “all singing, all
dancing models” and they are often forsaken, not because
of any quality problems but because of lack of confidence

on the part of users and lack of familiarity.
Clear, specific objectives supported by documentation and

training is very important for the success of a standard model.
For a standard model of any complexity, documentation and
training are essential.
For any standard model to be accepted the analysis it does and

the outputs it produces must be relevant to the decisions to be
made by users. This means consultation and clear design
scope.
File naming conventions
As significant changes are made to the model, it can be efficient

to create different versions of the model. An audit trail will
therefore be created showing how the model has been
developed. If a controversial amendment or difficult procedure
is to be added a new version should be created. If the
amendments prove to be ineffective / wrong then the previous
version can be used.
Additionally, if different people are working on the model,

coming up with different version names will make the
management of the development easier.
Decide on naming convention and stick with it. It should be

obvious from the name which is the most up to date version
and should be easily identifiable in the directory, e.g.
• Project name v001 (or 001 Project name) – will be filed in file
name order
• Project name 2007 03 23 (or 2007 03 23 Project name) –

having the year followed by the month followed by the day will
file it in name order.
Never call it “project name final”. It never will be the correct

name.
Sheet consistency
The more consistent the format (colors, numbers, columns,

titles, headings, footers, views, etc.) between sheets, the easier
the construction and review. Hence a lot of the formatting of
the entire model can (and should) be done up front.
There are two methods to arrive at the same result of

consistent formatting throughout the model:
• Group the sheets and format them all together; or
• Set up one sheet and then copy it the requisite number of

times.
The first method could be dangerous as data on other sheets

may be overwritten, whilst the second method is slightly more
fiddly when trying to get the correct number of properly named
sheets. When used with the care, the first group edit option is
the more straightforward.
The steps
1. Assess how many sheets are needed (and add one – it can
always be removed). New sheets can be added by right clicking
a sheet tab, choosing Insert and Worksheet or pressing Shift +
F11
• The easiest way is to name each sheet that you think you will
need
• Use abbreviated sheet names – the shortest name that is

understandable
• It is very useful to be able to see all of the sheet tabs at

once
• Short sheet names make shorter cell addresses when

used across sheets – making formulae shorter and easier
to interpret.
2. Select all sheets to do consistent formatting (to set up group

editing)
• Control+Shift+Page Down; or
Right mouse on a sheet tab – Select All Sheets.
3. Size the columns
• Column A (small); Column B (small); Column C (big)
• Natural indents for ease of reading text / headings
• To allow sufficient “space” should it be needed
• Column D (very small)
• For check digits
• Allows the data to be selected more efficiently if there is

a natural break
• Makes naming ranges easier
• Enables creation of consistent formulae on corkscrews
• Put in all the years (and currency) - i.e. column headings
• Column E is the 1st period and then copy the sequence

across all relevant columns
• Only if a period (e.g. y/e31/8/07) is in the same column

in every sheet throughout the model can the range name
tool be used effectively
• Leave a blank column at the end of the final period (make it

small)
• Allows easy insertion of further periods if they are

subsequently needed
• Allows the data to be selected more efficiently if there is

a natural break
The final column after the blank will be used for recording
range names.
4. Fit the spreadsheet to the appropriate size
• Highlight the next column (after the range names column);

and then
• Control+Shift+→ (selects the remaining columns on the

sheet);
• Format; Column; Hide or right mouse followed by H or

Control+) (hides all the highlighted columns). To restore the
hidden columns Control+Shift+) or Format; Column; Unhide.
5. Format numbers and text (see Formatting later) – if Styles are

to be used, then this can be done following the group edit
phase.
6. Print set-up (so it is ready to go from the start). If the sheets

have been grouped together and you use the File; Page; Setup
command, the settings you specify will apply to all sheets in the
group. If, however, you run File; Print Preview and run the
Setup command from there, the settings only apply to the

current sheet, whether or not it is one of a group
• Fit to page. Landscape orientation is often chosen. If a

standard layout has been adopted, all sheets will be a constant
width but the length will differ. Page Setup offers a percentage
value, or to fit to a specified number of pages. Rather than
specifying 1 page wide by 1 page tall, the width requirement is
entered and the height is left blank
• Default margins are often too large and need to be adjusted
• Headers & footers to include file name; sheet name; date and
time; and page&[Page] of &[Pages]. At times more information
needs to be entered than the header / footer codes provide. In
a worksheet, functions such as =CELL(“filename”,A1) will return
the full path of the spreadsheet rather than the simple file
name returned by the &[file] code used in the header / footer
dialogue box
• Print titles (probably the periods) – will have to be done

outside of the group edit as they are worksheet specific
• Remove the gridlines.
Once setup is complete Print Preview should be reviewed.
Freezing panes
The Window Freeze Panes command “freezes” the rows and

columns above and to the right of the selected cells. This is
very useful as it results in the row and column titles always
being visible on the screen.
Click the View tab and select “Freeze Panes”
In this case, the freeze panes command was used in cell D10.
Model structure
The structure of a model will be a function of the results of

earlier work in understanding the modeling needs. In
particular, the output desired, the level of detail required and
the degree of flexibility necessary will have been determined in
advance.
Good model design has a logical structure in which different

modules are separated into separate sheets in a workbook. A
standardised rule-book for the creation of the various sheets
will aid easy construction and review.
The most common structure for financial models is

Assumptions; Process; Results: i.e. inputs followed by workings
followed by outputs. However, no matter what kind of model
is being built, it should have a further three elements giving a
minimum structure of six key building blocks:
1. Log sheet
2. Description sheet
3. Checks sheet
4. Assumptions (or input) sheet(s)
5. Workings sheet(s)
6. Output sheet(s).
By creating separate sheets for each of the building blocks of

the model, a reviewer is able to build up knowledge of the
model step-by-step: model genesis, model description, checks,
assumptions, process and results. It aids clarity of thought
and is easier to maintain, view and print. The twin
disadvantages of lengthier formulas and file size are more
than outweighed by these advantages.
Log sheet / To-do list
Modellers face two contrasting problems:
• Having different “current” copies of the same model
• Only having one copy of the model.
Working on the move, at home, on laptops or at clients’ offices

gives rise to various copies, all with the same name and
perhaps with only minor but significant differences between

them. Particularly when under pressure, it is easy to waste
time trying to figure out which is the latest version.
Keeping only one copy can give problems which are more
fundamental. Crashing computers which corrupt the model,
bad design or changing design needs may leave the modeller
wishing he could go back a day or two to get back to an
undamaged copy or to avoid unpicking work.
A common practice amongst modellers is to keep a log sheet in

each model and to adopt a rigorous saving procedure. A
typical log sheet looks like this:
Saving procedure
The log sheet is maintained as part of a saving procedure.
1. When commencing a development session where you will

be editing the model, on opening the model, record the
name of it in the log sheet on a new line, make some quick
notes of what you are planning to do to it and before you
commence work, save the model with a new name and use
sequential (or date) naming, i.e. give each draft a reference
number but otherwise keep the name the same
2. Switch on Autosave, but leave the prompt checked so that
Excel only saves when you want rather than when it wants
to. For users of Excel 2016, Autosave will automatically run
in the background
3. Regularly save material when you are happy with the

alterations you have made and keep a record in the log
sheet
4. At a milestone in development, or when you start another
session go back to step 1 and start the saving routine again.
Although the procedure may seem like a chore, it will give a

clear idea of where you are in development, if you reconsider
design or have to make important changes / throw out part of
the structure, the log sheet will give you another clear option,
i.e. to go back to an older version and start again, instead of
“unpicking” unwanted code out of the model.
To-do list
Modellers are frequently aware of what is outstanding on a

model. Adding a To-do list will provide a reminder of what is
still to be done (particularly useful if a number of days separate
each bout of model building) and will indicate to anyone picking
up the current version of the model where improvements are
yet to be made.
The To-do list should be kept up to date, either by indicating

the date and in which version it was completed, or by cutting
and placing it into the log once it is completed.
Description sheet
A properly documented model can be picked up and

understood by others relatively easily.
It is useful to have a separate worksheet with instructions on

how to run the model. This will allow other users to
understand how to operate the model, especially when
additional or non-conventional procedures are needed to make
the model work correctly. Common errors and their solutions
should also form a part of this sheet.
The genesis of the model can be reviewed by looking at the

log sheet (see above) and the checks sheet (see below) should
be reviewed in order to verify that there are no red flags.
However, additional assistance can be derived from a

description sheet containing the following:
• Description of the proposed transaction / analysis This brief

description should:
• Describe the purposes of the model
• Identify the key assumptions and where they are to be

found
• Identify the key outputs
• Give instructions as to how to run the model.
When done properly, this will help set the context for the
model and so make it easier to use.
• Implicit assumptions / presumptions
Certain preconditions exist within each model which may be

obvious to the modeller but unknown to subsequent users (e.g.
that all cash flows arise at the end of each period; or the model
is not time flexible).
These implicit assumptions limit the scope of the model and so

should be briefly set out on the description sheet.
• Model flow
For more complex models, a description of the links within the

model (and, better still, flow diagrams) will help users
understand the structure of the model and make review and
auditing easier.
• Author / checker
By giving details of those who have worked on the model

ownership is assigned.
Additionally, the name and contact details of the author (and

the date of their last efforts) may be useful if questions need
to be asked. If the model has been reviewed, similar details
for the checker gives a second port of call.
Additionally, adding explanatory notes into the model allows

other users of the model to understand aspects such as
assumptions, formulae etc. that may be neither obvious nor
commonly used.
It is important to keep the explanatory notes up to date whilst

the model is built. It can be hard to remember what has
been done when the model nears completion.
Checks sheet
When a model goes wrong, the modeller needs to know. It

would be unprofessional and embarrassing to print or send out
a model with errors.
To help in quickly identifying these problems a checks area is

used.
All diagnostic checks from the model are housed in this part of
the model.
For larger models with significant checks, this will form a sheet
in its own right – an example of which appears below.
For smaller models, this may be housed on the output or

description sheet.
Checks will come in two forms:
• Those that check whether the model is functioning
• Those that check the sense and logic of the outputs
Examples of checks
Historic financials
• Historic balance sheet balances
• Historic model net income ties into historic income statement

from published financial statements
• Historic retained earnings in balance sheet reconciles to

income statement
• Historic model net cash flow ties into historic cash flow
statement in published financial statements
• Historic cash in balance sheet reconciles to cash flows
• Historic debt reconciles to cash flows
Forecast financials
• Proforma balance sheet balances
• Forecast balance sheet balances
• EBITDA in income statement is internally consistent – i.e. the

income statement adds down to give the same figure
• Retained earnings in balance sheet reconciles to income

statement
• Cash in balance sheet reconciles to cash flows
• Debt reconciles to cash flows
• The sum of all the capex workings ties into financials
• Sufficient capex, depreciation and book value inputs have

been used to drive all forecasts
• The return on capital has grown from x% to y% over the

forecast period – is this justifiable?
• Operating cash flow to sales moves from the current x% to y%

in the final forecast period – is this justifiable?
• Capex/depreciation is x in the final forecast period – is this

justifiable?
• Capex to sales growth moves from the current x% to y% in the

final forecast period – is this justifiable?
Financing
• Sources of funds equal uses of funds
• Debt schedules are working
• Senior A has been repaid by the end of its term
• Senior B (Senior C etc) has been repaid by the end of its term
• Maximum revolver drawdown - um (and date)
• Equity proportion – can this be justified?
• Minimum EBITDA / Net total cash interest (and date) – is this

sensible?
• Minimum EBITDA - Capex / Net total cash interest (and date) –

is this sensible?
• Maximum Senior debt / EBITDA (and date) – is this sensible?
• Maximum Total debt / EBITDA (and date) – is this sensible?
• Minimum Fixed charge cover (and date) – is this sensible?
LBO returns
• Equity IRR is x% below the hurdle rate
• Equity cash on cash multiple is x% below the hurdle rate
• Exit multiple same as entry multiple
• DCF value is x% bigger than offer value
• Equity value creation can be reconciled to drivers of value
• Chart of equity value creation bridge matches the total value

created
DCF
• Does the present value of the visible cash flows cover the
current net debt?
• Terminal value is x% of total implied EV – is this justifiable?
• Return on capital in terminal year is x% – is this justifiable?
• Cash flow growth in terminal year is x% – is this justifiable?
• Implied growth (using Gordon's (rb) Growth Model) in

terminal year is x% bigger than the y% used in the model
• EBITDA multiple implied in the terminal value is x – does this

tie in with peer multiples?
• WACC of x% – is this justifiable?
Sensitivities / pivot tables
• The sensitivity table outputs match the model outputs
• F9 needs to be pressed to update the tables
• The pivot tables must be refreshed
Inputs & assumptions
Keeping all of the inputs and assumptions (i.e. the model

drivers) in one place is an essential element to any model. The
user needs to be confident that he or she can control the
model from this single assumptions section. Having inputs
dotted throughout the model adds to the complexity of using
and reviewing the model.
Additionally, there are some Excel tools which require like

items to be grouped on the same sheet. The most common of
these is the Data Table which is used to check the sensitivities
of key assumptions to key outputs. Data Tables can only be
created on the same sheet as the assumptions.
The exception to this idea of keeping all of the inputs in one

place is historic (financial) figures. Although inputs should go
on the inputs page, historic financials are facts rather than
assumptions driving future value, and so it is reasonable to put
them on the appropriate sheets (e.g. P&L historics on P&L
sheet).
Control panel
Having a separate assumptions sheet (or sheets) is good

discipline in any model and a logical development is to
integrate a control panel into it.
A control panel is simply an area of the assumptions sheet (or

sheets) where all of the switches, list boxes and other controls
which are used to select scenarios and pick particular
calculation bases are placed.
It is not unusual for some of the key outputs from the model to
be linked back to the control panel area, so that the impact of
changing switches or scenarios can be seen immediately.
The fundamental design issue here is that once the model is

built, it needs to be easy to use, and that means that it must be
easy to input data and to see the results changing as this is
done.
The following is an example of a control panel on an

assumptions sheet from a simple model (no outputs are linked
to this control panel in the illustration):
In this case there are relatively few controls as the model is

quite simple – there is a scenario selector for the debt structure
and a switch to allow the valuation basis to be changed from
EBITDA multiple to perpetuity.
Workings
The workings (like the outputs) are merely calculations based

on the inputs and other workings. Inputs from the input sheet
are brought through to the workings sheet using link
formulae. Workings are most easily built up on a modular
basis and for navigation purposes it is easier if each module is
located on a separate sheet. For example, capital expenditure,
depreciation and book value calculations are inter-dependent
and should, therefore, be together on one sheet.
Outputs
Depending on the size of the model, the outputs may be the

same as the workings or, more often, a summary of the
workings (and inputs). Here, format matters.
• Outputs should require little calculation other than totals
• The most important figures (e.g. debt service coverage, NPV

etc.) should be formatted to give them the importance they
deserve
• Pictures speak a thousand words – diagrams and charts often

clarify the results and flows better than pure numbers
• Text strings may be useful to put the output numbers into

meaningful sentences.
Referencing
Relative vs. absolute references
Excel calculates in terms of the relative position of an item – i.e.

cell C4 is 3 columns and 4 rows into the sheet. Fortunately, to
ease interpretation, the references in Excel use the column
letter and row number address (i.e. C4).
A B C D E
1 147 852 654
2 741 951 357
3 753 258 456
If we placed the formula ‘=A1’ in cell C4 this is interpreted by

Excel as entering the value from 3 cells above and 2 columns to
the left, i.e. 147 from cell A1 in the above spreadsheet.
If we copy the formula in C4 to:
• D4, we are still trying to pick up the value from 3 cells above
and 2 columns to the left (of D4 this time) – i.e. 852 from B1
• C6, we are still trying to pick up the value from 3 cells above
and 2 columns to the left (of C6 this time) – i.e. 753 from A3.
By default Excel works in this relative way.
F4 – absolute referencing
‘Dollarising’ the cell reference in a formula (press F4 whilst the

cell reference is input or edited) will add dollars to a reference.
If we placed the formula “=$A$1” in cell C4 this fixes the
address as always column A and always row 1. This is still
interpreted by Excel as the 147 from cell A1.
However, if we copy the formula in C4 to:
• D4, we are still trying to pick up the value from column A and
row 1 – i.e. 147
• C6, we are still trying to pick up the value from column A and
row 1 – i.e. 147.
Alternatively we can partly dollarise or fix the reference.

When entering or editing a formula, pressing F4 repeatedly
will toggle through the fixing options.
• $A1 fixes the column A with the row number remaining

relative
• A$1 fixes the row 1 with the column remaining relative.
A rule of thumb: when trying to fix a reference to a cell which is
• To the side of the formula – the $ is to the side
• Above or below the formula – the $ is in the middle.
Naming (cells & ranges)
Cells and ranges can be named – that is, they can be referenced
in terms of a name rather than its column and row position
within the model.
A name may only be defined once per sheet – i.e. the name
relates to a unique cell or range on that sheet. However, the
same name can be defined across different sheets, e.g. 3
different cells named TaxRate can be created as cell E30 on
Sheet 1; as E45 on Sheet 2; and as F10 on Sheet 5.
F3 is the function key which triggers most of the functionality,

i.e. the third function key. This implies that Microsoft believes
that the use of names is the third most important function to
the smooth running of Excel, behind only Help and formula
editing (F1 and F2 respectively).
Why name?
1. Clarity and speed
Using the F4 dollarising option is quick and widely understood

and so has its advantages. However, where the cell or cell-
range is to be used in calculations:
• On a number of occasions
• At a distance from where it is situated
• On different sheets
• In different models
• As part of a complex formula or function
• Within a macro
then naming the cell or cell-range is a better solution. Applying

a name to a cell or range can make model construction and
review quicker and easier.
2. Auditing
As will be covered later, all the auditing tools work in exactly

the same way for both cell references and names. However, if
names are used then additional auditing approaches can be
introduced.
3. Functionality
Additionally, Excel was created with the intention that names

would be used. Consequently, some functions require the use
of names, particularly across sheets (e.g. conditional formatting
and data validation).
4. Geographic precisions
Some modellers prefer the geographic precision of the cell

reference. There is no dispute over Inputs!D2. However, most
of the time, it is what the cell contains rather than where it is,
that is more important.
Creating names
There are a number of ways to name cells or ranges. The

following are the two most widely used.
1. Insert; Name; Create
The Name Create command uses labels at the end of a range,

or beside a cell, to name the range or cell respectively. By
using this standard referencing approach and formatting these
labels (red, italic) the named cells and ranges are clearly
identified.
This can be automated:
1. Type the name to the right of the cell or range to be named
2. Highlight the cell containing the name that has just been
typed in
3. Control+Shift+← this will highlight all the cells, which may

just be one, with contents to the left which require naming
4. Control+Shift+F3 – should see the following dialogue box:
5. Check the Right column box (Excel may have already checked
it)
6. Press Return.
The real value of this function is that all of the row ranges in a
sheet can be named simultaneously by highlighting all required
ranges or cells and the cells containing their names and then
following the above steps.
If the name is typed to the Right of the cell or range, ensure

only Right column is checked.
2. Quick and dirty
1. Highlight the range or cell to be named
2. Click in the name box at the top left
3. Type in the name (with no spaces)
4. Press Return.
To check the name just click on the down arrow by the name
box and the names which have been defined in the model will
be listed.
“IS Assump”
The Ctrl+Shift+F3 method has a formality to the method (so
reducing modeling errors) and visibly identifies the named cells
and ranges immediately to the right (so helping use and
review). However it cannot be used for twodimensional ranges,
which is where this second method proves useful.
Changing or “stretching” a range which has already got a

name
Where a row of data for a number of periods is to be named,

leave a blank cell between the data and the name and follow
the Ctrl+Shift+F3 naming procedure. This allows additional
periods to be added (as per best practice model set-up
procedures) with the named range automatically extending as
new periods are inserted.
However, it is not unusual to want to extend a range after it has

already been created. If the above has not been done or a two-
dimensional data range is to be changed, the only practical way
to do this, without deleting the name and recreating it, is as
follows:
• Ctrl+F3
• Select the name from the list which you want to attach to the
new or stretched range
• Press the browse button. Excel will display and highlight the
range that is attached to the name. Now click and drag to
highlight the new range you want to attach. Press the finish
selection button, you will now return to the Define Name
dialogue box
• Click on the Add button. This overwrites the old definition of

the name and range with the new one you have just selected.
Using names
Names can be used in formulae in the same way as other

references. To use a name in a formula:
• Click on the named cell; or
• Type in the name (it is not case sensitive); or
• Press F3 and the names listed alphabetically will be available

for selection. As the list of names can be quite long, the initial
few letters of the name can be typed in to enable more rapid
scrolling through the list.
When a cell name is used, it is used as an absolute reference –

as if it were fully dollarised.
When a range name relating to a row of data is used in a

particular cell, the data within the range which is in the same
column as the particular cell will be returned.
For example, if the range named “Sales” is defined on Sheet1 as

E6:N6 and if the formula in cell G72 on any sheet is “=Sales”, the
value returned will be that from column G in the named range
(i.e. cell G6 on Sheet1). If the formula is in a cell which does not
have a corresponding name in the same column, the result is
#VALUE.
Note, only those ranges which will be used extensively

elsewhere on the model have been named. These cells are easy
to review due to the use of names.
Pasting the list of names
This feature is used to create a checklist of all the names and

the number of names used within the model by listing the
names and their location.
Select the place where the first name is to be listed and then
• Formulas; Use in Formula; Paste names
The names will be in the first column and the location will be
in the next column.
Applying names
It is undoubtedly quicker to write some formulae using cell

references and it would be laborious to then rewrite the
formula using the appropriate names. Instead, the Insert;
Name; Apply commands can be used. Excel will scan through
the worksheet and identify any cell references that correspond
to named ranges and convert the reference to the name.
When using this command, Excel has automatically selected
one or more names. This is because Excel remembers the last
names that have been created.
Deleting names
Good practice suggests that misspelled or redundant names

should be deleted at the earliest opportunity. Control+F3 is the
only way to delete range names.
If the deleted name has already been used in a formula the

#NAME? error value appears. To correct this problem use
Home; Find&Select; Replace (Control+H) to substitute a new or
corrected name for the deleted name.
When to use a name
Naming rules
Do not name everything
Despite all the advantages of naming cells and ranges, too

many names cloud the model (a list of 237 names is not easy to
use or review).
Only name those cells or ranges which will be used extensively

and at some distance from their current location – be
systematic but not out of control.
Range names – all sheets must be consistent
If rows of data are named, Excel interprets the reference in

subsequent formulae in relation to the columns. As seen, if
the range named “Sales” is defined on Sheet1 as E6:N6 and if
the formula in cell G72 on any sheet is “=Sales”, the value in
this cell will be that from column G in the named range (i.e.
cell G6 on Sheet1).
Where range names are used, all sheets must be consistent –

column G in the source sheet must relate to the same time
period, for example, as on the target sheet.
If new columns are to be added on any sheet, then they must

be added to all sheets in order to allow named ranges to be
used.
Naming conventions
• The name labels should be formatted as Red and Italic and

should lie directly to the right of the cell or range to which it
relates
• The shorter the name the better – as long as it is

understandable to the user and reviewer
• Avoid spaces – Excel will interpret these as “_” making

unwieldy names such as Costs_gas_in rather than the more
refined CostsGasIn (i.e. capital letters can be used to separate
words instead)
• CostsGas, PriceGas, DepnTax, etc. – i.e. begin name by

category or by most important word first for ease of use later
• CostsTot is better than TotCosts – otherwise searching for

total costs may require trawling through 30 names in the list
starting with total
• WkCapIncr is better than WkCapChange – it is easier to

understand the sign convention: a positive number must be an
increase
• Those on the inputs page should end with “In”, e.g.

CostsGasIn, PriceGasIn, etc. for ease of review
• Names must be unique. If a name is created that already

exists on the same sheet Excel will prompt and offer the choice
of going ahead with a new name and eliminating the earlier
definition or to stop and set up an alternative name for the
current range.
Do not over-engineer
A name should be used in a formula when it is helpful and not

too onerous to do so.
• For example, if sales is calculated as a function of three

names and EBITDA is calculated as a (named) percentage of
sales, it would be over-engineered to calculate the EBITDA
based on four names rather than the more straightforward
named percentage % (the previously calculated) sales.
Subtotals on workings and outputs can be calculated in two

ways – by reference to a (possibly named) cell elsewhere in the
model or by summing the nearby cells.
The latter method is the preferred route as this checks that the
current region is populated with only appropriate values –
particularly important on outputs.
• For example, if EBITDA has been calculated in a working (as

above) and is then used as part of the income statement – the
EBITDA on the income statement should be re-calculated using
the details on the income statement (sales less costs) rather
than referred back to the original working.
The MAX MIN issue
When the MAX and MIN functions are being used with named
ranges, the maximum (or minimum) number in the range is
returned rather than those relative to the column in which we
are interested. This is avoided by including a + sign in front of

the named range when coding the formula. For example:
=MAX(+PAT,+RetainedProfits)
Copying to other models
As long as the inputs to the tax sheet, for example, are defined
in the destination model (i.e. using the same names) then the
tax workings sheet can be easily inserted into the destination
model.
• Click right mouse button on the tax sheet’s tab in the source
model
• Move or Copy
• Define the destination model
• Check the copy box.
This can be useful, but can also cause problems if there is not
complete rigour in naming – the more rigour incorporated in
naming and model set-up, the easier the copying of modules
between models.
Transpose
Occasionally numbers appear horizontally in a row when it

would be useful to have them vertically in a column or vice
versa.
If these are numbers (rather than formulae), then the solution

is straightforward:
• Copy the relevant range
• Go to the first of the cells where the range is to be copied to
• Home, Paste Special, Transpose.
The transpose function can be combined with other functions

in paste special.
More likely, the range to be transposed is made up of formulae.
The paste special transpose will only be suitable if all formulae

contain only constants and absolute references (i.e. named
cells or cells of the type $D$4). Where more complex formulae
exist which have relative references, the TRANSPOSE function

can be used.
For example, it would be useful to show the formulae from the

range D3:J3 vertically in D10:D16:
• Count the numbers of cells in the range to be copied (7)
• Select the cells in the range to be copied to (D10:D16)
• Type: =TRANSPOSE(D3:J3)
• Press Control+Shift+Enter.
By pressing Control+Shift+Enter, an array has been created (as

shown by the { } around the equation). Deleting the whole
array rather than any one individual cell is the only way to
modify this.
Formatting
Some formats and formatting conventions (for example,

outputs) will be pre-defined to adhere to corporate templates
which will have their own logic. The more logical and consistent
the formats, the easier the model is to use and review.
Sign convention
Choose a sign convention, stick with it and explain it.
Negatives are difficult to work with and it may be easier to

avoid them.
All inputs and workings should therefore be positive, unless

they are unusual.
For example, interest in the income statement is mostly an

expense but should be entered and calculated as a positive. To
ensure that this is clearly understood it is necessary to describe
the line as “Net interest expense (income)”. In this way, the
user of the model understands that a positive number refers to
an expense whilst a negative implies net interest income.
The downside to this is that users misunderstand the sign

convention (through not reading the description carefully) and
the simple =Sum() calculations may not be possible. The major
advantage is that the logic of the model is uncluttered by
thoughts of sign convention – everything is positive.
The exceptions
• Outputs
This may be governed by the corporate style rules. Ordinarily

the sign convention on the outputs is the one which is most
easily understood by the reviewer. If it is easier to understand
an income statement if expenses are negatives, then expenses
should be negatives.
• Specifics
Some workings, for example cash flows, may be easier to work

with if the sign convention follows the cash flows. An increase
in working capital will reduce cash flow – trying to explain this
in words as “Decrease (increase) in working capital” may prove
cumbersome whereas having the increase as a negative (and
all other cash flows following this convention) is likely to be

easier.
Colors, size and number formats
Text & data
Feature Setting Justification
Size Default – probably 8 If elements are to be

point pasted into other
applications such as
Change the view
PowerPoint, it is easier
settings if this is too
to expand than
small on the screen
contract the selection
Anything smaller than once it is in
8 point will default to PowerPoint.
Times New Roman
For example, a sheet
when pasted into
using
other applications
14 point when pasted
into PowerPoint may
miss some data. When
using 8 point, more data
can be trapped (and
dragged to expand if
needed)
Inputs Blue text, pale yellow To stand out –

background and underlining stands out
underlined even if printed in black
and white
Names Red and italic To stand out
Workings Different backgrounds To help navigation

sheets to highlight different
sections and
summaries
Totals, Bold, italic, borders – Used to emphasise

sub-totals use sparingly
Headings To highlight key rows, Format is a personal /

& outputs columns and cells corporate decision
Everything Default settings So that all outputs and

else inputs stand out
Numbers
Number Format Comments
Decimal 12,345.6 Align with negatives

points &
commas
Negatives (12,345.6) Bracket (parenthesis)

stands out more than a
minus sign
Zeros – Stands out more in a list

of figures than 0.0
Unfortunately, rounding
errors will still appear as
0.0 which may be
misleading
Thousands May take out the In the outputs only

& millions 000s and millions
Formatting numbers
To format the numbers:
• Select the range to be formatted
• Format; Cells; Custom; or
• Control-1; Custom and press Alt-T into the type box.
The sections, separated by semi-colons, define the formats (in

order) for:
1. Positive numbers
2. Negative numbers
3. Zero values
4. Text.
If you specify less than 4 sections then the text will have a
standard format. e.g.
# displays only significant digits; does not display

insignificant zeros.
0 displays insignificant zeros if a number has fewer

digits than there are zeros in the format. [the above
would show 1234.56 as 1,234.6; .123456 as 0.1; and
0.0 as -]
, adds a comma to separate 000s.
Additionally, it can scale a number by a multiple of

one thousand (useful for the output sheets)
e.g. 1234567890 as 1,234,567,890.0 #,##0.0
1234567890 as 1,234,567.9 #,##0.0,
1234567890 as 1,234.6 #,##0.0,,
1234567890 as 1,234.6m #,##0.0,,”m”
_ aligns the numbers with the character following the

underscore. For example, when an underscore is
followed by a closing parenthesis “_)”, positive
numbers line up correctly with negative numbers
that are enclosed in parentheses.
? adds a space a character wide, used to indent

(normally from the right)
* put at the front, a format will add the next character

to fill the cell.
e.g. 123 as -------123.0 *-0.0
[Red] also available in black, blue, cyan, green, magenta,

white and yellow. Only used for outputs as may
undermine default color conventions.
@ used to denote text. The default alignment for text

is left. However, it can be right aligned to match
with numbers) if the following reference is used
after the third semi-colon.
*@_)
The following is the normal format used at CTG:
#,##0_);(#,##0);--_)
(See later for date formats.)
Numbers (with text for presentation)
Sometimes it is useful for a number to be followed by the units,

e.g. p, years, cents, x.
For example, if an input in a model is the number of years on

which a valuation is to be based, the number of years can be
entered, say 7, and it will appear in the cell as ‘7 years’.
As before, select the area to be formatted, Control+1; Custom,

choose the number format (e.g. 0) and then leave a space
followed by “years” – i.e.
0 “years”
Combined with knowledge of other number formatting

rules, this can be very useful as custom formatting can be
used as a basic type of conditional formatting.
For example, if a company has a price per share of 36.50 and

an earnings per share of –1.25 and 3.30 in years 1 and 2
respectively, its P/E ratio (price ÷ earnings) can be easily
calculated.
The results are –29.2 and 11.0606 for years 1 and 2

respectively. The result in year 2 should appear as 11.1x
(format “0.0x”), whilst that for year 1 is not meaningful or “nm”
– all negative results from such an equation are not
meaningful.
Armed with this the following number format can be applied to

the P/E cells:
Note that the “nm ” has a space the width of a x at the end to
align it with the positive.
White text
It will often be necessary to use white text where certain

cells are not to be part of the presentation. Not only can this
be done using conditional formatting, where data is to be
hidden on the output pages if certain conditions are fulfilled
(i.e. through conditional formatting), but also there will be
cells used as counters (maybe linked to switches or as part
of VLOOKUP or INDEX) which you do not want to be part of
any presentation. For these cells select the white font.
The main problem now is that with a white background, these

cells cannot be seen. It is therefore recommended that the
background be altered to grey:
– see Excel set-up earlier in the notes.
Styles
The use of styles within Excel, as within Word, enables quick

and easy changing of all the formats within the whole
model. Headings, dates, subtotals, percentages and others
can be selected (and globally modified) quickly.
At set-up it is worth defining the styles (i.e. the formats) that

may be used in the current model – consequently, formatting
need only be done once and then quickly and easily applied
elsewhere.
For example, it is often worth having the font size as 8 pt for

easy transfer to presentations. By defining styles up front the
default can be changed for the whole model.
As within Word, to apply a defined style – use the styles drop-

down box for the selected cell(s).
Adding styles to the toolbar
In order to use styles efficiently, add the styles drop-down box

to the toolbar – the style in use will then be listed.
The Styles drop-down box can be added by:
• The Style drop-down box is part of the Formats category
• Drag the drop-down box into the toolbar.
Once the drop-down box has been placed in the toolbar it can
be accessed by
Alt ‘
followed by Alt + either the up or down arrow key to scroll

through the styles.
To change / add a style
The Comma, Currency and Percent styles exist by default in

Excel to support the corresponding toolbar buttons and should
not be deleted. Additionally, the default setting for all cells is
Normal.
1. To change, for example, Normal:
• Home; Bottom Right Icon of the Number Section ; Custom
• Format, as required, the
• Number format (e.g. #,##0.0_);(#,##0.0);-_)
• Alignment (e.g. vertically Center (sic) Aligned)
• Font (e.g. Automatic, Arial 8)
• Select OK.
The formats of all (previously unformatted) cells within the

model will change to this new default normal.
2. If you wish to create a format, e.g. dates, to be used as a

standard to be applied elsewhere:
• Home; Bottom Right Icon of the Number Section ;
Date
On any of the tabs in the dialogue box, select the formats you
want, and then click OK – e.g. number to custom “dd-mmm-yy”
(without the quotation marks) etc.
• To define and apply the style to the selected cells, click OK
• To define the style but not apply it to the selected cell, click
Add, and then click Close.
3. If you wish to choose the format of a particular, previously

formatted, cell, e.g. a multiple, as a standard to be applied
elsewhere:
• Select the cell containing the required format
• In the Style drop down box type in the name – e.g.

“Multiple” – and press Enter.
Alternatively:
• Home; Bottom Right Icon of the Number Section

;
• In the Style name box, type a name for the new

style – e.g. “Multiple” (without the quotation marks)
• To define the style, click Add, and then click Close.
To check the boxes or not
A cell can have more than one style applied to it. As a result, a
cell may have the Dates style applied and then another style
laid on top – where there are any conflicts in styles the second
style will take precedence.
For example in the following, the Dates style has been defined
using only Number format. All other Cell formats in the Dates
style have not been defined.
Input cells should be differentiated from calculation cells by

format (and protection) and so an input style should be
defined. As there are likely to be a number of different input
types it is useful to have the common features of an input style
superimposed onto other styles. For example, a cell could
havc both a Multiple and Input format:
As the number format in the Input style is not defined it will

follow the previously selected number format for all cells. The
components of the Input style which are applied are:
• Font – Blue
• Protection – No protection
As the Multiple and Input styles do not conflict, the cell has
both styles applied.
Copy styles from another workbook
Once the time has been taken to define a set of styles in a

model, these can be used as the template for future models.
• Open the workbook that contains the cell styles that you want
to copy.
• Open the workbook that you want to copy the styles into.
• On the Home tab, in the Styles group, click Cell Styles.
• Click Merge Styles.
• In the Merge Styles dialog box, in the Merge styles from box,
click the workbook that contains the styles that you want to
copy, and then click OK.
• If both workbooks contain styles that have identical names,

you must indicate whether you want to merge these styles by
doing the following:
• To replace the styles in the active workbook with the

copied styles, click Yes.
• To keep the styles in the active workbook as they are,

click No.
Color
Note: the color template used on the source document may

be different to that in the destination file – so that when styles
are merged, the text, borders and background colors are not
as required. To apply the colors from the source document,
ensure that both models are open and in the destination
model:
• File; Options; Save; Under “Preserve visual appearance of the

workbook”; Click “Colors…”
• In the “Copy colors from” box select the workbook that

contains the colors to be copied
• OK.
In this way a template model with all necessary styles and

colors can be easily created (and updated) for quick merging
into all future models.
Conditional formatting
Conditional formatting applies a defined format to cells

which fulfil a condition.
To conditionally format the numbers (for example, where a

negative result should not be possible, or should be flagged, or
where a balance sheet does not balance)
• Select the range to which the conditional formatting will apply
• Home; Styles; Conditional Formatting.
The more obvious the formatting (size, color etc.) the more
useful the result.
There are two condition (logical argument) options:
• Cell Value Is the value of the current cell fulfils the criteria
• Formula Is the result of the formula (which may not refer to

the current cell) fulfils the criteria.
Note the format chosen is only applied when the condition is

true.
When using multiple conditions it is important to get the

sequence right:
• Cell value less than 10 Blue
• Cell value less than 100 Green
• Cell value less than 1,000 Red.
The above sequence gives expected results.
• Cell value less than 1,000 Red
• Cell value less than 100 Green
• Cell value less than 10 Blue.
This sequence gives unexpected results – any value below

1,000 is colored red and the subsequent criteria are not
applied.
Conditional formatting to hide cells
There will be occasions where it will be useful for cells to be

hidden. For example, if a discounted cash flow (DCF)
valuation model has been set up for a maximum of 10 years,
but 7 years has been input as the project length (named
“length”), from a presentation perspective, it would be good to
hide the 3 years which are now not part of the output. (It is
assumed that there is appropriate coding to calculate the
valuation based on 7 years!).
If the year counters are in row 2 with column D containing the

first period, go to Format; Conditional Formatting; enter the
appropriate formula (essentially the logical test of an IF
statement); then choose Format and select white font and no
borders from the menus.
Text strings
Text strings allow phrases, sentences, labels and headings

within a model to be automatically updated for changes in
assumptions or outputs. For example, it may be useful to
have a standard header in B2 with the company name (Bigco
defined in cell E5) and currency (um defined in cell E6) – both
of which are inputs which may change.
The ampersand [&] is the key to linking different bits of text:

The formula in B2
=E5&“ in ”&E6 results in Bigco in um
In the above example, there are three bits of text (the

company name, the word “in” with spaces around it and the
currency) each connected using the ampersand.
The TEXT function
Text and numbers which use the default format settings can be
linked with the use of the ampersand. However, where
numbers form part of the text string, they may need to be
formatted. This is when the TEXT function needs to be added
to the text string.
For instance, a model may be titled “Year ended 31 December

2006”. Assumptions within the model may change the year-
end which has been defined in cell G4. Without a text string,
whenever the date in G4 changes the model will have to be
updated cell by cell, a tedious task!
Alternatively, the text can be coded as:
=“Year ended ”&TEXT(G4,“dd mmmm yyyy”).
The TEXT function picks up cell G4 (assumed to contain the

year-end information) and then formats the number contained
within this cell into the date format dd mmmm yyyy (which
must be put within quotation marks).
Similar things can be done for multiples [=TEXT(G6,“0.0x;“nm

””)] and percentages [=TEXT(G7,“0.0%;(0.0%)”)] etc. Note that
where more than one format is to be chosen in a TEXT
function (for positives and negatives), they must be separated
by a semi-colon within the format text part of the function.
Regional settings
To change / view the profile for regional settings:
Start; Settings; Control Panel; Regional and language

options; Regional options
This is a profile setting rather than merely an Excel setting – it

has applicability across all applications.
Often there are company policies on regional settings – all staff

in all locations have the same regional setting, e.g. English
(United States). However, it may be useful from time to time to
alter this for local language, currency and formatting
idiosyncrasies.
Where a cell is formatted using the number formats and the

users regional settings are English (United Kingdom) then the
language (d for day, m for month, etc.) and settings (e.g.
commas as thousand dividers, etc.) will be used. If the model is
then passed onto someone with a French (France) regional
setting, then the language (j for day, m for month, etc.) and
settings (space as thousand dividers, etc.) will automatically
update even if formats have been customised.
However, the regional settings do not update the formats

contained within a TEXT function. The result is that Excel is
unable to interpret the TEXT function. Care must be taken
when using the TEXT function if it is likely that a model will be
accessed by users with different regional settings.
IF and some other logical functions
When writing functions into the spreadsheet it can be difficult

to remember the sequence of arguments. Shift+F3 can be
used to bring up the paste function dialogue box or Control+A
brings up the function window once the function name has
been typed.
A fundamental function to add flexibility to models is the IF

statement. IF can most simply be thought of as a switch.
Excel carries out a test and depending on the result chooses
between two answers, TRUE and FALSE.
The syntax of an IF statement is as follows:
=IF(logical_test,value_if_true,value_if_false)
Excel evaluates the test and if it is true it returns the

value_if_true, otherwise it returns the value_if_false. The
following extract shows a simple example:
Logical test
Any formula or cell result which yields TRUE or FALSE is a test.

When the test is in the form of a formula, Excel evaluates it and
produces the result TRUE or FALSE.
There are a number of “operators” that can be used to create

different logical tests:
= Equals
> Greater than
< Less than
>= Greater than or equal to
<= Less than or equal to
<> Not equal to
Excel is capable of evaluating logical statements. Try typing in

=1=2 and look at the result: the result is FALSE.
The words TRUE and FALSE in Excel have a special status, in

that Excel understands them in the same way that it
understands a number or a formula. Excel also understands
TRUE as the number 1 and FALSE as
a zero. In the above =1=2 equation, the result of this cell could
either be regarded as FALSE or 0 for further calculations.
If the formula is rewritten:
=(1=2)+0
Excel will return a 0, 0 is FALSE (1 being TRUE). The addition of

the zero forces Excel to return the value of the logical operator.
Value arguments
The arguments value_if_true and value_if_false can be given

any of a number of different types of statements, for example:
1. Numbers – commonly 0 and 1 for use in flags.
2. Formulae – for example
=IF((C5/C17)>=3.75,C5/C17,”N/A”)
Note: it is not necessary to put an equals sign immediately

before the logical test formula (C5/C17)>=3.75, nor before
the value_if_true argument formula C5/C17.
3. Comments or “labels” – the label N/A is enclosed in inverted

commas. If not in inverted commas, Excel will try to interpret
the message as one of the following: a formula name; the
name of a range; the address of a cell; or a logical value such as
TRUE or FALSE. N/A is none of these and the formula will
produce an error when Excel tries to return this as a result.
Common problems with IF statements and some simple

solutions
Using equals in a test
1. Although IFs are very useful, they can easily break down. If
we are testing for a particular numerical value from a formula,
=0 can give spurious results because Excel shortens decimals to
store them and therefore cannot calculate exactly.
As a result of Excel’s rounding, a formula which logically should

give exactly zero as a result will often give a very small number,
typically of approximately 0.000000000001 in value. This
problem can easily be solved by using an AND statement to test
if a number is nearly zero, i.e.
=IF(AND(cell<0.001,cell>-0.001),“Effectively zero”,“Not zero”)
Alternatively one of Excel’s rounding or other functions, such as

ROUND(), ROUNDDOWN() or ABS() can be used instead.
=IF(ABS(cell)>0.001, “Not zero” , “Effectively zero”)
2. Another potential problem in using equals is where the IF

statement refers to a user input; for example where the user
has to type “yes” or “no” into a cell and then using IF to switch
to the relevant formula.
Simple typing errors can cause big problems here: a typo in

the cell entry will result in the second choice, i.e. the value if
false being selected in error. This is a particularly insidious type
of mistake because it will usually not result in an error
message, but the wrong data or a wrong calculation being used
in the model.
Using data validation to limit data entry into the ‘switch’ input
cell, so only the specific alternatives (for example, “yes” or
“no”) can be selected, will solve this problem.
Checks
Checks are commonly used to indicate when errors have

occurred. For example, the difference between the top-half
and the bottom half of the balance sheet should indicate
whether the balance sheet balances. An IF statement can then
be used of the type
=IF(difference=0, ”BS OK” , “Balance sheet OFF”)
Due to Excel’s occasional rounding problems, the error

message may result even when the balance sheet does
balance.
By understanding the imperfections in Excel we can come up

with statements such as:
=IF(difference>0.0001, ”Balance sheet OFF” , “BS OK”)
But this doesn’t solve the problem if the difference is a negative

number. Consequently, most check digits should be made
absolute (typically we don’t care whether the check is positive
or number, we merely care that it exists) so that the conditional
statement is, therefore, easier to solve:
=IF(ABS(difference)>0.0001, ”Balance sheet OFF” , “BS OK”)
The AND and OR Statements
Suppose we want to choose an option if two tests are passed.

To deal with these more complex problems there are two other
useful tools, the AND and OR function. These functions are
often used as the logical test of IF statements. The syntax of an
AND statement is as follows:
=AND(test1,test2, test3….testn)
In the case of the AND statement, Excel evaluates all of the

tests in the formula (and there may be up to 30 of these) to see
if they are TRUE or FALSE. If they are all TRUE, then the AND
statement will give TRUE as a result. Otherwise it will give a
FALSE.
In the following illustration, €45m of debt is raised

(DebtInitialIn) on 31
December 2005 and then is to be repaid following a 2 year

grace period (DebtGraceIn) over the remaining 5 years of its 7
year term (DebtTermIn).
One solution is to use AND as the logical argument, using the

year counters to decide whether it is after 2 years and also
within the 7 year period:
The syntax of an OR statement is the same:
=OR(test1,test2, test3….testn)
In the case of the OR statement, if any of the tests are TRUE,

the staGraceintement will result in TRUE.
Another solution to the debt problem above is to decide

whether the year is within the grace period or after the debt
term. If this is the case, no payment is made:
Whether to use AND or OR depends on your thought process.
• If you are an inclusive modeller, then your thought process is

to define everything that falls within boundaries – AND is your
solution.
In the above illustration, the logical argument is to require all

the criteria to be met / to fall within the boundaries.
• If you are an exclusive modeller, then your thought process is

to define anything that falls outside boundaries – OR is your
solution.
In the above illustration, the logical arguments were written so

that if any were outside the limits, then no payment was made
and if ‘value_if_false’ was returned, payments were made.
Nested statements
Excel is a very simple and flexible language and it is very easy to

combine formulae to write quite complex programmes in a
single cell.
For example, a corporate tax formula:
If we make a loss, we do not pay tax, if we make a profit,

then if our profit is less than 300,000, we will have a tax
rate of 19%, if we have profit of 300,000 or more, we will
be charged at 30%.
This would be written as follows:
Here the “value if false” of the first IF statement is another IF,

and both of the results from the second IF are formulae too.
The main thing to be aware of here is that as the formula gets

longer, it becomes harder to work out what the formula is
trying to achieve.
Data retrieval – the LOOKUP school
IF, although perhaps the most useful function for creating

flexibility in models, is limited in its applications. If we have a
problem involving a selection of possible answers, rather than
a simple yes / no, then IF rapidly becomes difficult to use.
Excel will allow us to use a maximum of 7 IFs in a statement.

This is very hard work to both code and audit.
The following functions can help resolve this problem.
• CHOOSE
• MATCH
• INDEX
• OFFSET
• VLOOKUP
• HLOOKUP.
They can all be found in Insert; Function; Lookup &

Reference. Which function to use depends on:
• The flexibility required
• The way the data is sorted
• The sort of information that needs to be returned.
CHOOSE
A CHOOSE function takes the role of up to 29 embedded IF

statements and is used widely in scenario management. It is
driven by a selector cell which must be an integer between 1
and 29 and consequently requires references to up to 29
different target cells.
=CHOOSE (index_num,value1,value2,...)
In the above illustration, the scenario to be used to drive the

income statement sales figure is selected using C10 – known as
the index_num in the CHOOSE function. In order to use
CHOOSE, this must be a positive integer (not text) – value of 2
in this case.
The reference of the cell to be used if the selector cell (or

index_num) is 1 is the next argument in the function (value1 – if
C10 is 1 this indicates that the first or “Management case” has
been chosen and so the 342 in cell D4 should be referenced),
and then 2 (second scenario and so D5), etc. up to the number
of options (maximum 29, although only 5 used in the above).
The CHOOSE function is easy to use, but requires a significant

amount of input – i.e. if 10 options are to be used, then the
CHOOSE function requires reference to the selector cell and
the cell to be returned for each of these 10 options in the
correct order.
This, together with the manual nature of extending the

CHOOSE function for, say, adding new scenarios, may cause
modeling errors to creep in.
If the user enters an invalid scenario number #VALUE! errors

are generated. If the order of the option listed should change
or if an option should be added or deleted, the dependent
CHOOSE function will need updating. Consequently, where the
data to be selected is large and / or will be extended, then

other functions may prove more flexible and robust.
MATCH
MATCH is a much under-used and relatively straightforward

function. It returns the relative position of an item in a 1-
dimensional data area, i.e. the output is a number referring
to the position within a series.
As a result, it is often used to identify coordinates for use in

other lookups – namely INDEX, OFFSET, VLOOKUP and
HLOOKUP.
In the above illustration, the MATCH function is used to indicate

the period number in which the semi-annual sales finish. 30
June is the 4th monthly period in the sequence and so the
MATCH function is used to calculate this.
The function is of the form:
=MATCH(lookup_value,lookup_array,match_type)
• lookup_value
The value we want to find the relative position of. This is the
semi-annual period end (30 June in cell D15) above.
• lookup_array
The one-dimensional data area in which the lookup_value can

be found. This area (D11:AE11) has been named
DatesMonthly for ease of reference. 30 June appears in cell
G11 – the 4th item in the data area.
• match_type
A key element in many lookup formulae, not just MATCH. The

reference 0 has been used above to indicate that only an exact
match is possible. If the value in D15 were anything other
than a month end (say 28 June) then the MATCH equation
would not be able to find that value in DatesMonthly resulting

in #N/A.
The other possibilities for match_type are 1 or –1. These

require the data area (lookup_array) to be sorted in ascending
order or descending order respectively. If match_type is 1,
MATCH finds the largest value that is less than or equal to
lookup_value. If the value in D15 is 28 June then MATCH
returns 3: 31 May is the next lowest value. If match_type is -1,
MATCH finds the smallest value that is greater than or equal to
lookup_ value. If the value in D15 is 28 June then MATCH
returns #N/A: the DatesMonthly are not sorted in descending
order.
If this argument is omitted, Excel assumes that the match_type

is 1.
INDEX
The simplest explanation of INDEX is:
=INDEX(range,position)
Range is the area to be looked up. Position is a value

corresponding to the location of the value to be returned.
Position must be a positive whole number. Position 1 is
always the left hand cell in a row, or the top cell in a column.
There are two forms of INDEX:
1. =INDEX(array,row_num,column_num)
2. =INDEX(reference,row_num,column_num,area_num)
Both are used to return the contents (or position) of a cell as

defined by its coordinates from within a data area (or data
areas for the reference version). INDEX is a highly flexible and
robust function as long as the coordinates (row and column
position) can be identified.
The array version
=INDEX(array,row_num,column_num)
If a data area is 5 rows deep by 6 columns across and we wish

to extract the value in the 3rd row and 6th column. The
formula becomes: =INDEX ( DataArea, 3, 6)
The row_num and column_num are often found by use of the

MATCH function. For example, in the following illustration
we are trying to find the charge out rate for a director in
Hong Kong. The data area has been set up so that it is easy
to interpret, using text as row and column headers. Similarly,
the way to select the data is based on these headings
(selected in cells E14 and E15). Only once these selections of
Hong Kong and director have been turned into numbers can
we use an INDEX function.
One dimensional data
Often, the trick with such functions is finding a way in which it

will help.
The following is an asset schedule for one class of assets

which calculates the depreciation charge (in row 13) based on
the cumulative cost at the end of the year (in row 9). The key
is to ensure that assets which have been fully depreciated
drop out of the calculation – which is where row 8 comes in.
If the asset life (in E3) was to always stay the same at 4 years,
then we could merely link cell J8 to F2. However, to ensure a
fully flexible solution the equation in row 8 needs to be
flexible also.
The trick with INDEX, as with many functions, is to know what

the answer should be. In cell J8 (in year 6) we want to
eliminate the assets acquired in year 2 – the 324. This is the
number which appears in the second column of the data area
in E2:L2 (named Capex). As we know the coordinates of this
within the data area (row number irrelevant as it is a one row
data area; and second column) we can use INDEX to pick up
the required cell.
Analysing the above formula but ignoring the IF statement:
• array
The data area from which the target value of 324 is to be

extracted - E2:L2 (named Capex).
• row_num
The row number within the data area where the target value of
324 is situated. In the above, the data area (Capex) is a one
row array and so it can be ignored.
• column_num
The column number within the data area where the target
value of 324 is situated. In the above, the 324 is in the second
column of the data area and so the column number coordinate
should be 2. The “J$1-Life” [6-4] is merely a way of ensuring we
have the appropriate column counter as the formula is copied
along row 8.
In summary, the formula is:
= INDEX (E2:L2, leave blank, 2)
which returns the value in the second column of the range

contained in E2:L2.
The reference version
=INDEX(reference,row_num,column_num,area_num)
The reference version comes into its own when there are
different versions of the same data. It could be that:
• The input assumptions are based on three different options
• There are income statements for 10 different companies /

divisions
• There are costing structures for 25 different products; etc.
The key is to ensure that each data area is set up in the same
way and that row and column counters are introduced.
In the following illustration, there are operating contribution

calculations set out in the same way for each of 4 regions
(North, South, East and West), each of which has been
appropriately named (e.g. North is the name for the range
E13:J19). We wish to select one of these regions (using cell C2)
as the output in rows 3 to 9.
• reference (North, South, East, West)
This defines the various data areas from which the data is to be
retrieved. Each of the data areas is the same size and has been
named for ease of identification.
Note: all the data areas must be contained within a set of

parentheses inside the INDEX function.
• row_num $A6
We are trying to return wages which is in the 4th row of the

data area called South. As the data area is of the same
dimensions as the summary, we can put in row counters in
column A to help.
• column_num E$2
We are trying to return the result for April which is in the first
column of the data area called South. As the data area is of the
same dimensions as the summary, we can put in column
counters in row 2 to help.
• area_num $B$2
This identifies which of the data areas (defined in reference) is

to be used. As South is the second in the list, then we need to
convert the selector word “South” into the number 2. MATCH
again comes in handy.
For three parts of the function, numbers have been used to

identify the row, column and data area. If we are concerned
about presentation, these counters could be hidden using
white text.
OFFSET
Like the INDEX function, the OFFSET function uses row and
column coordinates to identify the value (or position) of the
target cell. In simple terms, the OFFSET function identifies the
target cell in relation to how many rows and columns it is
positioned away from a starter cell – the data area does not
need to be identified.
Using the same example as for the INDEX function, the charge
out rate for a director in Hong Kong can be found using
OFFSET.
=OFFSET(reference,rows,columns)
• reference $C$2
This is the “starter cell” or the reference point from which the
OFFSET rows and columns are counted. To make the row and
column counting easier, with two-dimensional data areas it is
usually best to have this cell immediately above and to the left
of the data area as the reference cell.
• rows, columns F14, F15
As with the INDEX function, we need to turn the row and

column selectors (in E14 and E15 respectively) into numbers so
that they can be used within OFFSET. Hong Kong is in the
seventh row of the city names and Director is in the fourth
column of job titles – MATCH has been used to identify these.
Likewise, they are 7 rows and 4 columns respectively away
from the reference cell C2.
The row and column numbers can be negative, in which case

the target cell will be above and / or to the left of the reference
cell.
Identifying the reference
OFFSET is often used to locate the contents of a target cell.

However, it can also be used to identify the position of a cell
from within a range, or a range from within a range for use in
other functions.
In the charge out illustration, OFFSET can be used to identify

the charge out rates for all of the Directors or the Hong
Kong office using the extended version:
=OFFSET(reference,rows,columns,height,width)
Using the extended function to find the reference of the

Director charge out rates:
=OFFSET($C$2,1,F15,9,1)
The range we are looking for starts 1 row (rows) below the
starter cell C2 (reference) and 4 columns to the right (cols –
using F15). It is 9 rows deep (height) and 1 column wide
(width).
An alternative is:
=OFFSET(C3,,F15,9)
This time the starter cell (C3) is in the same row as the start of
the range.
Consequently, we do not need to define how many rows away

the range starts (the second argument, rows, is left blank).
Additionally, as the default (height and) width is 1 then we do
not need to populate the final (width) argument.
The above formulae have identified a reference and are only of

use when incorporated within another function. For example:
=AVERAGE(OFFSET(C3,,F15,9))
will return the average charge out rate for the directors.
INDEX vs. OFFSET
INDEX and OFFSET both require column and row coordinates to

identify the target cell or cells. However, they both have their
idiosyncrasies:
1. Defining ranges for use in other functions
If a range from within a range is to be defined for use in other

functions then the full version of OFFSET has been created for
this purpose. However, two INDEX functions can be used to
define the start and end positions of a range. The start and
end point can be used to define the range for a function if the
two INDEX functions are separated by a colon within the
equation. For example:
=SUM (INDEX (DataArea,3,6) : INDEX (DataArea,4,10))
2. Auditing
An INDEX function is easier to audit. If F2, the trace precedents

or the
Ctrl-[ is pressed, then the components of the formula are

shown. If the OFFSET function is used, then the data area from
which the target cell or range is to be retrieved, is not shown as
it is not part of the function.
Additionally, if we are trying to find the dependents of a cell, it

will not be identified as a precedent of an OFFSET whereas it
will indicate the relationship with the INDEX. This can cause
problems as whole tracts of data may appear to have no links
with any other parts of the model if OFFSET is used – and could,
therefore be changed or deleted without understanding the
impact until it is too late. This may prove difficult to audit for
those users of the model who are unfamiliar with OFFSET.
3. Volatility
OFFSET is volatile whilst INDEX is not. Volatile functions always

recalculate when the model is calculated, even if their
components have not changed. For most users this is
whenever anything is changed anywhere in the model.
This means that if the model is heavily populated with OFFSET

functions, it will take a long time to recalculate.
4. Variable data area
Often the data area from which values or references are to be

retrieved is fixed. However, if this database is variable in size,
(eg it is downloaded data the size of which varies; or it is from /
linked to another model in which changes are made) then
problems may arise in the use of Index as it requires a data
area to be defined.
Offset may be useful in such circumstances as the “starter” cell

is likely to remain the same and Match can be used to locate
the row / column position within the variable data area.
5. Macros
The OFFSET function is a fundamental tool in visual basic.
VLOOKUP
A flexible solution for multiple option selection is VLOOKUP.

However, it may require some planning as VLOOKUP requires
the data to be set out in a specific way.
If we take the simple case of recommending whether to buy,

sell etc. a stock based on the target price generated by the
model, then we see how simple a VLOOKUP solution can be.
The value of a share is computed using a DCF valuation

approach and then this value is compared to the current share
price.
The threshold for a “buy” recommendation is that the current

share price is at a discount of up to 15% to the DCF share
valuation, up to no premium for an “Add” recommendation and
so on.
This is easier to think about if we know what the answer should

be. Our model suggests that the current share price
undervalues Carrefour shares by 22%. Looking at the decision
box would indicate -100% to -15% is a Buy; -15% to 0% is Add;
0% to 10% is a Hold etc. Consequently, we think that Carrefour
should be a Buy.
The VLOOKUP formula at its simplest has three components:
=VLOOKUP(lookup_value,table_array,col_index_num)
• lookup_value B7
This is the output driver (the -22% premium to DCF implied

price target for Carrefour in cell B7)
• table_array E5:F9 – named DecisionBox
The data area where the required result is located (the decision
box with the grid of premia and investor action). The
lookup_value will be checked against the values in the first
column of the table_array – i.e. the values to be checked must
be in the first column.
• col_index_num 2
The column number of the required result (the investor action)

within the lookup table (i.e. the second column of the
DecisionBox). The first two arguments of the equation have
narrowed the result down to the specific row in the specific
data area. The col_index_num indicates which column in that
data area to then select from.
How VLOOKUP works is very simple: Excel takes the

lookup_value
(-22%) and looks down the first column of the table_array (-

100%, -15%,
0%, 10%, 20%) until it finds a match. If it cannot find an exact

match, then Excel chooses the next nearest lower number
instead (i.e. the last number it is bigger than on the way down: -
100% in this case).
In the case of Tesco, it will get to the last line of the table before
it stops. Having chosen a line in this way, Excel then chooses
the result from the column number (2) you have specified.
Beware
1. The data in the first column must be in ascending order

down the table for this kind of VLOOKUP to work properly
2. The column number is just that. Excel will consider the first
column of the lookup table as column 1, the second column as
2 and so on. If the lookup table does not have enough
columns, i.e. the column number is bigger than the total
number of columns in the table, an error message will be
returned.
The final argument – TRUE / FALSE
In the example above, we have not included a final fourth

argument. The final argument is TRUE or FALSE. If we put
TRUE or omit the last argument, then VLOOKUP works as in

the above example.
If we enter FALSE, then VLOOKUP accepts only exact matches.

If an exact match cannot be found, then a #N/A error message
will be returned. This form of VLOOKUP must be used when
the selector cell is text (or if column 1 is not in ascending
order).
The result of the formula in cell D14 is €89.10 (the value in the
4th column of the Casino row). The selector cell is B14, which
this time is text (Casino).
Additionally, the data in the first column of the data area

(named Data in cells B2:F10) is not sorted in any particular
order. Consequently, the last argument in the VLOOKUP must
be FALSE (or 0).
Strangely, if FALSE was missed off, the VLOOKUP may give
1. The right answer 2.

Another erroneous value or
3. #N/A.
It is the second one of these which is the dangerous one – a

number appears and so it is assumed that it must be right, but
it may not be. Therefore, when using text as a selector in
VLOOKUPs, ALWAYS USE FALSE.
HLOOKUP
VLOOKUP and HLOOKUP work in very similar ways. The

difference in their use depends on the way the data is
arranged:
• VLOOKUP requires the lookup_value to be represented in the

first column of the data area (or table_array) – that is, the
lookup is driven by vertically looking down the first column of
the data area to find the correct row (and then finding the
appropriate column)
• HLOOKUP requires the lookup_value to be represented in the

first row of the data area (or table_array) – that is, the lookup is
driven by horizontally looking across the first row of the data
area to find the correct column (and then finding the
appropriate row).
In the comparable company table below, supposing the

company (Ahold – in row 8 of the spreadsheet, but row 7 of the
data area) was a given and we wanted a formula that would
return Netherlands if Country was chosen, €23.95 if Price was
chosen and so on.
=HLOOKUP(lookup_value,table_array,row_index_num,range_lo
okup) =HLOOKUP(C12,Data,7,false).
• lookup_value C12 (Country in this case)
As with VLOOKUP, this is the output driver (the word

Country). This points to which type of output value we are
looking for.
• table_array B2:F10, named Data
The data area where the required result (Netherlands) is

located. The lookup_value, Country, will be checked against
the values in the first row of the table_array – i.e. the values to
be checked must be in the first row / header of the data area.
• row_index_num 7
The first two arguments have narrowed it down so that the

lookup is looking down the Country column of the range named
Data. The 7 indicates that we are looking for the 7th row in that
column – that relating to Ahold.
The 7 has been hard-wired into the formula for illustration

only. It should not be a hard input number but related to a row
counter which could be derived using MATCH to find where
Ahold is positioned.
• range_lookup false (or 0)
As the first row is not sorted in any particular order and the
lookup_value is text, we want an exact match only (not the
closest approximation). As we have seen with VLOOKUP, if
the FALSE argument is not added the HLOOKUP may give:
1. The right answer
2. Another erroneous value or
3. #N/A.
INDIRECT
The INDIRECT function returns the reference specified by a text

string and allows you to put the address of one cell in another
cell, and get data from the first cell by referencing the second
cell. For example, if cell A1 has the value "C3" and the content
of C3 is 12,345 then =INDIRECT(A1) will return the value in C3,
i.e. 12,345.
The syntax is:
INDIRECT(ref_text,a1)
Where
Ref_text is a reference to a cell that contains a cell

reference or a name defined as a reference, or a
reference to a cell as a text string. If ref_text is not a valid
cell reference, INDIRECT returns the #REF! error value.
A1 is a logical value that specifies what type of reference

is contained in the cell ref_text: If a1 is TRUE or omitted,
ref_text is interpreted as an A1-style reference; if a1 is
FALSE, ref_text is interpreted as an R1C1style reference.
The real power of the INDIRECT function is that it can turn any
string into a reference. This includes any string that you build
up using string constants and the values of other cells in the
formula, strung together with the “&” concatenation operator.
For example, the simple formula
=SUM(A5:A10)
will sum the values in the range A5:A10. However, suppose

you want to be able to specify which range of rows to sum
(for example, based on which year / division / scenario is to
be summed) without having to change the formula. The
INDIRECT function allows you to do this. Suppose the
starting row number is placed in cell B1, and the ending row
number is in C1, then you can use the formula
=SUM(INDIRECT("A"&B1&":A"&C1))
If B1 contains 5 and C1 contains 10, this evaluates the string as

"A5:A10". The INDIRECT function converts this string to an
actual range reference, which is passed to the SUM function.
Warning
Care must be taken in using the Indirect function as it is a

volatile function. Volatile functions always recalculate when
the model is calculated, even if their components have not
changed. For most users this is whenever anything is
changed anywhere in the model.
This means that if the model is heavily populated with OFFSET

functions, it may take a long time to recalculate.
Address
The INDIRECT function is frequently used in conjunction with

the
ADDRESS function. The ADDRESS function uses row and

column numbers to create a string address using the following
syntax:
ADDRESS(row_num,column_num,abs_num,a1,sheet_text)
Where
Row_num is the row number to use in the cell reference
Column_num is the column number to use in the cell

reference
Abs_num specifies the type of reference to return –

probably omitted
A1 is a logical value that specifies what type of reference

is contained in the cell ref_text: If a1 is TRUE or omitted,
ref_text is interpreted as an A1-style reference; if a1 is
FALSE, ref_text is interpreted as an R1C1style reference.
Sheet_text is text specifying the name of the worksheet to

be used as the external reference. If sheet_text is
omitted, no sheet name is used.
For example, the formula =ADDRESS(5,6) returns the string

$F$5, since $F$5 is the 5th row of column 6. You can then pass
this to INDIRECT to get the value in cell F5. For example,
=INDIRECT(ADDRESS(5,6))
If additionally the sheet_text can also be defined then the

indirect can be a very powerful tool to retrieve data.
In the following example, we have six divisions laid out in the

same format on six individual sheets (named after the division).
The indirect function can then be used to retrieve a specified
division on the summary sheet by inputting the division name
in cell D8:
A frequently seen alternative solution to the above would be:
=INDIRECT($D$8&"!"&ADDRESS(ROW(),COLUMN()))
The reference we are trying to retrieve in cell F2 is from WP!F2

and so we must create a text string with all these components
for use in the indirect function. As you can see, using the
Address function to its full effect (per the original solution) gets
around this problem.
Volatile functions
Volatile functions recalculate each time a change of any sort

occurs in any cell on any sheet. Most functions will only
recalculate if a cell which they are referencing has changed,
i.e. a volatile function in a formula means that cell will always
be recalculated at each recalculation even if it does not
appear to have any changed precedents and will lead to the
Excel prompt to save changes to the model when you close it.
The result is a model which takes longer to calculate.
To understand the issue, enter the formula:
=RAND()
in any cell. On Pressing F9 (the calculate key), the value in the

cell will recalculate. If cells, rows or columns are deleted or
inserted or another formula is entered elsewhere, the cell will
also recalculate. This illustrates how these volatile functions
work and shows that many actions in Excel cause all volatile
functions to automatically recalculate.
Consequently, avoid volatile functions wherever possible.

Using volatile functions sparingly will afford the benefit that the
model will recalculate faster because it is only recalculating
what it needs to.
The reason functions are specified as volatile is because Excel

has no means of knowing when to recalculate them because
they are in some sense outside of the normal dependency
chain. INDIRECT for example, as its name implies, only has an
indirect link with its source data − the rangename. Random
number functions do not depend on anything, so the only safe
thing to do is to generate a new random number every time
the spreadsheet is recalculated.
Excel’s volatile functions
Some of Excel’s functions are obviously volatile: RAND(),
RANDBETWEEN(), NOW(), TODAY()
Others are less obviously volatile: OFFSET(), CELL(), INDIRECT(),

INFO(),
COLUMNS(), ROWS()
Some are volatile in some versions of Excel but not in others:

INDEX() became non-volatile in Excel 97.
Using a volatile function in a formula will flag the cell containing

the formula as volatile, even if the volatile function never gets
executed. e.g.
=IF(1<2,99,NOW())
will always return 99 and the volatile NOW() function will

never be called, but the cell containing the formula will be
treated as volatile.
If the results of volatile functions are going to be used

frequently throughout a model, avoid the temptation of nesting
these functions within other functions. Instead, simply type the
volatile function into a single cell and reference that cell from
within other functions. This alone can potentially cut down on
the amount of volatile functions by hundreds, if not thousands
at times, and speed up the model’s performance.
Conditional formats
Because conditional formats need to be evaluated at each

calculation any formulae used in a conditional format is
effectively volatile. Actually conditional formats seem to be
super-volatile: they are evaluated each time the cell that
contains them is repainted on the screen, even in Manual
calculation mode, although VBA functions used in conditional
formats will not trigger breakpoints when executed by the
repaint.
Consolidating data
Similar data may need to be pulled together and summarised.

Excel can do this in a number of ways, some of which are more
rigorous and flexible than others.
Data Consolidation
The Data Consolidation tool within Excel would appear ideal.

To use it, select the cell where the consolidated data is to be
presented and enter Data, Data Tool, Consolidation . The

following dialogue appears:
In the illustration above, the same data is presented in the

same cells on 6 different sheets (although only 4 references are
visible above). Select the data on the first sheet and then press
Add. If a second sheet is selected, the reference will
automatically be for the same cells on this second sheet etc.
Linked or not linked?
If the check box to link the data remains un-checked then the
consolidation function will merely sum (or whichever function
is chosen) all the relevant cells and paste the values. Changes
to the base data will not alter the consolidated data. This
method has limited applicability to modeling.
If the data is linked then the following output will result:
The Data Consolidation function automatically groups the

individual data lines (the default is that they are hidden) and
then sums them up in the summary lines. In the illustration,
the rows 2 to 7 are automatically linked to the source (in
alphabetic order according to sheet name) and row 8 sums
them up. The formatting (borders) have been done manually.
Partial consolidation
If only a selection of the divisions were to be summed, then

flags (0,1) would have to be used against each line (each of
which would also have to be manually identified). This would
involve altering 6 rows for each of revenues, costs and
depreciation.
The standard way in which Excel outputs the combination and

the difficulty in subsequently manipulating is seen by some as a
drawback to this method and shows its inflexibility.
3-D formulae
Excel can create 3-dimensional formulae which may be useful

when the data to be consolidated are of the same dimensions
and in the same position on different sheets. All sheets must
be arranged together, i.e. no other sheets can be between
them.
• Select the cell where the consolidated data is to be presented

(e.g. first year’s sales)
• Enter the formula =SUM(
• Go to the first sheet and select the relevant cell (e.g. first
year’s sales)
• Ctrl-Shift-Page Dn until you get to the last relevant sheet and

select the relevant cell (e.g. first year’s sales) – alternatively,
using the Shift key select the final sheet
• Close the bracket on the sum
The result is a 3-dimensional formula summing up all the

divisions.
=SUM(WP:Holding!F2)
This formula can then be copied to all other relevant cells.
If only a selection of the divisions were to be summed then the

sheets containing the divisions to be excluded could be
manually moved to be outside the relevant range. For
example, the order of the sheets initially is:
1. Summary
2. WP
3. WT
4. ES
5. IS
6. IW
7. Holding
If the ES and IW divisions are to be excluded, then the sheets

should be dragged to either before the WP sheet or after the
Holding sheet.
This is a manual process which somewhat limits flexibility.

Additionally, if other sheet are introduced between WP and
Holding (or these sheets are moved) then the 3-dimensional
formula will be selecting inappropriate data.
Named ranges
An alternative to the Data Consolidation route is using named

ranges. If all of the data areas are of the same dimensions on
different sheets, then they can be individually named (select
the area, then type the name in the Name box avoiding
spaces).
If the summary consolidation area is to have the same position

on a separate sheet, then the row and column references will
be the same and so the following simple formula can be copied
everywhere:
The formula in cell F2 uses the reference of a 2-dimensional

range called WP (from the sheet of the same name). Excel will
look to the same row, same column in the source, i.e. cell F2 on
the sheet WP.
If only a selection of the divisions were to be summed, then

flags (0,1) could be easily appended to the full consolidation
formula:
Indirect
The indirect function can be used to do the full consolidation –

e.g. combining all the divisions – but is probably best used for
selecting individual components.
For full (or partial) consolidation, the summary sheet is best set
up along the lines of that automatically created using Data
Consolidation – separate rows for each division for each of the
revenues, costs and depreciation (the revenue rows are shown
in the model below).
Using the indirect function we need to come up with the cell

reference of the source. For example, in F4 we need to source
the data from F2 on the ES sheet. The ADDRESS function inside
the indirect does this by
Row_num (2) – cell A8 has a number 2 in it (derived from

a MATCH function to pick out the row number of the
“Revenue” row title in the source data
Column_num (6 or F) – using the COLUMN() function to

denote the current column
Sheet_text (ES) – using cell C4 which contains the sheet

name
The 0s and 1s in column D are flags to indicate whether a

division is to be consolidated or not.
A more straightforward format and formula can be used if only

one of the divisions is to be output – see the indirect section of
the notes.
Pivot table
A pivot table can be easily created to output one, some or all of

the data to be consolidated. See the pivot tables section of the
notes.
Despite their suitability for consolidating, pivot tables have

limitations in that:
• They must be manually updated / refreshed when changes

are made to the model
• The format is often sub-optimal
• They are not widely understood by all users
Arrays
An array is a rectangular range of cells or values. In Excel, data

can reside in a single row (called a one-dimensional horizontal
array), a column (a one-dimensional vertical array), or multiple
rows and columns (a twodimensional array).
Most data analysis is done in one cell and then copied to

others, but advocates of arrays would suggest that this
approach is:
• Cumbersome
• Error-prone
• Hard to follow and maintain.
Most of these potential problems can be avoided with a

rigorous approach to model building. However, an array
formula returns an array that is spread over the cells and so
has the advantages of:
• One array=>One formula
• Faster computations.
An array formula is a formula that can perform multiple

calculations on one or more of the items in an array. Array
formulae can return either multiple results or a single result.
For example, an array formula can be placed in a range of cells
and calculate a column or row of subtotals. An array formula
can also be placed in a single cell and calculate a single
amount. An array formula that resides in multiple cells is called
(logically enough) a multi-cell formula, and an array formula
that resides in a single cell is called a singlecell formula.
Illustration
Using the following data:
To create a multi-cell array formula
To multiply the values in the array (the cell range C2 through

D11):
1. Select cells E2 through E11
2. Enter the following formula =C2:C11*D2:D11
3. Press CTRL+SHIFT+ENTER.
Excel surrounds the formula with brackets ({ }) and places the

same formula in each cell of the selected range. This happens
very quickly, so what you see in column E is the total sales
amount for each product for each region.
To create a single-cell array formula
1. Select B13
2. Enter the following formula =SUM(C2:C11*D2:D11)
3. Press CTRL+SHIFT+ENTER.
In this case, Excel multiplies the values in the array (the cell
range C2 through D11) and then uses the SUM function to add
the totals together. The result is a grand total of 111,800 in
sales.
(Note: The same result could have been arrived at without the
use of arrays by the use of the SUMPRODUCT function.)
This can be a very powerful type of formula. For example, say

there are 15,000 rows of data. Part or all of that data can be
summed with a single formula in a single cell.
Also, notice that the single-cell formula is completely

independent of the multi-cell formula. This points to another
advantage of using array formulas − flexibility. Any number of
actions, such as changing the formulae in column E or deleting

that column altogether, will not affect the single-cell formula.
Rules for entering and changing array formulae
The main rule is to press CTRL+SHIFT+ENTER whenever you

need to enter or edit an array formula. This rule applies to
both single-cell and multi-cell formulae. However, whenever
working with multi-cell formulae, there are additional rules to
follow:
• You must select the range of cells to hold the results before
you enter the formula
• You cannot change the contents of an individual cell in an

array formula
• You can move or delete an entire array formula, but you

cannot move or delete part of it. In other words, to shrink an
array formula, you first delete the existing formula, and start
again
• You cannot insert blank cells into a multi-cell array formula.
Expanding an array formula
At times, it may be necessary to expand an array formula

(though it is not possible to shrink them). The process is not
complicated, as long as the rules listed in the previous section
are followed.
Illustration
To add the following data to the previous illustration
In the sample model insert these additional lines of data into

the model starting at cell A12. Note, that the new data cannot
be entered into the middle of the current data due to the multi-
cell array formula.
• Select the range of cells that contains the current array

formula (E2:E11), plus the empty cells next to the new data
(E12:E17)
• Press F2 and edit the formula to extend the C11 to C17 and
change D11 to D17
• Press CTRL+SHIFT+ENTER. Excel places the revised formula in

the new cells.
The same process can be followed to edit the single-cell array

formula in B19:
Adding logic to arrays
As seen, arrays perform the same action many times.

Consequently, the same logical argument can be performed
many times.
Illustration
Suppose we want to find how many of a certain product was

sold or what the revenue was for that product.
If we want to calculate the total number of tailored products

sold we could create a series of IF statements in column F of
the =IF(B2=“tailored”,C2,0) type (or a multi-cell array of the
same type {=IF(B2=“tailored”,C2,0)}) and then sum these up.
As the same logical argument and the same result if true or

false is used for the whole range, then a single-cell array
formula can be used.
To calculate the total number of tailored items sold in cell C20:
{=SUM(IF(B2:B17=“tailored”,C2:C17,0))}
i.e., the IF statement looks in the array B2:B17 for those

matching “tailored”, and then returns the number of units sold
for each. By placing the SUM around it, all the units fulfilling
the criteria are summed.
(Note: the Excel function SUMIF would produce the same result
without the use of arrays.)
To take this further and calculate the revenue from all tailored
sales in E20:
{=SUM(IF($B$2:$B$17=“tailored”,$C$2:$C$17*$D$2:$D$17,0))}
(There is no one function within Excel which could perform this

without the use of arrays.)
Testing for duplicate entries
In the following illustration, the summary at the foot of the

table is wrong as the data contains duplicate entries:
If you need to determine whether a 1 dimensional range

(CoNames – the list of names in the first column above) has
duplicate entries, you can use the following formula. It will
display "Duplicates" if the list in Range1 has duplicate entries
or "No Duplicates" if the range does not have any duplicates.
=IF(MAX(COUNTIF(CoNames,CoNames))>1,"Duplicates","
No duplicates")
This formula requires that the complete range contains data. If

only the first N cells contain data, and the rest are empty, the
formula will return "Duplicates" because it considers the empty
cells to be duplicates of themselves.
The duplicate cells can then be tagged by use of the following

non-array formula in a matching column to Range1 (where B3
is the first cell in the Range1 to be tested):
=IF(COUNTIF(CoNames,B3)>1,"Duplicate","")
We can then create another non-array formula in a further

column to extract the non-duplicate entries:
=IF(COUNTIF($B$3:B3,B3)=1,B3,"")
Advantages and disadvantages of arrays

Array formulae offer these advantages:
• Consistency
Clicking any of the cells from E2 downward (in earlier

illustration), the same formula is revealed. That consistency
can help ensure greater accuracy.
• Safety
Part of a multi-cell array formula cannot be overwritten. For

example, clicking cell E3 and pressing DELETE would not work.
It is necessary to either select the entire range of cells and
change the formula for the entire array, or leave it as is.
• Smaller file sizes
A single array formula can be used instead of several

intermediate formulae. For example, the model created for
this exercise uses two array formulae. Standard formulae
(such as =C2*D2), would have required 11 different formulas.
Array formulae can work what seems like magic, but they also
have some disadvantages:
• Do not forget to use CTRL+SHIFT+ENTER
Remember to press those keys whenever entering or

editing an array formula
• Other users may not understand the array formulae
Array formulae are relatively undocumented, so if other people

need to modify models, it is necessary to either avoid array
formulae or make sure they understand how to change them
• Depending on the speed of the system, large array formulae

can slow down calculations.
Dates
When a date is used in Excel, it is identified as a number

providing it is written in a valid date format. For example, 30
July 1966 day is the 24,318th day of the world, according to
Microsoft i.e. it has been given the unique number 24,318.
This can be seen by entering the date 30/07/66 and then
stripping the formatting from the cell by using
Control+Shift+1. The cell can be reformatted to the date
format using Control+#.
So when did the world begin? The first day of the world
(according to Microsoft), i.e. number 1, is 1 January 1900,
despite a sizeable body of evidence to suggest otherwise. This
is an important date: if Excel knew that the world started on
that date then any other date is merely a number of days from
1 January 1900. Hence, a unique number can be allocated.
Date formats
1 January 1900 was a Sunday (which Excel, by default, treats as

the first day of the week). Consequently, not only can Excel
count the number of days from 1 January 1900, but also can
very easily work out which day of the week it is.
As dates are numbered, they can be formatted in the same way

as other numbers. For example, to format the date 4 July 2006
(number 38,537):
• Control-1, Number and Custom
Days d dd Ddd dddd
4 04 Mon Monday
Months m mm Mmm mmmm
7 07 Jul July
Years y yy Yyy yyy
06 06 2006 2006
Date functions
Appreciating that a date is a number adds a lot of

functionality. Some of these functions are not in the
standard set-up of Excel and may need to be added:
• File; Options; Add-ins
• Select Analysis Toolpak
YEAR, MONTH, DAY etc.
Where the data is in 3 different cells, being day of the month

(28), number of month (2 for February), and year (2004), this
can all be combined into ‘28 February 2004’ by the Date
function:
=DATE(year,month,day)
The result in the cell is now the unique number for 28 February
2004 which can be formatted as appropriate.
The YEAR, MONTH and DAY functions can be used to reverse

this process to find the component parts of a particular date.
WEEKDAY can be used to find out which day of the week a date
is from 1-7 (although this could also be done by formatting the
number with enough “d”s). Note: because 1 January 1900 was
a Sunday, then by default, Sunday is assumed to be the first
day of the week, whilst Saturday is the 7th. By changing the
return type, the start of the week can be altered to, say,
Monday.
Defining time periods
Date series
Excel can help set up sensible date series as, for example,
column headings. If a row of dates for the week commencing is
required, the first two dates of the sequence are input. The fill
method can be used to copy the series across the row.
• Select both cells
• Edit; Fill; Series
• Type; Date should be checked
• Step value 7
• OK.
Or select both cells, click and drag the little box (AutoFill
handle) at the bottom right corner of the active range.
The same functionality can be used to put in month ends.
• Put in a month end and select area to put in month ends
• Edit; Fill; Series
• Date unit; Month should be checked
• Step value 1
• OK.
Alternatively, this can be done by typing in the date of the first

month end and this time right click and drag the AutoFill
handle.
If the start date is 31 January 2004 (say in cell D1), then to link
other cells (to create more dates) to the start date can be
done in a number of different ways:
1. =D1+365
As all dates are numbers, and years are 365 days, this will
generally work. In the above example, the result will be
30 January 2005 because 2004 is a leap year.
This method is good but not great.
2. =EDATE(D1,12)
EDATE adds the full number of months (in this case 12) to
the starting number. In the above example, the result will
be the correct date, 31 January 2005.
3. =EOMONTH(D1,12)
EOMONTH puts in the last day of the month specified (in

this case 12 months later) after the starting month. In the
above example, the result will be the correct date, 31
January 2005.
This method always works – but is less useful if the month

end is not the relevant date.
If monthly or quarterly dates are to be used, method 1 is not

suitable but either method 2 or 3 can be used.
If the relevant date is to be, say, the 5th (of each month,
quarter or year) then EDATE is the appropriate function.
If the month end is the relevant date then EOMONTH always

works. By comparison, EDATE will always add on the relevant
number of months from a given date - if quarterly dates are

needed and the last day of February is to be used, then 3
months after that is 28 May rather than 31 May. The same
issues can arise with other month ends as some months have
30 days and some 31.
Length of periods
As dates are numbers, then subtracting one date from another

generates the number of days between the dates.
Consequently, to count the number of days in a month, quarter
or in fact between any 2 dates is easy.
Yearfrac
The YEARFRAC function looks at the proportion of a year

between 2 given dates:
=YEARFRAC(start_date,end_date,basis)
The basis should be one of the following, each giving a

slightly different outcome:
0 or omitted US (NASD) 30/360
1 Actual / actual
2 Actual/360
3 Actual/365
4 European 30/360
Note: the function only gives positive results and so care

should be taken in ensuring that the start date is the earlier
date as it will not be apparent from the output.
Consolidating time periods
It is possible to consolidate monthly, quarterly or semi-annual

workings into annuals. There are a number of fully flexible
approaches to this, the most straightforward of which depends
on the modeller and users’ Excel proficiency and preferences.
The coding can be simplified by the use of range names.

However, care must be taken when using range names when
the model contains different time frames. For example, the

data in column H may relate to a quarter in one part of the
model, whilst referring to an annual period elsewhere. Range
names such as DatesQ, SalesQ could be used to contrast with
DatesY etc. to help identify quarterly and annual data so that
only the appropriate ranges are used.
SUMIF
=SUMIF(range,criteria,sum_range)
The SUMIF function requires data (the range) to fulfil a criterion

(criteria). If it does fulfil this requirement, then a corresponding
set of data (sum_ range) can be summed.
As dates are numbers (masquerading in a text format), the

quarterly dates are the data which must be less than or equal
to the annual date (which must be the criteria). Unfortunately,
by default, the data must equal the criteria. It is only by adding
the text string component (“<=”&F6) to the criteria that we can
get around this restriction within SUMIF.
Once the quarterly dates have been identified as being less

than or equal to the respective year end, then the
corresponding sales data to be summed must be chosen (from
the same columns as the quarterly dates). As the criteria is to
be less than or equal to the respective year end then the
function will sum all sales up to that date. Consequently, a
further line, which eliminates all previous year’s sales, can be
easily added to create only the relevant sales.
in F9 =SUMIF(DatesQ,”<=”&DatesY,SalesQ)
or SUMIF($E$2:$AA$2,”<=”&F6,$E$3:$AA$3)
in F10 =F9-E9
SUM OFFSET
OFFSET can be used to identify a single cell or a range. For the

latter, the address of the range is identified and then the
contents summed. The trick is to identify the starting and
finishing point of the range.
Preliminary step – period counters
In the above illustration, the first year’s sales are for the first 3
quarters (i.e. the 1st to 3rd sales figures) and the second year is
from the 4th to 7th figures, etc. The start and end point in the
sales range can be identified in the following corkscrew:
• The end position within the range can be identified using

the MATCH function to find the relevant year end in the
range of quarterly dates (using the exact [0] matching
criteria):
in F16 =MATCH(DatesY,DatesQ,0), or
=MATCH(F6,$E$2:$AA$2,0)
• The start is merely 1 period after the previous ending

period in F15 =E16+1
OFFSET
The OFFSET function identifies a cell or range which is a

specified position away from a starter cell. The sales data is a
1-dimensional (1 row) range and so only the column and width
criteria are required (together with the required starter cell). It
is cleaner to use a cell outside the data area as the starter cell
(in this case D3 – immediately to the left of the data to be
summed) as the address of the target area is always offset a
given number of cells from this point.
The OFFSET function then identifies the relevant range as

starting so many columns (1, 4, 7 etc.) away from the starter
cell (D3) and being 3, 4, 4 etc. cells wide (being the difference
between the end position for the relevant year and that of the
previous year). As a result, the OFFSET function has identified
E3:G3 for year 1 and H3:K3 for year 2 etc. By placing a SUM
around this range, the relevant consolidated sales is returned:
in F11 =SUM(OFFSET($D$3,,F15,,F16-E16))
SUM INDEX
INDEX can be used to identify, from within a specified data

area, a cell value or address. For the latter, the addresses of
the start and end of a range are identified and then the
contents summed. As with OFFSET, the starting and finishing
point of the range needs to be identified − done using the same
preliminary step as for OFFSET.
Two similar INDEX functions are used to identify the addresses

of the start and end of a range. As the sales data area is a 1-
dimensional (1 row) range then only the sales data area and
the start (or end) column number within this area need be
identified.
In cell F15, the starter cell address is identified by

=INDEX(SalesQ,,F15) where SalesQ is the sales data area and
F15 indicates that the cell is in the 4th column of this data. On
its own, the result of this function would be the sales in the 4th
quarter. However, when combined with another function,
Excel knows to use the address result instead. Similarly, the
end cell address is identified by =INDEX(SalesQ,,F16).
By combining the results of the 2 INDEX functions a range can

be identified and then placed within a SUM:
in F12 =SUM(INDEX(SalesQ,,F15):(SalesQ,,F16))
or =SUM(INDEX($E$3:$AA$3,,F15):INDEX($E$3:$AA$3,
,F16))
Switches
A switch can be created to allow a model to alternate between

different sets of criteria. This allows Excel to model different
potential outcomes.
For example, if the funding for the project / acquisition will be

either 75% or 100% debt, then a switch can be used to highlight
the 2 alternatives; or where Monte Carlo simulation is used so
that the model shows either the expected or the Monte Carlo
output results.
The Forms toolbar is used to create boxes and buttons which

enable the user to quickly select between the various options.
All items within the Forms toolbar are created and amended in
the same way. The common theme is that the buttons / boxes
all sit on top of the model and require some link between the
model and the box / button through a cell link – a previously
blank cell - which is then used to drive further equations.
Two-way switch
For example, to create a two-way switch:
• Open the Forms toolbar (Developer; Insert) or right click whilst

on toolbar and select forms
• Select the Check Box, move the cursor onto the model where
the check box is to appear (the cursor now becomes a
crosshair) and create the check box by dragging with the left
mouse button held down
• Using the right mouse button, click on the check box and
select Format Control; Control; Cell Link (type or go to the cell
reference for an unused cell)
• Click outside the check box to finish.
A ticked checkbox will return TRUE in the linked cell, whilst an

unticked checkbox will result in FALSE in the linked cell.
An IF statement based on whether the switch is TRUE or FALSE

can be used to alternate the model assumptions. When using
the IF statement it is useful to name the linked cell containing
the TRUE / FALSE statement.
For example, if the switch is to be used to alternate between

equity accounting and proportional consolidation as the two
options, then
=IF(Switch=TRUE,”Equity accounting”,“Proportional
consolidation”); or, more simply
=IF(Switch,”Equity accounting”,“Proportional
consolidation”) would change the cell text from equity
accounting to proportional consolidation.
The check box can be formatted for color, using the right
mouse button, Format Control; Colors and Lines.
Multiple options
These buttons / boxes are created and amended and then

linked to further formulae in the same way as the Check Box.
Option button
When an option button is created and linked to a cell (B3

below), 1 appears in the linked cell. If a further option button is
created and clicked, the number 2 will appear in the linked cell,
and so on. The number allocated to each option button is the
order in which they are created (the first created is allocated
value 1, the second value 2,…).
The option button is useful where there are several different

possibilities allowed. The linked cell could then be used with an
embedded IF function (or a lookup function such as CHOOSE).
For example, if the calculation of interest on an overdraft

balance could be performed on either the opening, average or
closing balance, the following formula would generate the
appropriate text.
=CHOOSE($B$3,“opening”,“average”,“closing”)
The CHOOSE function returns a value from a list of arguments,

which could be text, references, calculations, etc. In the above
formula, B3 returns a value between 1 and 3. If, say, option
button 2 is chosen, then the formula would generate the result
average.
Option button with group box
As more option buttons are created on the same sheet, they

are automatically linked to the original linked cell. If more than
one set of option buttons is required on the same sheet, it is
necessary to use the group box.
In the above, two different sets of option buttons are being

used to drive different scenarios. If the group box was not
used, all the options buttons would have the same cell link
(either A3 or A8) which would count between 1 and 6.
List box
The list box generates a drop-down list box. The item that is
selected in the list box appears in the text box. The linked cell
generates a number, being the numerical position of the
selected item within the list.
Combo box
The combo box works in broadly the same way as the list box,
requiring the same inputs as the list box. The key difference is
in the appearance – a dropdown box with the options will
appear when the combo box is selected; whilst only the menu
item selected will show when the box is not selected.
Formality
As we have seen, the boxes and buttons sit on top of the model
and then are linked to the model by use of cell links (and
extract data from the model, for combo and list boxes, through
the input range). Consequently, they result in the cell link

values changing as the different options are selected.
Therefore, despite the user not physically using the keyboard
to type in a hard-wired number (or TRUE / FALSE), the cell link
changes.
The consequence of this is that all cell links MUST be situated

on the Inputs sheet – the home of all other hard-wired inputs.
The switches should, therefore, also appear on the Inputs sheet

as they are the way in which the user effects the change in the
hard-wired cell link. However, this can be inconvenient. For
example, if we wish to see the impact on the key outputs of
changing an option, then we may wish to have the switches on
the key workings / outputs sheet.
Switches can be copied – the key is to ensure that the cell link
(and input range, if relevant) refers to the same cell in both
locations. The result will be that the options can be changed
simultaneously:
• On the input sheet using the switch
• On the workings / output sheet using the copied switch;

or
• On the input sheet by changing the value in the cell link.
Sensitivity
Goal seek
Goal Seek is a simple but powerful sensitivity and testing tool.

Goal Seek can be used for “break even” analysis and to answer
many typical questions that would be asked of a model for
example: ‘how much growth is required in order to achieve the
target return?’.
Goal Seek is very easy to use:
1. Select the cell containing the formula whose result you wish
to calculate (in this case D23), then select Data;What-If-
Analysis; Goal seek. The following dialogue box will be
displayed:
Target Cell
2. In the second (To value) box enter the value you would like
the Set cell to equal
3. In the third (By changing cell) box input the address of the
cell containing the input you wish to vary. In the case of the
question above it would be the cell containing the growth
rate assumed in the model. This must be an input – it
cannot be a formula
4. Press OK.
Excel will then vary the value in the input cell until the value in
the target cell reaches the target value.
If the target cell is formatted to a number of decimal places,

you will notice that Excel usually does not exactly hit the target.
Excel stops the iteration process when it meets the target value
set +/- the iteration limit set in the model. To change the
iteration limit to get Excel to get closer to the target, go to File;
Options; and select the Calculation tab. Set the iteration limit
to an appropriate number of decimal places.
Goal Seek, like the Data Table tool which follows, is very
powerful, but both rely on a simple set of single parameter
inputs and key results. Both of these tools lend themselves
very well to simple broad brush models. The more that inputs
can be simplified, for example using a single interest rate, sales
growth rate or inflation rate for the whole forecast, the more
useful simple powerful tools like Goal Seek will be.
Data tables
Data Tables are sensitivity tables by another name and they are
brilliant as they are highly effective tools in assessing which are
the most sensitive inputs (i.e. have the greatest impact on
outputs) of the model. Sadly they use up a lot of memory and
so it is essential that the
• File; Options; Calculation tab.
is checked for a manual (F9) calculation (or automatic except

tables). Otherwise, after each new entry anywhere on the
model, Excel will try to recalculate the table – which will take a
particularly irritating amount of time.
The sensitivity table can look at variations of up to 2 variables.
Unfortunately, Excel requires that the 2 variables are on the

same sheet as the sensitivity table. It is likely, therefore, that
the table will need to be on the input sheet (although the
tables’ contents can be referred to an output page for printing
purposes).
To set up a data table to check the sensitivity of the Enterprise

Value for changes in the EBITDA exit multiple and equity
discount rate, the following steps must be followed:
1. Select the output value upon which the sensitivity is to be

performed (the Enterprise Value) and place the reference for
this in the cell to the top left hand corner of the table
2. Choose the inputs to be varied (e.g. EBITDA exit multiple and

equity discount rate) and input a series of values in the row
across the top of
the table (e.g. EBITDA exit multiple) and a series down the left
hand column of the table (e.g. equity discount rate). Note:
these series of inputs must NOT be linked to the inputs that
you are looking to vary
3. The ranges in the top row and left column are generally
driven from the center values (7.0 and 13.0% respectively in the
following illustration) with equal increments from this center
value
4. Highlight all the entries thus made which will, therefore,

require a rectangular table to be highlighted
5. Using the
• Data; Table function
The row input cell reference (being the input varying across the
top row of the table) – will be the input for EBITDA exit multiple
which drives the rest of the model; and
Column input cell (being the input varying in the left column of
the table) – will be the input for equity discount rate which
drives the rest of the model.
6. Using
• F9
A data table will be produced which highlights the sensitivity of

the Enterprise Value to the changing EBITDA exit multiple and
varying equity discount rate.
Enterprise Value – £m sensitivity
EBITDA exit multiple
Equity 147.7 5.0 6.0 7.0 8.0 9.0

discount
rate 12.0% 133.0 143.7 154.3 165.0 175.7
12.5% 130.2 140.6 151.0 161.4 171.7
13.0% 127.5 137.6 147.7 157.8 167.9
13.5% 124.8 134.7 144.5 154.4 164.2
14.0% 122.3 131.8 141.4 151.0 160.6
In the above table, the model output for Enterprise Value is

£147.7m with an EBITDA exit multiple of 7.0x and equity
discount rate of 13.0%. This is the value at the center of the

sensitivity table and in the top left corner.
If the EBITDA exit multiple were to be 5.0x and the equity

discount rate became 13.5%, on the assumption that all other
inputs remained unchanged, then the Enterprise Value would
be £124.8m – i.e. £22.9m of value has been destroyed.
Making the table more flexible
To make tables more flexible and more useful to review, it is

sensible for the middle of the series of values across the top of
the table (7.0 above) and the middle of the series of values
down the left hand side (13.0% above) to be equal to the actual
inputs in the model.
However as said above, the table will not work if these are
linked to the actual inputs.
Therefore a sensitivity range schedule can be set up as follows:
Link to This is Incremental

actual middle change
inputs value
EBITDA exit multiple (x) 7.00 7.00 1.00
Equity discount rate 13.0% 13.00% 0.50%
The first column is directly linked to the actual inputs. The

second and third columns are entered as hard numbers.
• The number input in the second column must be the same

value as that in the first column (but not linked). It is this cell
which is linked into the center of the top row / left column of
the sensitivity table
• The values either side of the middle values can be controlled

by setting the increment (in the third column) by which the
values should increase or decrease.
Error diagnostics
Often the model works in the way it should and the user
concentrates on the key outputs. Sometimes, however, due to
changes made to inputs, the sensitivity tables do not represent
the values appearing in the rest of the model. Sadly, this is

often only spotted once the model has been printed.
Error messages can be used to flag up problems with sensitivity

tables.
These errors are of two types:
1. When inappropriate values are being input into the top

rows / left columns of the tables which do not coincide with
those of the inputs used in the rest of the model.
By setting up a sensitivity range table (as above), the values

in column 1 (based on the numbers driving the rest of the
model) and column 2 (used to drive the sensitivity tables)
can be compared. Any differences should be flagged and
all differences summed.
An error message can be driven from this sum of the

differences.
2. The sensitivity tables may not have recalculated as F9 may

not have been pressed.
When the sensitivity tables are working, the value in the

center of the table and that in the top left corner should be
the same. The user can be alerted to press F9 by
comparing these two numbers and driving an error
message if they do not agree.
Validating data
A major problem of financial modeling is controlling the quality

of inputs and the results. Data validation is tremendously
useful because it enables data entry to be limited, cell by cell,
within a model.
Data validation – with inputs
Where the cell is an input cell, invalid inputs will not be allowed
(and a prompt will indicate why). This is particularly useful if
dates, currencies or text are to be entered in a precise format
or to ensure that an input is within an allowable range.
For example, assume that only a date lying between today and
the next year end (which is in cell E17) can be chosen.
• Select Data; Data Tools; Validation
• Click on the down arrow by the Allow box and a list of options
will be displayed
• Allow Date, between, and then either enter the start and end
date or link to dates within the model.
The above Allow list shows the different ways in which the
inputs can be constrained, e.g. whole numbers only, dates,
values from a list and so on.
The Data box gives a series of choices for limiting the data
(between, not between, greater than etc.) once a category
has been chosen. The illustration shows the relevant
entries to constrain date entry to the range described
above.
If it is necessary to control the denomination entered to, say,

bn, m, or ’000, Select Data; Validation; select List – either enter
the data as shown below in the source box or put the source
data somewhere within the Excel model and then click on the
arrow and highlight the area where the source data is entered.
Note. As shown, if the source data is on another sheet, then it

is necessary to name the source data.
Input message
Input messages can appear at the same time as the data

validated cell is selected. There is no other visual indication in
the worksheet that validation is in use. This should give
instructions as to what to enter in the cell.
Where a dropdown (list) box has been chosen in the settings it

is unlikely that an input message will be necessary.
However, where the user has to enter, for example, a forecast

date, then by selecting the Input Message tab, a message can
be composed so that the following instruction will appear:
“The forecast date entered must be within the next 12

months”
Error alert
Data validation is best used to make inputting easy and to

ensure robust inputs drive the model. It is imperative that
inappropriate inputs are blocked – which is what data
validation does.
When entries are blocked the following default message

appears:
As this does not indicate how to solve the problem, it is useful

to change the message. By selecting the Error Alert tab, a
message can be composed so that the above message is
replaced by “Must enter a forecast date within the next 12
months”.
Data validation – with outputs
Additionally, data validation of outputs can be used to “sense

check” results: If we apply data validation to a range of cells
containing formulae, Excel will not stop the results of the
formulae from being outside the required range, but if the
“Circle Invalid Data” button is pressed under Data; Data Tools;
Consolidate Data Dropdown, then cells with results outside the
required range will be highlighted:
Conditional formats can be used to validate results. For

example, conditionally format so that those cells which are not
valid / do not fulfil the benchmark criteria appear as a different
color, with borders, with a colored background, etc.
The advantage of this is that the problems are highlighted

without the use of other functions (i.e. the auditing toolbar for
data validation above).
The disadvantage of this method is that these cells are merely

formatted without having any other functional implication – i.e.
the fact that a cell fails a test does not prevent that cell from
being used elsewhere.
Conditional statements
The use of flags (0 and 1) through IF statements can add

functionality if the result of an equation is not valid / does not
meet the benchmark criteria.
If, for example, a project has to fulfil 4 out of 5 criteria to get

funding then conditional formatting and data validation can still
be used to identify whether the benchmarks have been
reached on each criteria.
However, to indicate that some of the inputs need to be

changed as they do not fulfil 4 criteria, a series of IF statements
with 1 or 0 as the values if TRUE or FALSE respectively can be
added. If the sum of these statements is greater than 1 then
the tests have failed (and so a message stating that inputs
should be changed should appear). If the sum comes to 1 or
less then the project can get the funding.
The ISERROR function
It can be irritating when #DIV/0! appears in a cell, not because a

genuine error has been made but because one of its
precedents has not yet been completed. It then has a knock-on
effect to all the current cell’s dependents, so making the model
ugly.
This function effectively eliminates errors from the formula and

also stops its spread to any of its dependents.
For example:
If the contents of A1 were 187; A2 were 0; and those of A3

were =A1/A2 the result would be #DIV/0!.
By amending the formula in A3 to:
=ISERROR(A1/A2)
the result would be TRUE (i.e. there has been an error).
This has its uses, but could be made more useful by adding a
logical test to the function:
=IF(ISERROR(A1/A2),0,A1/A2)
The result being 0 this time rather than TRUE.
Note: the ISERROR function should be used with care.

Sometimes when an error occurs it is because something has
gone wrong with the model. This error needs to be fixed. The
ISERROR function will cover up any errors and so can
undermine the controls put in the model.
Pivot tables
Pivot tables are used to quickly summarise large volumes of

data. By using a pivot table, you can calculate and present
summary information without writing a single formula or
copying a single cell. They allow data to be analyzed by using
multidimensional data views which can be quickly created by
dragging and dropping category headings to move data
around.
There are three key reasons for using a pivot table:
1. To summarise the data contained in a lengthy format into a

more compact, readily understandable form;
2. To find relationships between the data; and
3. To organize the data in a form that is easy to chart.
Caution
Best practice modeling techniques create models which update

based on changes to the inputs and workings. Unfortunately,
the data in the pivot table is not automatically linked to the
original source – changes in the source data will not
automatically alter the values in the pivot table. The pivot table
can be refreshed, but there is no default message to warn
about this. Consequently, pivot tables should be used with
caution in financial modeling.
Pivot table data
When using pivot tables, the source data must be set out in a
table: i.e. there must be more than one column of data and
each different column must have a heading.
When setting up a table the following points should be noted:
• Headings must be in the row directly above the data, i.e. there
cannot be rows separating the headings from the data
• Blank cells should be avoided
• Leave a blank column between different tables on the same

sheet
• It is easier to work with the pivot tables if the data ranges are
named.
Data characteristics
The following characteristics must be identified within the data:
• The data field, where the data field is the variable that you
want to summarise. In the table below, this will be the “score”.
• The row and/or a column field, where the row and/or the
column fields are the variables that will control the data
summary. The month, subject and student will be the row or
column fields in the following data.
Creating the pivot table using the wizard
To create a pivot table place the cursor anywhere in the data

area and then start the pivot table wizard as follows:
• ALT + D; P
• The Pivot Table wizard starts up
Step 1
Specifies the source data and whether you want a chart as well
as a table. Most commonly you will get your data from the
table that is part of the current sheet. Therefore select an Excel
list.
Step 2
If you were in the table when you started the wizard, Excel will
display the range of cells automatically. If not, select the cells
to be analyzed. If the table is to be extended at a later stage it
may be better to name the table.
Based on the above selection, Excel will use the words from
Row 2 (the top row of the data range) as the headings.
Step 3
The final screen displayed asks for the position of the pivot
table. The pivot table can either be displayed on a new sheet
or on the same sheet. If the pivot table is to be displayed on
the same sheet then a cell reference must be given.
However, it is useful at this stage to click on the Layout button.

Here you can design the table by dragging the field buttons,
located on the right of the dialog box, to the appropriate row

page and data fields.
The “field buttons” mentioned in the Wizard are those four on

the right: Month, Subject, Student and Score. These can be
dragged to an area on the left. One button will be dragged to
the Column area, one to the Row area, and one to the Data
area.
Click on Month and drag it over to the Row area. A button will
appear in the row area.
Drag the Subject button to the Column area, and the Score
button to the Data area (the sum function will be the default
and is used for columns containing numerical data. It will
count the number of entries for text values).
The final pivot table will look like the following:
Modifying a pivot table
Pivot tables are so called because they allow the tables of data
to be pivoted so allowing data to be analyzed in different ways.
Using the Pivot Table toolbar allows this analysis to take place.
If you don’t see the Pivot Table toolbar
• click on View > Toolbars > Pivot Table; or
• click on any part of the pivot table
Moving or adding pivot table fields
Dragging the drop-down field box to the appropriate position is

the quickest, though sometimes most fiddly approach to
moving the fields around.
To put the Students button on the pivot table, locate the

Student button on the pivot table toolbar and drag the Student
button to the top of the pivot table, where it says “Drag Page
Fields Here.”
Each of subject, student and month are now shown as drop-

down boxes. Any or all categories within each can be displayed
(e.g. all subjects, selected subjects or an individual subject
could be shown).
A field can be removed by dragging the field to any location

outside the pivot table boundaries.
Using the Pivot Table Field List
The Pivot Table Field List should appear when you click on a
pivot table. If it doesn’t, click on the field list button on the
pivot table toolbar.
To alter the pivot table, select the field to be moved and the
position to be moved to (displayed at the bottom of the pivot
table field list).
Adding a new row or column field widens the view, whilst

adding a new page field helps you to focus on the detail of your
table.
Changing values
To change the values from say sum to average, on the pivot

table toolbar, click on the pivot table button. Alternatively, right
mouse on the data area of the pivot table.
• Select Field Settings and the following dialogue box appears:
Changing the format of numbers
Click in the data area of the pivot table, then click Field Settings
button
(either by right mousing or using the Pivot Table toolbar). Click

on the Numbers button, a format dialog box is displayed
containing only the numbers sheet. Select the category
required and build the format.
Displaying the source of data
To display the data that gives a specific result, double click on

the data entry and the source will be presented on its own
sheet. Caution should be used: this new data is not linked to
the original source so changes to the source data will not alter
this new data and it cannot be refreshed, unlike the pivot table.
Creating a pivot chart
Pivot charts can be created at the same time as the pivot table
or as required simply by clicking on the Pivot Chart button.
A new window will be opened containing a stacked bar chart

(as default) of the data contained in the Pivot Table.
Once the chart has been created it can be manipulated in a

similar manner to the pivot table and you can change the chart
type and format as with any other chart.
The following shows the result if a pivot chart is added based

on the pivot table:
The pivot table will then be modified, together with the chart,
when any of the drop-menus is changed (by dragging or using
the pivot menus), e.g. Student name is changed to Mary; or
the headings on the chart are pivoted, e.g. the subject
becomes the x-axis and the month is the legend field.
Consolidating data with a pivot table
Pivot tables can also be used to consolidate data. In the

following example, we have six divisions laid out in the same
format on six individual sheets and with no empty rows
between the headings (date) and the data. As the data areas
are all the same, a pivot table can be used to summarise,
consolidate or select any number of these divisions.
Using the pivot table wizard we can consolidate this data.
1. Select one of the sheets / divisions and start the wizard – this
time check the “Multiple consolidation ranges” in step 1
2. Create a single page field for me in step 2a
3. Select the data range on the first sheet; press “Add” and then
click on the next sheet tab – the same data range for the next
sheet will automatically be selected; continue this for all 6
divisions before moving on to the final step. Note the pivot
wizard orders the divisions alphabetically according to sheet
name.
4. Having the pivot table as a new sheet will default to the

following:
The default pivot table is not perfect, but minor changes will get
it into the required form:
• The order of the income statement is alphabetical – drag

“Revenues” to the top then the order can be re-worked. Some
income statement headings can even be removed (through the
use of the “Row” drop-down menu)
• The number of years of output can be refined by eliminating

some through the use of the “Column” drop-down menu
• The default is for all divisions to be included in the summary.

Alternatively any one division could be shown in the output by
changing the selection in the “Page 1” drop-down menu. Note,
each of the divisions is known as “item 1”, “item 2” etc so care is
needed to ensure the correct division is output.
• If a selection of divisions is required, drag the “Page 1” to

beside the Row in the row headings part of the table. At this
point all 6 divisions will appear. Their names can be changed
by typing over them (remember “item 1” is the first of the
sheets alphabetically) and then using the “page 1” drop-down
menu to select the number of divisions required.
The final table could look like the following:
Model completion
Group outline
When printing or presenting the model, there may be parts of

the model which you do not want to print – e.g. historic
periods, detailed calculations for check balances etc. In this
case, the relevant rows or columns can be hidden:
• Select the column(s) or row(s)
• Right mouse
• Hide.
This is quick, but is shoddy practice:
• It is not always obvious that columns or rows are hidden
• Why are they hidden?
• Do they have any effect on any other parts of the model?
• Do they contain fixes for the rest of the model...?
There may be perfectly good reasons for doing it but many

users would be suspicious as it is seen as a way to hide things
that are suspicious.
A far better way is to:
• Select a cell(s) in the relevant column(s) or row(s)
• Data; Group and Outline; Group – Alt-D-G-G
• Select either rows or columns.
The selected area can now be hidden but with the use of a
column or row bar (to the top or left hand side of the
window respectively). If the bar outline symbol is “+” then
the user can click this to show the hidden area. If the “-”
symbol appears in the outline bar then a defined area can
be hidden.
Protecting the model
Once the model is complete and everything works, then it is

worth protecting the model to ensure the modeller (or the
reviewer) does not amend the formulae and corrupt the hard
work done to date.
It is unlikely that the inputs and assumptions should be

protected, but all other sheets are formula-driven and these
are the ones that need protecting.
Note: If report manager is used, at least one sheet must

remain unprotected in order to allow report manager to be
activated.
Whole sheets can be protected by:
• View; Project; Protect sheet. Leave the default boxes in the

dialogue box ticked
• The use of a password is optional − without a good reason, it

is sensible not to use one, unless the modeller wants to be
contacted at any time of the day or night by any subsequent
user for the rest of the model’s life!
Selective protection
The default setting within Excel is that all cells will be protected
when a sheet is protected.
To protect a sheet, but allow some specific cells to be changed,

then cells and ranges can be “selectively unprotected” using the
following procedure (note: this will only work if the sheet is
unprotected first):
• Highlight the cells which you want to be able to amend •

Format; Cells; Protection, untick the “Locked” box. Press
OK
• Protect the sheet (as above).
This creates “windows” in the locked sheet where the model

can be manipulated. This is useful for the inputs sheet where
the text is protected but the actual inputs can be changed.
Styles and protection
Selective protection can be done through the use of Styles.

The last of the Style options is “Protection”. All input styles
should have this box checked and then modified (protection –
locked box is NOT checked) to be “No protection”.
As the default setting for cells is to be Locked when the

sheet is protected, by leaving the “Protection” style option
unticked for all other styles, the result will be that only those
cells with the input style can be changed once the sheet is
protected
Hiding
If you wish to hide all (or some) of the formulae and only
allow the user to have access to the results of the cell(s),
ensure the sheet is unprotected and then:
• Select the sheet – Control+A
• Format; Cells; Protection, tick the “Hidden” box. Press OK
• Protect the sheet (as above).
What you have created is a sheet which looks the same, but is
protected and the user cannot see the formulae that underlie
each cell.
Charts
To quickly create a chart that is based on the default chart type,

select the data that you want to use for the chart, and then
press ALT+F1 or F11. When you press ALT+F1, the chart is
displayed as an embedded chart; when you press F11, the
chart is displayed on a separate chart sheet. This chart can
then be modified as required.
The default chart type created by using the above shortcut can
be easily changed by:
• Right mouse on any chart and select Chart Type
• Use the menu to select the preferred chart type
• Select “set as default chart” to the bottom left of the menu
Typically, however, the chart wizard is used to create charts.
Chart wizard
To create a chart using the chart wizard, select the cells that
contain the data that you want to use for the chart. If you
select only one cell, Excel automatically plots all cells
containing data that directly surround that cell into a chart. If
the cells that you want to plot in a chart are not in a
continuous range, you can select nonadjacent cells or ranges
as long as the selection forms a rectangle. You can also hide
the rows or columns that you don’t want to plot in the chart.
The chart wizard can either be accessed by the button in the

toolbar of from the Insert menu (Alt-I H):
Step 1 of 4 – chart type
Click the chart type, and then click a chart subtype that you
want to use. To see whether a specific chart looks right for
your data select the “Press and hold to view sample”. Click
Next.
Step 2 of 4 – source data
a. On the Data Range tab, the data from the first step will be
selected. It can be changed at this point.
You are also asked whether the data series is in a row or a

column. For example, using the following data, if we wish to
compare the performance of each division over time (as a line

chart), then the series are in rows. Alternatively, if we wish to
chart the development of the performance of each division (as
clustered columns), then the series are in columns.
In short, the series relates to the legend and the other heading
will form the x-axis.
b. The Series tab. If the data range is a continuous area, then

the series names and values will be automatically selected
together with the X values. If the data range is not continuous
or the default references are inappropriate, the names and
ranges can be altered at this stage on a series by series
nature. Note, the series name can be named by either using a
reference or typing in the appropriate text directly in the name
box. Click Next.
Step 3 of 4 – chart options
a. Titles – The axes and chart title can be added at this stage.
Despite the need to type in the appropriate labels rather than
using references to the labels used in the model it is worth
doing – these can be changed (dynamically) later. Axes – used
to select whether both axes are to be presented. Usually don’t

change from default
b. Gridlines – used to select the need for gridlines. Usually

don’t change from default
c. Legend – used to select whether to show the legend and its

position. Usually don’t change from default – it can be easily
removed and its position altered later
d. Data Labels – used to give labels for each data point. Unless
there are very few data points (e.g. pie chart), the chart will look
cluttered with the labels. Individual labels can be added later
e. Data Table – used to show the values as a data table directly

below the chart. Infrequently used. Click Next
Step 4 of 4 – chart location

Charts can be created:
• In a separate chart sheet – a sheet in a workbook that

contains only a chart. A chart sheet is beneficial when you
want to view a chart or a PivotChart report separately from
worksheet data or a PivotTable report
• As an object in a sheet as an embedded chart. Embedded

charts are beneficial when you want to view or print a chart or
a PivotChart report with its source data or other information in
a worksheet
Modifying the chart
When a chart is created, the chart tools become available

and can be used to modify the chart so that it presents the
data the way that you want. In general, right-mousing on
the relevant part of the chart will give the appropriate
modification options. Sadly, some of the steps are a little
onerous and take time to master.
Fortunately, many of the normal Excel menus and functions

remain active and so the chart can be manipulated in the same
way as data is manipulated. When selecting the chart, see
which of the menu items and icons remain active.
Different elements of the chart can be selected by use of the up

and down arrows to move between components – when doing
this, the Name box (to the left of the Formula bar) will show the
name of the item selected.
Change the location of a chart
If a chart is embedded as part of a sheet it can be easily

dragged around the sheet. If the chart is on a chart sheet or it
is embedded on one sheet and needs to be moved to another,
then right-mouse on the chart and change its location, using
the location choice.
Under ‘Choose where you want the chart to be placed’, do one

of the following:
• To display the chart in a chart sheet, click New sheet. If you

want to replace the suggested name for the chart, you can type
a new name in the New sheet box
• To display the chart as an embedded chart in a worksheet,

click Object in, and then click a worksheet in the Object in box
Change the standard text size, font and color
When the chart is selected, the size and font of all text within
the chart can be changed at one time by using the Font and
Font Size drop-down menus (and color if needed) rather than
having to select each bit of text separately.
Removing elements of the chart
To quickly remove any part of the chart, select that item by use
of the left mouse and press the delete key. For example, the
legend, an axis, the (default grey) background color, or the
gridlines, etc could be removed.
Adding a series
There are two ways of adding a series, the standard way and
the quick way:
Standard approach
• Right mouse on the chart and select Source data
• On the Series tab select Add
• Enter the Values section and select the new data range (and
Name if required)
Quick approach
• Select and then copy (Ctrl+C) the data series to be added
• Click on the chart and paste (Ctrl+V) – the series should be

automatically added
Mixing bar charts and line charts
• Select any individual series (using the up and down arrows to

tab through the series)
• Right mouse on the series and select Chart Type
• The bar chart for that series can then be changed to a line
chart (or vice versa)
Modifying the axes
An axis can be modified in many ways through the menu

derived from right mousing (or double clicking) on it. Some of
the options require you to play around to get the right look for
your chart but the following options may be useful:
• Scale – the default maximum and minimums (commonly zero)

may not be appropriate for your data
• Font – Autoscale is the default so that when the chart is re-

sized, the font size moves relatively. If the font size is to remain
at, say, 8 point then the Autoscale should be removed
• Number – Linked to source is the default which may not

always be appropriate. For example, where the range is €0 –
€10,000,000 it may be useful to specify the number style as
€#,##0.0,,”m”. The result will show the axis €0.0m – €10.0m.
Dynamic axes and titles
The chart title or axes labels must be typed in using the chart
wizard rather than being dependent on data from the model.
Consequently, changes to the model may change the chart, but
the axes and title labels will not change. These labels can easily
be made dynamic (i.e. linked to the model) once the chart has
been created.
By selecting a label on the chart (e.g. the title or an axis label),

the formula bar becomes active (and the Name box to the left
of the formula bar shows “Chart Title” or “Value Axis Title”, etc).
A formula can then be entered into the formula bar – this
should be the cell reference of the text which needs to be the

label.
For example, if the chart title is to be “Value creation –

exit year 3” (where 3 is a variable in cell E4), a text string
of the form
=”Value creation – exit year “&E4
can be created in, say, cell C43. The formula to be input

into the formula bar once the chart title is selected
should be
=C43
Note, the text string cannot be created in the formula bar of

the chart title – only simple single cell references can be used.
Additional dynamic labels can be added by the use of text

boxes. (A quick way to get a new text box is to start typing in
the formula bar: a new text box is then created using this
formula which can then be moved and formatted as
appropriate).
Dynamic labels
The chart wizard can be used to label each data point.

Alternatively, by selecting the data series in the chart and then
using the Format Data Series menu (by right mouse), a data
label can be added for the entire series. However, this is often
overkill so that the labels take over the chart.
If only selected labels are wanted then each superfluous label

can be selected in turn and deleted so that only the required
labels remain. When there are many data points or data series
then this can be onerous (and not dynamic).
If, for example, only the final data point should show a label,
this can be easily created:
• select the data point on the chart
• right mouse to get Format Data Point menu
• add a label using the Data Labels
Another approach is to create a new series which only has one

point. For example, if a chart is to be created from a column of
data and only the maximum point in the series is to be labeled,
then a new series can be easily created to show this dynamic

data label.
If the values making up the series are in E20:E39, then a new

range can be created in column F of the form:
=IF(E20=MAX(E$20:E$39),E20,0)
The formula will give a series of 19 zero values and one true
value. If the range is charted for this series, Excel will give one
point surrounded by 19 zero values. If a line chart is created
from this series then this hasn’t quite fulfilled the need.
In charts, Excel ignores any error values and does not attempt
to plot them. Understanding this, an alternative can be
created:
=IF(E20=MAX(E$20:E$39),E20,NA())
The result will be a series of 19 #N/A and one value. If the

range is charted for this series, Excel will ignore the #N/A
references and merely give one point. The series can then be
formatted to show labels; the result being that only the
maximum will be shown.
Dynamic gridlines
By adding new series, dynamic gridlines can be inserted.

Using the above example, if a gridline is required for the
maximum value in a series then a new series can be created
in G20:G39:
=MAX(E$20:E$39)
By selecting and then copying the data in G20:G39, followed by

selecting the chart and then simply pasting, a horizontal (grid)
line will be created at the maximum value which can then be
appropriately formatted.
Historic financials
Decide which historics are necessary – i.e. income statement,

cash flow statement and balance sheet.
Inputs should go on the inputs page, but historics are facts

rather than assumptions driving future results or value and so
it is reasonable to put them on the appropriate sheets (i.e.
income statement historics on IS sheet, etc.).
Think about the structure of the financials.
• Decide on which headings are necessary in each – for

example, in an income statement it may be Sales, EBITDA, EBIT
and net income with all other numbers being of limited interest
to the output
• Alternatively, a detailed income statement might be deemed

necessary for the required output. Here the limit may be the
level of detail in the historic financials, or more likely, the level
of detail in the forecast assumptions available (e.g. from
brokers or management)
• In the balance sheet, a detailed breakdown is lovely, but

realistically, it is often only the capital structure that is
necessary for most outputs – many of the other categories can
be combined.
The income statement
Put in the necessary headings – and the other figures between

these are “noise” to make the statements reconcile.
Ensure that the bottom line figure ties in with the source – and
put in a check to ensure this.
It will be necessary to tie some of these numbers into the other

financials – a profit figure (one of EBITDA, EBIT or net income
depending on preference) to start the cash flow and the
cumulative reserves (or equity) for the balance sheet (see
below).
The cash flow
Put in the necessary headings (probably operating cash flow

and prefinancing cash flow) and the other figures between
these are “noise” to make the statements reconcile.
The starting point for the operating cash flow is likely to have
been fed from the income statement sheet (one of EBITDA,
EBIT or net income depending on preference).
Ensure that the bottom line figure ties in with the source and
put in a check to ensure this.
It will be necessary to tie the cumulative cash (or net debt) into
the balance sheet (see below).
The balance sheet
Put in the necessary headings (probably capital structure, PPE

and working capital) and the other figures between these are
“noise” to make the statements reconcile.
The source for the equity (or retained earnings) should come
from the income statement sheet:
On the income statement sheet, reconcile the bottom line

to the equity (or retained earnings) from the balance
sheet using:
Start of year X
Net income X
Less: Dividends (X)
Other additions (deductions) X
End of year X
The category “Other” should be explainable (e.g. equity

raised, other recognised gains or losses), but some
adjustments may not always be laid out in the source.
The source for debt, cash or net debt should come from the
cash flow sheet:
On the cash flow sheet, reconcile the bottom line to the

net debt (or cash) from the balance sheet using:
Start of year X
Cash flow (pre net debt flows for net debt X

reconciliation)
Other additions (deductions) – e.g. foreign exchange X
End of year X
The category “Other” should be explainable, but some

adjustments may not always be laid out in the source.
Put in some checks to ensure that the balance sheet balances

and put the result on the Checks sheet.
The historic balance sheet from the source will always balance
and so must the balance sheet in the model before moving on
– and this should be done without the need for a “fudge” figure.
Forecast financials
To make life easier, the first step must be to get the forecast
balance sheet to balance.
Ensuring balancing balance sheets

This is done by:
1. Filling in all the totals and subtotals in all the forecast

financial statements (including the retained earnings /
equity and cash / net debt reconciliations together with the
balance sheet check calculations).
If the historic financial statements have been set up
correctly, then all these formulae can be copied from the
historics.
In order to ensure that the forecast financials continue to
integrate, the retained earnings / equity will be fed from the
retained earnings / equity reconciliation in the income
statement workings and the cash / net debt from the cash /
net debt reconciliation. As profits are inserted into the
forecast income statement and cash flows into the cash
flows statement then the balance sheet will update. On
setting these up in the forecast periods, there will, initially,
be no movement.
2. The balance sheet will not currently balance. By linking
each value in the balance sheet (other than retained
earnings / equity and cash / net debt) to the value in the
previous year, the balance sheet should initially balance (at
the same value as the last historic year).
3. All movements in other categories within the balance sheet
will be updated on a module by module basis.
For example, if capex is forecast, formulae should be
updated to accommodate this - capex will reduce cash in
the cash flow and increase assets in the balance sheet.
When adding the results of the forecast workings, the
financial statements should then automatically update and
any errors will immediately be revealed through the checks
you put in earlier – if they do not, you should not move on.
The objective is to create all the individual lines which will make
up the income statement, cash flow and balance sheet. The
usual minimum requirements in terms of the number of
modules is three and the components are as follows:
a) Operations and working capital
• Sales
• EBITDA margin
• Working capital balances
b) PPE / fixed assets
• Net book value
• Annual depreciation charge
• Aggregate annual capital expenditure
c) Debt
• Closing debt balances
• Interest costs
• Fees payable
• Aggregate drawdown and repayment assumptions
• Repayments of overdrafts or revolving credits from free cash

flow.
Error identification
After each module, the outputs from the workings should be

tied into the financials, so creating a balancing balance sheet
at each stage of building up the model. For example, if the
balance sheet does not balance after processing the
operations and working capital numbers, then the error must
have occurred in that module and so the error should be
easier to track.
Find the difference in the balance sheet in the first period of

imbalance.
• If the difference is recognisable – error of omission – the entry

has not been entered in all the appropriate places
• If the difference ÷ 2 is recognisable – the entry has been made

but added rather than taken away or vice versa.
For example, to tie in the operations and working capital

numbers:
Sales, operating costs (excl. depreciation & amortisation) & EBITDA IS
Working capital increase (add to appropriate brought forward BS

figure)
EBITDA & working capital increase CFS
Setting up the reconciliation
Operations and working capital
PPE
Debt and interest
Tax and dividends
Debt modeling
The big problem when modeling debt is the ease with which
circularities can be created. As a model is a simplification of
the world, then the circularity problem can be circumvented by
use of appropriate simplifying assumptions.
The problem
Tax is often calculated using the following:
EBITDA X
Depreciation (tax based) (X)
Net interest expense (X)
Taxable profit X
Net interest expense is interest on debt less (add) interest on

cash (revolver) respectively.
Interest on cash / revolver balances is calculated using the

following:
Opening cash (revolver) balance X
Cash increase / (decrease) in year X
Cash (revolver) at end of year X
Cash increase in the year is a post-tax, post-interest figure and

so, therefore, is the cash at the end of the year. Consequently,
• The tax expense is dependent on interest on cash and
• Interest on cash is dependent on both tax expense and

interest on cash
i.e. a circularity has been created:
• Without changing the calculation settings of Excel, the model

is likely to crash and even if it doesn’t, the numbers populating
the model cannot be trusted.
• By changing the calculation settings to switch the iteration on

(Tools, Options, Calculation, Iteration) the numbers can be
trusted, but, particularly with a large model, the model remains
unstable. If the model is populated with volatile functions and
data tables then it may from time to time crash and/or #REF!
out.
A solution
(Assumption: the debt instruments have a structured

repayment profile and any shortfalls or spare cash goes to the
cash / revolver)
1. Build up the individual debt schedules with structured

repayments
2. Calculate the interest arising on debt instruments
3. Set up the cash / revolver schedule as:
Opening cash (revolver) balance X
Cash increase / (decrease) in year (leave blank for now)
Cash (revolver) at end of year (opening +/- increase / (decrease)) X
4. Calculate interest on cash / revolver based on OPENING

balance (to avoid circularity)
5. Sum up all interest to find net interest expense
6. Do tax working (including the net interest from above)
7. Put tax expense into both the P&L and the cash flow (and
balance sheet if it is not all to be paid in the year)
8. Fill in the “Cash increase / (decrease) in year” line above as
Net debt decrease (increase) in year X
Scheduled debt repayments (X)
Cash increase / (decrease) in year X
Where net debt decrease (increase) in the year is the post-tax

(but not yet post interest) cash flow.
9. All the debt (and cash) and interest information is now

calculated and so can be put into the financial statements
10. Put a check to ensure that the net debt (or cash) from the
debt sheet equates to that in the balance sheet (which
already equates to that in the cash flow).
Putting in a switch
The interest on cash / revolver uses a simplifying assumption to

get around the circularity problem. However, if there are
significant movements in cash then the interest may not be
accurate enough.
In this case it would be useful to build a switch which would

vary the way the interest was calculated:
• If the switch was on, interest would be calculated on average

balance (and hence circularity)
• If it were off, then interest would be calculated on opening

balance (no circularity).
The settings should be set to allow iteration in the calculations

(Tools, Options, Calculation, Iteration). The model will work but
is less stable – and so the switch should be on only when there
are few amendments left to be made to the model in order to
avoid the model crashing. A check can be put in to inform
whether to turn the iteration on or off.
If the model crashes and/or #REF! out whilst the circularity

mode (average method) is used, simply switching back to the
opening method should fix the model.
Formatting Continued
The Home menu in Excel (Alt-H) is home to most formatting
tools. Sub-menus for Clipboard, Font, Alignment, Number,
Styles, Cells and Editing are grouped under Home.
Note: All of these commands can be accessed using the

keyboard via Alt, as well as with the mouse.
The mini toolbar forms part of the menu when you right click
on a cell using the mouse. The mini toolbar allows the user to
quickly apply basic formats to text and numbers. Unfortunately
the mini-toolbar cannot be customised.
Most formatting tools from the Home menu can be more

efficiently navigated using the Format Cells menu that is
accessed through the shortcut Ctrl+1 as before.
Styles
Cell styles is possibly one of the least used areas of Excel.
Some applications may be useful to the financial modeller.
Style functionality is now found in the Home menu. The extract

below displays all the new default styles that are included in
Excel, revealed in the command Cell Styles (Alt-H-J), a useful
icon to have on the Quick Access Toolbar, replacing the Style
dropdown box.
A new feature is the introduction of the “live preview”. This

feature will display the impact of a style directly into the
workbook so that when the mouse glides over the style
options, the selected cell or range in the workbook
temporarily displays the style (unless the style options area
completely covers the chosen cells!). When you identify your
chosen style, click on the selection and the style will be
applied.
Excel enhances the style control. We are able to:
• Modify an existing style (refine the normal style)
• Create new styles
• Delete styles
• Merge styles from an another workbook into the active

workbook
Modifying an existing style

To modify an existing style the user must go through the Home
menu and hit the Cell Style tool ( or Alt-H-J). This will open up
all the styles available in that particular workbook. Pick the
style you wish to modify and right click it (or shift-F10). This
opens up the style dialog box below.
If we are building a financial model, we will usually wish to

redefine the default Normal style in Excel. Therefore a right
click / Shift F10 and modify on the Normal style will allow the
user to redefine the Normal style to a financial modeling

standard
Creating a new style

The example below will illustrate how new styles are created,
using an input style as an example. Cell E4 below has been
formatted with a yellow background color, blue font and not
protected. Note, Excel has a standard style called Input, hence
we have used the name Inputs. The Input style can be
modified to suit users requirements.
To record this formatting as a style navigate to Home menu;

Cell Styles ; New Cell Styles (Alt-H-J-N) found at the bottom of
the style listings. This opens up a Style dialog box. The user
must then:
• Enter a new style name in the name box. The check boxes
display the current formats for the cell. By default all check
boxes are checked.
• If you do not want the style to include one or more of the

format categories, then remove the checks from the
appropriate boxes. For instance, the Inputs style needs
flexibility on the number format, as inputs can be various types
of number or text. Therefore in the example below, checks
have remained only in Font, Fill and Protection. This suggests
that this user wishes the style to apply the font and fill color
consistently, and be unprotected even if a sheet is protected.
• Click OK to create the style and to close the dialog box.
User customised styles appear first in the Cell Style list.
Deleting styles
To delete a style in the menu, right click on the style and select
Delete.
Merging styles from another workbook

User defined styles are stored only in the workbook in which
they were created. If you have created some styles which
would be useful in another financial model, these styles can be
transferred to the new model.
To merge styles from another workbook:
• Open both the workbook that contains the styles that you
want to merge and the workbook into which you want to merge
styles
• From the workbook into which you want to merge styles,

choose Home; Cell Styles; Merge (Alt-H-J-M)
• Excel will then display the merge styles dialog box. This box
will display a list of all open workbooks.
• Select the workbook that contains the styles you want to

merge and click OK. Excel will transfer across all styles to the
new workbook.
Paste Special
Paste special is now within the Home; Paste; Paste special
menu (Alt-H-V-S).
As before, copy the area first, Ctrl+C. Then navigate to the

Paste menu (AltH-V). A sub-menu appears that allows the user
to paste one of six qualities:
• paste (P)
• formulas (F)
• paste values (V)
• no borders (B)
• transpose (T)
• paste links (N).
Alternatively select the Paste Special (S) tab. To paste formats

(Alt-H-V-S-T)
Conditional formatting can be found within the Styles section of
the Home menu, Alt-H-L. The key improvements in Excel are:
• No limit to the number of conditional formatting rules per cell

(previously restricted to three). In past versions of Excel if more
than one of the conditional formatting rules evaluated to
“True”, only the first conditional format was applied. In Excel,
all rules are applied in order of listing which can be managed in
the Manage Rules menu.
• Number formatting can result from conditional formatting.
• In previous Excel versions, it was relatively easy to accidentally

wipe out conditional formatting by copying and pasting a range
of cells to cells that contained conditional formatting. This
conflict has been eliminated in 2016.
The conditional formatting menu looks very different to earlier

versions of Excel.
To apply a conditional formatting rule to a cell or range, the

range must be selected and then one of the commands from
the conditional formatting menu must be chosen.
Alt-H-L opens the conditional formatting menu.
Conditional formatting choices are:
Highlight This choice accords with the traditional use

cell rules of conditional formatting. This option
includes rules that highlight cells that are
greater than a particular value, between
two values, contain a specific text string or
are duplicated
Top This type of conditional formatting will

bottom highlight, for instance, the top ten items,
rules items in the bottom 20% or items that are
above average
Data bars Applies graphic bars directly to cells,

proportional to the cell’s value
Color Applies background colors, proportional to

scales the cell’s value
Icon sets Displays icons directly in the cells. The

icons depend on the cell’s value
New rules Enables the user to specify other

conditional formatting rules for the
selected cells
Clear rules Deletes all the conditional formatting from

the selected cells
Manage Displays the rules manager dialogue box, in

rules which the user can create new rules, edit
rules and delete rules
One problem with conditional formatting is we are unable to

conditionally format across a number of sheets at the same
time. When sheets are grouped the function is not available.
To resolve this, create the conditional format rule on one
sheet, then copy and paste the formats using paste special or
the format painter, it can be paste to multiple sheets at once.
User defined conditional formatting rules

Modellers can define their own conditional formatting rules
through the New Rules menu within conditional formatting.
This menu allows the user to recreate all default conditional
formatting rules as well as new rules. As with all other
conditional formatting, the user must select the cells to be

formatted and then navigate to the New Rules menu.
• Select cells to which the conditional formatting rules will apply
• Select a Rule Type (see extract below)
• With each rule type the ‘Edit the Rule Description’ changes to
show the rule components.
• The preview pane provides an idea of the nature of the

formatting to be applied.
As normal, cells on other worksheets can be referenced in

conditional formatting rules if those cells have been named.
Conditional formats using graphics

The spreadsheet extract below illustrates a few examples of
how the new conditional formatting functionality in Excel can
be easily used. All of the examples below were set up by typing
in the numbers, selecting the ranges and applying the relevant
type of conditional formatting (Icon sets, data bars, color scales
etc).
Conditional formatting rules manager

The conditional formatting rules manager (found at the bottom
of the conditional formatting dialog box in the Home menu)
allows the user to fully manage the conditional formatting rules
contained within the current worksheet.
Conditional formatting rules can be viewed for:
• A selection
• An entire workbook
• Individual sheet tabs
Once the rules have been displayed, they can be edited or

deleted. New rules can be added an the rule priority can also
be altered within this manager.
Creating a workbook template

Saving a template for modeling workbooks is good practice to
save time for future models.
Setting up a workbook from scratch ready for financial

modeling is a 10-15 minute task for an experienced modeller.
The setup procedure is relatively standard from model to
model. As a time saving device, once you have set up your
model, the Excel document can be saved as a template.
Therefore, each time a new model is required, a standard setup
template can be applied, thus saving a little time during the
initial set up procedure.
Once the setup has been completed, save the file as a

template. The “Save
As” (F12) command is included in the Office Button. This will
display the Save As menu. The user must then choose Excel
Template from the “Save as type” field.
Once the template has been saved, it will be stored and the
next time the user wishes to set up a new model the template
can be opened. The template will be found through the Office
menu within the New command.
Excel has a number of embedded templates which are listed in

the
New Workbook dialog box. All user defined templates are
stored in the My Templates options. Choose the template and
the workbook will be setup automatically.
Formulas
Excel now has a dedicated Formulas menu. All formula
commands are contained within this area of the product. The
Function Library within the Formulas menu conveniently
organizes the 340 standard excel functions into nine categories:
• AutoSum
• Recently Used
• Financial
• Logical
• Text
• Date & Time
• Lookup & Reference
• Maths & Trig
• More Functions
The menu below is accessed using Alt-M
The sum and other common mathematical formula commands

can then be accessed through the AutoSum (∑) dropdown
button. Alt+= still works as the keyboard shortcut to sum.
Shift+F3 still works as a shortcut to access the Function

Arguments box.
Ctrl+A still works to access the Functions Arguments box, when

opening a new function.
Interesting functions
Excel has 5 interesting functions:
New function Purpose
IFERROR Used to check for an error and display

a message or perform a different
calculation Better than ISERROR
AVERAGEIF Used to calculate an average if condition

fulfilled (similar really to sumif and
countif)
AVERAGEIFS Used to calculate an average if multiple

criteria fulfilled
SUMIFS Used to calculate a sum if multiple

criteria fulfilled
COUNTIFS Used to count if multiple criteria fulfilled
If these new functions are used in any financial model that you
build, bear in mind that the model cannot then be shared with
users of earlier versions of Excel. See section on compatibility.
New features of existing functions

Some commonly used functions have been enhanced. Those
relevant to financial modeling include:
Function New feature
IF Up to 64 nested IFs are possible now,

though not recommended for good
practise modeling.
CHOOSE Up to 254 values can be chosen. It is

advisable to use an array if you require
large selections.
Formula AutoComplete
Formula AutoComplete is very useful and easy to use. With
Formula AutoComplete, you can quickly write or select proper
formula syntax and get help completing the formula
arguments.
Formula AutoComplete is prompted by the user typing = plus

a letter into a cell. It provides additional assistance by
displaying an alphabetical list that contains function names
and range names. The extract below helps to illustrate this.
The user in this extract has merely typed =in into cell F5. The
dropdown list has initially highlighted the Index function and
has provided a short description of what the function does.
Once the correct formula has been found from the dropdown
list using the arrow keys, press TAB and the formula will
populate the cell and can be edited as normal.
Formula assistance works with nested formulas as well.

Getting to grips with this additional functionality will increase
the speed and accuracy of your formula construction.
Formula AutoComplete can also be used to apply historically

created names. See section on Using Names.
Resizable formula bar

The formula bar automatically resizes to accommodate long,
complex formulas, thereby preventing the formulas from
covering other data in your worksheet. You can also write
longer formulas with more levels of nesting (though not best
practice!) than you could in earlier versions of Excel
To expand the formula bar click on the dropdown arrows at the

far right of the bar or Ctrl+Shift+U.
Watch Window
The Watch Window function is found in Formulas Menu, in the
Formula Auditing grouping (Alt-M-W).
Names
Names functionality is located within the Formulas menu.
Microsoft has added more functionality to this area of the

product, making the use and management of names
significantly easier with the introduction of the Names
Manager. This has addressed an area of conflict amongst
financial modellers, as some financial modellers have criticised
the use of names due the difficulty of auditing a model
containing a number of named cells and ranges.
Creating names
Names can be created using Ctrl+Shift+F3 shortcut. This will
bring up the traditional Create Name dialog box.
Alternatively, the name can be created using the New Name

dialog box that has been included in Excel. Select the cell or
range you wish to name and then navigate to Define Name
command in the Formulas menu (Alt-MM-D). This will activate
the new name dialog box below.
The name of the cell or range is typed into the “Name” field.
The location of the named cell/range is displayed in the “Refers

to” field.
A feature of Excel is the ability to define the “Scope” of the

name. The scope of a name can be set to apply to a whole
workbook or just individual sheets. It allows a user to avoid
circularity if using the same name on different sheets.
However, this is not best practice and causes major auditing
issues. If you are using the keyboard shortcut (Ctrl+Shift+F3) to
apply a name, the default applies the name to the workbook
and cannot be changed retrospectively.
Users can also add a comment to be associated with the name;

this can be edited at any time. This comment can be very
useful when using the Name Manager (next section) as it will
assist in the auditing of names within larger financial models.
Name Manager
Name Manager is an enhancement of the old define name
menu. The manager is accessed with the shortcut Ctrl+F3.
Name Manager provides:
• full disclosure of the cell reference
• the values included in the name cell / range
• the ability to filter the names according to purpose
• the scope of the name (whether the name is workbook

specific or not)
Name Manager dialog box is re-sizeable to view more

information as required.
New functionality included in the Name Manager is the ability

to add comments associated with the name. If the modeller
double clicks on a name in the list or hits the Edit button (Alt-E),
the menu below pops up and allows the modeller to add
comments to the name.
Such comments could outline the use of the name and how it is
used within the model – useful for numerical switches.
Using names
In addition to pasting names using the F3 key, functionality has
been included with respect to using names through Formula
AutoComplete which we mentioned previously.
The extract below shows a choose function that will select from
one of three named ranges. The formula has been partly set
up and the user is about to define the three arguments of the
equation. The user has just typed in the letter “c”. Formula
AutoComplete displays a dropdown list with entries beginning
with the letter “c”. Names and functions appear alphabetically.
The arrow keys can then be used to find the relevant name or
function. Hit the TAB key to apply.
Saving a workbook as a PDF file

You can download a free Office add-in that enables the user to
save a workbook as a PDF file. The add-in can be downloaded
from http://office.microsoft.com/downloads
The PDF file format is widely used as a way of disclosing

information to third parties in a read-only format that allows
precise control over the form and content of the document.
Once the add-in has been included, financial models can be
saved in a PDF format via the “Save As” menu.
Finalising a workbook
Models can be marked as final. This action will make two
changes to the model:
• It will make the model read-only so that the file cannot be

saved with the same filename.
• It makes the workbook view-only so that nothing may be

changed in the model. When you open a finalised document,
the status bar displays an additional icon. Also most of the
Ribbon will be made inactive.
In order to finalise a workbook, go to the File; Protect

Workbook Dropdown; Mark as Final.
Marking a document as final is not a security measure. Excel

will prompt you to look for the security icons in the status bar
below the sheet tabs. The finalising can be easily switched off
by repeating the steps above.
Inspecting a workbook
In the Office; Prepare menu there is the option to Inspect
Document. This tool is useful if you plan to distribute your
financial model to others. Excel can inspect the file for
comments, hidden data and personal information. This tool
can locate hidden information about you, your team or about
the workbook that you may not want to share with others. It
also allows the reviewer to delete comments, hidden data or
block personal information. It is advisable to save the
workbook before inspecting as changes using this cannot be
undone.
Comments
From a financial modeling perspective the use of the comment
is an essential and often an underused discipline. These
comments form part of the documentation that supports a
model. They should be used for:
• assumption justification
• formula explanation
• sourcing information
• general reminders
Comments can still be inserted with the shortcut Shift+F2.
Excel has added some additional comment management in the

Review menu in the Comments grouping.
The tools allow the user to quickly:
• Insert new comments
• Go to the next comment in the model
• Go to the previous comment in the model
• Show all comments
• Show/Hide comments
Data functionality
Sort and filter
The sort and filter functionality is housed in the Home menu as
part of the Editing grouping.
Dates
Excel automatically recognises some inputs as dates. Excel
applies a date format where a date is recognised. For example,
the date 1st January 2009, which is denoted by the general
number 39814, will return as a particular formatted date
depending on the cell input:
Cell input Return
1 January 2009 01-Jan-09
01 Jan 2009 01-Jan-09
01 Jan 09 01-Jan-09
01/01/2009 01/01/2009
01/01/09 01/01/2009
Note: The cell style does not change in the style name box.
Date formats can be customised as in previous versions of

Excel.
Auditing and error detection tools
Tracking editing changes
The track changes function will provide a clear trail of

amendments made to a model from a specified date using
comment boxes. The comment will detail the nature of the
change, the date and its time.
For example:
• Tools; Track Changes; Highlight changes
• Tick checkbox for track changes while editing.
Excel will save a temporary file – maintaining a record of

the model pre changes.
Any editing changes made will be noted in a comment box

providing a full trail of amendments.
To subsequently accept or reject the changes:
• Tools; Track changes; Accept or reject changes (Excel will save

a temporary file maintaining a record of all changes made)
• Select changes to Accept or Reject; OK
• Review proposed changes selecting from the menu whether

to accept or reject changes.
Once the work has been reviewed, the original model can be
updated with the reviewed changes by:
• Tools; Merge workbooks
To switch off the track changes function:
• Tools; Track changes; Highlight changes
• Remove tick checkbox for track changes while editing.
This function is also very useful when making changes to or

reviewing somebody else’s model to explain or provide detail
about the amendments.
Error values
#VALUE!
This error has two common causes:
1. Referencing a cell that contains text. Select the cell with the
error and press F2 or Control+[. Inspect the precedents and
correct as necessary
2. Referencing a range instead of a single cell, for example,

=E10+(E12:E20). In this case SUM is required.
#REF!
This error is commonly found when rows or columns are

deleted from the model, such that a formula refers to a cell
which no longer exists.
#NAME?
This indicates that Excel does not recognise the range name
entered in the formula.
#DIV/0!
This error often occurs either when data is being deleted from
a model, or when formulae are written in advance of the
information being provided. The denominator is missing or is
0.
#NUM!
This usually occurs with the IRR function. If it cannot generate

an answer within 20 iterations when calculating IRR it returns
the #NUM! error.
#N/A
This is often generated by VLOOKUP, HLOOKUP and MATCH

type functions, often because no exact match for them can be
found.
The NA() function will return a #N/A which can be useful in

charts. For example, if a data label is to be added for the
maximum value in a series then a new series can be created by
copying the following in the column to the side of series 1:
=if(cell value=max(series 1),cell value, NA())
When this is added as a new series to the chart, Excel will

ignore all #N/A values and so only one value will be charted
which can then be automatically labeled.
Auditing a formula
F2
The F2 button, when on a cell, edits a formula. Excel will

highlight the cells in colored boxes which are precedents of the
cell that is being edited. Consequently, F2 is the quickest way
to audit a formula when the precedents are located close to the
formula, but of limited use when they are elsewhere.
If more information about the cell is needed, press F2 to

inspect the formula and then select one of the cell references.
If F9 is then pressed the reference converts to the value of the
precedent cell. This can be repeated until all cell references are
converted to values. Do not press Enter, otherwise the
references are permanently converted to values. If this
technique is used with range names, Excel will treat the name
as an array reference and on pressing F9 will return every value
in the array!
Control+[
Control+[ Goes to all the precedent cells on the same

sheet (goes to first precedent only if on
different sheets)
Control+] Dependent cells (on same sheet only)
F5
When the precedents are elsewhere in the model, highlighting

the cell reference or name in the formula and pressing F5 (the
Go To command) will go to the relevant cell (or range).
Unfortunately each component of the equation needs to be
done in isolation.
Often the best use of this function is when switching between

2 parts of the model. By going to a cell (possibly by using the
auditing toolbar or Control-[), F5-Enter will return you to the
original cell.
Auditing toolbar
The auditing toolbar is a powerful tool and should form part of

the main toolbar for any Excel user. It can be used to:
• Trace all the precedents of a cell (and their precedents, and

their precedents … if needed) in order to find what a cell is
dependent upon
This is particularly useful for identifying where the coding has

gone wrong (a negative has been formed when it should not
have been, or worse a #REF! or #DIV/0!) or when you are trying
to follow someone else’s model.
• Trace all the dependents of a cell (and their dependents …) in

order to find what effect the cell has elsewhere
Particularly useful for finding out if, by the end of model, a cell
is not referred to something. If this is the case, it is either an
output or rubbish. The tool is also useful for finding out why a
cell is used when picking up someone else’s model.
• Trace errors. Where a cell has an error in it (such as #VALUE!

or #NAME!), the use of this function selects the cell that
contains the original formula that has an error and has all that
cell’s direct precedents arrowed.
Double clicking on the trace precedents / dependents tool will

show both direct and the next indirect precedent / dependent.
Double clicking on the arrows takes the cursor to the end of the
arrow.
Where an arrow points to another sheet, double click on the

dotted arrow which then returns the relevant locations in the
Go To dialogue box.
Summary
Order Pros Cons
1. F2 Highlights Quickest when Only useful if

precedents precedents are precedents are near
near
2. Control+[ Go to Quick Only goes to first

precedents precedent on other
sheets
3. Auditing Traces Easy visual Requires significant

toolbar precedents reference mouse action
Double clicking on
precedent line
takes you to other
end of line
4. F5 Go to Can go to specified Only goes to one

precedents precedents precedent at a time
Better as a way Requires significant

to get back to mouse action
original cell
Additionally, if names have been used:
5. The name means something to the reviewer
6. Name (drop-down) box – top left of spreadsheet – can be

used to go to the named cell / range
7. F5 (all names are listed) – can be used to go to the named

cell / range
Finding links
For reviewing a model from a third party or for modellers

trying to fix their own models, locating and understanding the
links is very important. Excel does not have any built in tools
to help, but this can be easily done: Firstly, to find the name
of any linked files, open the Edit menu and select Links. A
dialogue box will be displayed showing the names of linked
files and allowing the links to be updated.
The address of the linked cell(s) will appear as
=‘[Big and Clever.xls]Input’!$P$134
Finding the cells containing links in the workbook requires

the following method:
1. Go to the first sheet in the model, go to the Edit menu and

select Find
2. As the [ is a bit of a give away in the above address, insert a

square bracket, [, into the find box and press return. Excel will
take the cursor to the first linked cell in the sheet and further
linked cells can be found by pressing the find next button in the
Find dialogue box.
The shortcoming of this method is that it is laborious: if there

are a lot of links in a sheet this process can take a long time
and Excel will only reliably search to find links if searching sheet
by sheet.
Contained in old names
A source of spurious links is the copying of data between

models where the copied cells use a range name. This can
lead to a range name being included in the list of range names
in a workbook, where the cells in that range are in another
workbook. These can be found by going to the Insert menu
and selecting Name and Define (or Ctrl+F3). Selection of the
names in the list one by one will show up any ranges defined
in other workbooks.
The F5 Special
The Go To Special is a very powerful auditing and orientation

tool.
It can be activated by
• Selecting a single cell for most of the options in which case the
whole sheet is searched (not possible for Row and Column
differences)
• Selecting an area in which case only the selection is searched;

or
• Highlighting the whole sheet in which case the whole sheet is

searched (very useful for Row and Column differences).
When the cell or area is

selected:
• Press F5 and then Special and

then the following box appears:
Auditing for consistency over columns
A good model should have the contents of column E (assuming

this is the first period of data) copied to each subsequent
column on all sheets (other than inputs, of course). This will
ensure that each period is calculated consistently and that the
same assumptions are being used in each period.
The F5 Special function can highlight rows where there are

inconsistencies across the periods.
• Select the appropriate columns (probably from column E to

the end period)
• F5 (Go To)
• Special
• Row differences.
The inconsistent rows are highlighted for further investigation.

To move between the differences use the Tab function.
(If there are inconsistencies which are quite spread out, then
whilst they are highlighted, fill the selected cells with a color so
that it is easy to identify the inconsistencies. Each
inconsistency can then be examined individually.)
Other auditing tips
Unknown functions
If a formula contains a function which needs some explanation,

by pressing the fx button when editing the formula, Excel will
bring up the dialogue box for that function.
In the following, as the CHOOSE function is selected from

within the IF statement (cursor flashing on that part of the
equation), then the dialogue box for CHOOSE will be shown.
Alternatively Shift F3 can be used to put functions back into

their dialogue boxes.
Alt-Return
Although formulae should never be long and complicated,

occasionally someone else’s model has these features. When
auditing the formula it is useful to break it down. For example,
the following formula has no complex functions but is not easy
to decipher:
=-((PP/(PP+’Inputs &
Results’!$F$25+AStart))*((SUM(F76:F81)+SUM(F84:F93))*(1-tax)- =-
(Crate_monthly *Cstart*(F29/F30))))/(1-((PP/(PP+ ‘Inputs &
Results’!$F$25+AStart)*tax)))
By pressing Alt-Return at the appropriate breaks in the formula,

the formula will read as:
=-(
(PP/(PP+’Inputs & Results’!$F$25+AStart))
*(
(SUM(F76:F81)+SUM(F84:F93))
*(1-tax)-
(Crate_monthly *Cstart*(F29/F30))
/(1-((PP/(PP+ ‘Inputs & Results’!$F$25+AStart)*tax)))

The formula will remain in this form for subsequent
users.
F2-F9
A formula can be edited and audited by pressing F2. If we then

select part of the formula, e.g. a cell reference, an argument or
a function within the formula, its value can be assessed by
pressing F9. For example, with the following:
=-((PP/(PP+’Inputs &
Results’!$F$25+AStart))*((SUM(F76:F81)+SUM(F84
:F93))*(1-tax)- (Crate_monthly *Cstart*(F29/F30))))/(1-((PP/(PP+

‘Inputs & Results’!$F$25+AStart)*tax))) by pressing F2 and then
selecting ‘Inputs & Results’!$F$25
and then pressing F9, this part of the formula changes to the
value of that source cell, i.e. 3. (press escape after this or the
reference will be replaced by the number 3 in the formula).
Alternatively, if we pressed F2 and then selected
SUM(F76:F81)
By pressing F9 the value of this sum function replaces the

reference in the formula, i.e. 1,587.35.
Evaluate formula
Evaluate formula is a more advanced version of F2-F9.
• Select a cell to be evaluated
• Tools; Formula auditing; Evaluate formula
Two options are then given:
• Evaluate – the underlined part of the formula is evaluated

(i.e. the value replaces the cell reference).
• Step in – the precedents of the underlined part of the

formula are shown. If the precedent is a further formula then
the same options of Step in or Evaluate remain available until
the ultimate hard-coded precedent is reached.
At any stage any underlined part of the formula could be

evaluated (i.e. the value replaces the cell reference) or where a
precedent has been selected a further option of Step out
becomes available (i.e. we are moved back up the chain of
precedents)
Other model review tools
The inputs are generally some distance from the outputs and
so it may not be easy to analyze how changes in these outputs
affect the key outputs. Excel has a number of ways of making
this review easier.
Using more than one window
When reviewing a model it is often useful to be able to see two

parts of the model simultaneously.
This can be achieved by opening a second window and viewing

both of them at the same time. In this way, as we make
changes in one part of the model, we can look at the impact of
those changes in a completely different and, possibly, distant

part of the model.
With the current model visible:
• Select Window; New Window – there are now 2 windows

open, both looking onto the same file – Filename.xls:1 and
Filename.xls:2
• To see them simultaneously, select Window; Arrange;

Horizontal (or vertical or cascade) and ensure ‘Windows of
active workbook’ is checked
Amending either window will update the model in the normal

way. When 2 windows are no longer required, one of them
(preferably the new window opened) can be closed and the
original version will still be open.
Switching between windows is very straightforward: through

the Window menu by selecting the relevant window from the
list, or by using the shortcuts Ctrl+F6 or Ctrl+Tab. Using this
shortcut repeatedly will take you consecutively from one
window to another window.
Watch window
Specific cells can be selected and their values watched as other

parts of the model are changed.
• Select the cell(s) to be watched
• Select Tools; Formula auditing; Show watch window
• Click Add Watch
As other inputs are altered the values of the watched cell(s) will
change in the watch window. Double-clicking on the cell
reference in the watch window will take you to the cell.
Camera
A camera icon is available in the Tools category when

customising toolbars and should be placed in your toolbar.
Once the camera is in the toolbar:
• Select the (output) area to assessed
• Press the camera icon – a picture has now been taken of the
selected area
• Go to the (input) area which drives the outputs which have

had their picture taken
• Click on a blank area and the picture of the output area will be
pasted into this new location
The picture is an image which sits on top of Excel which can be

deleted or moved without affecting the running of the model.
The inputs can now be changed and the values in the picture
alter, i.e. it is still linked to the original formulae and so any
changes to the model affect the picture – more like a CCTV
image than a still photograph.
Auditing a model – a process
Upon opening
• Does it contain macros (message when opening re. enable /

disable macros)?
• Does it have links to other models?
Message on opening states “The workbook you opened

contains links to information in another workbook. Do
you want to update …”
It is unlikely that you will be able to update the links as

the file path of the linked file(s) are likely to be different
to your path.
To find the links, select all sheets and
Control F (find)
In the dialogue box window for “Find what” type [
(all references to file locations have square

brackets)
Alternatively, on the bottom of one of the sheets
F3
Paste List
Review the addresses of the names for any that

have links to other models
• What size is it?
File, Properties, General
• Are the sheets protected?
Tools, Protection
and then one of the options available is Unprotect sheet

(alternatively, have the protection icon in the toolbar – it
will state “Unprotect sheet” if the sheet is protected)
• Are there any hidden sheets?
Format, Sheet
And then one of the options available is Unhide
Coding clarity index
The coding clarity index is a scoring system to quickly assess

the quality of the code in a model.
The purpose of the index is to give an “objective”, or at least

independent, basis for assessing quality in the model and give
a guide as to the ease with which the model will be audited.
Using the index is very simple.
1. Choose 50-60 lines of code in total from 3-4 different areas in

the forecasts and review the code
2. Review the whole model to get a feel for the layout and
structure and review any documentation, help or notes that
come with it
3. Review the questions in the questionnaire and score the

model. If the answer to the question has a score against it,
score the relevant marks for that question. It does not matter
how many times or how few times the design problem has
occurred
4. Add up the scores and look up the score in the results table.
Coding clarity questionnaire
Score for Score for Model

a yes a no score
1. Are any numbers hard coded or embedded into

5
formulae? Even just for the conversion of units?
2. Are formulae inconsistent across the rows in the forecast

5
area?
3. Are assumptions spread around the various schedules of

the model and not in a separate assumptions sheet or 3
sheets?
4. Are inputs color coded? 1
5. Are complex formulae used where more than 2

1
formulae are nested inside each other?
6. Is switching done by multiplying formulae by statements

1
like (c3=1), instead of using an If statement?
7. Are complex formulae annotated with “post-it” notes or

1
clear labels or explained in model documentation?
8. Are dynamic labels used if relevant? 1
9. Are data tables annotated? 1
10. Are range names used for key assumptions? 1
11. Does the model have diagnostic calculations to flag

1
inconsistencies?
12. Does the model have documentation, User instructions

2
or Help?
Total
Coding clarity results table
Score Conclusion
0-6 This is a good score, and the model should be

straightforward, clear and simple. As a general
rule, this is easy to achieve in simple small
models but more difficult as models grow.
7-10 This score should be readily achievable in most

models and is a reasonable level to set as a
minimum quality standard.
It is important to consider when reviewing

scores to see if a score in this range has been
achieved without answering yes to question 1
or 2. These are much higher scoring than the
other questions because the implication of
them is poor discipline and structure. If these
are the problem, then they should be resolved
before the model is used.
11 & The model will have scored on question 1 or 2

above and on most of the other questions too. This
suggests that the model has been put together
in a hurry or that the design scope has changed
as the model has developed. It also suggests
that the discipline and structure, which ensure
quality, are missing.
The obvious quick test of quality on a model

like this is to look at the balance sheet and
whether it balances. Whilst the model may
appear alright now, it is unlikely to have a clear
structure and is likely to have hidden implicit
assumptions not explained in notes. It will be
difficult to work with and develop later if it is
not “polished” now.
There will be big concerns about the internal

consistency of the model and of its ability to
produce sensible representative forecasts. It
will be very difficult to be confident as to what
the shortcomings and approximations are
which will affect how the model’s results will

change as it is sensitised.
Troubleshooting
The steps for spotting errors in models:
1. Find and correct errors
Find and correct the original source of any of the following (i.e.
the location of where the original problem started), by use of
the “Control-[“ or the auditing toolbar:
#N/A #VALUE! #REF! #DIV/0! #NUM! #NAME?
Until these are corrected the model will continue to have

errors.
2. Find any inconsistencies in the sheets
Use the F5-Special-Row differences on each sheet to highlight

where different formulae have been used across a row.
Find what is the appropriate formula to apply all the way across
the row and then copy this across for consistency.
3. Balance sheet not balancing
Find the difference in the balance sheet in the first period of

imbalance:
If the difference is recognisable – error of omission – the entry

has not been entered in all the appropriate places.
If the difference ÷ 2 is recognisable – the entry has been made

but added rather than taken away or vice versa.
4. Check specific diagnostics
A good model should have specific diagnostics telling the user

when errors / inconsistencies have occurred, such as the need
to press F9 to recalculate the data tables. Ensure that all these
diagnostics have appropriate messages.
5. Sense checks
By eye and calculator, check as to whether the output numbers

are sensible.
Appendix
Excel tricks
Auditing consistency over columns (highlights rows that are
inconsistent)
• Select the appropriate columns; F5; Special; Row

differences (or Constants if inputs / hard-wired numbers
are to be identified)
• F5, Special can also be used to find conditional

formatting, data validation, row differences …
Auditing tools
• Ensure these form part of your Quick Access Toolbar to

enable inconsistencies to be spotted quickly
• Double clicking on the trace precedents / dependents

tool will show both direct and the next indirect precedent
/ dependent
• Double clicking on the arrow takes the cursor to the end

of the arrow
• Where an arrow points to another sheet, double click on

the dotted arrow which gives the relevant locations in the
Go To dialog box
• Ctrl+[ to trace precedents or Ctrl+] to trace dependents
Column selection
• Ctrl+space bar; or
• Place cursor on column header – Left mouse button
• Ctrl+- to then delete selected column; or
• Ctrl++ to then insert a column
Comment insertion (descriptive labels for more complex

calculations)
• Shift+F2; or right mouse button
• Shift+F10; Insert comment
• Home; Conditional Formatting; (Alt-H-L) and then follow

the prompts
• F5, Special can also be used to find conditional

formatting on selected sheet
Constants creation (dollarising)
• F4 – pressing F4 toggles between the various dollar

options
Data validation (to ensure only valid results can be input)
• Data; Data Validation; and then follow the prompts (Alt-

A-V)
Find
• Shift+F5 or Ctrl+F
Format painter
• Put the paint-brush symbol on the Quick Access Toolbar

to allow for easy copying of formats. Double clicking on
the paint-brush symbol retains the copied format, so that
it can be applied to further cells straight after. Press Esc
key when finished with copying formats
• Alternatively: Ctrl+C on the cell(s) with the appropriate

format; go to target cell(s) and Alt-H-V-S-T (paste special,
formats)
Formatting numbers for consistency
• Ctrl+1
• For use of _ #; , see Formatting section
Function wizard
• ‘fx’ button to use function wizard or Shift+F3
• Type in name of function preceded by =; press Ctrl+A to

go directly into the function wizard for that function
Go To
• F5
• Ctrl+Home Top of sheet
• Ctrl+End End of active part of sheet, i.e.

the junction of last row and
column used
• Ctrl + any arrow Goes to the start/end of the

block of formulae/data that the
cursor is in
• Ctrl+Page Up/Page-Down Previous/next sheet
• Ctrl+F6 or Ctrl+Tab Switch between open

workbooks
• Shift+F6 Switch to other window when

screen is split
• Ctrl+[ Moves the cursor to the

precedent cells (on same
sheet); Moves to the first
precedent cell in formulae if on
different sheets
• Ctrl+] Moves the cursor to the

dependent cells (on same
sheet)
Graphs
• F11 produces instant best fit graphs for selected data
Hide extraneous columns to fit sheet to appropriate width
• Select the first column to be hidden (either by mouse or

Ctrl+Spacebar)
• Ctrl+Shift-→ (selects the remaining columns on the

sheet)
• Home; Format; Hide (Alt-H-O-U-C) hides all the
highlighted columns
• Alternatively, select columns to be hidden, Right mouse;

Hide, or
• Select columns to be hidden - Shift+F10; Hide or Ctrl+0
Insert
• Shift+F11 New sheet
• Alt+H-I-R or C New row or column
• Ctrl++ New row or column when column or row

selected
• F3 Paste name into a cell or formula
Listing names
• Formulas; Use in formulas; Paste names; Paste list
• Alternatively, F3, Paste List
Menu selection
• Alt followed by letter to get to Ribbon or Office Button

(e.g. Alt+F to enter Office Button);
• To get to next level merely press the letter (e.g. I to enter

Excel Options)
Naming a cell/range
• Type in text in cell to the right of cell or range
• Ctrl+Shift+←; then F3 (whilst Ctrl+Shift still held); check

the right box; Return
Protecting the contents
• Review; Protect sheets – leave the default boxes ticked

and don’t bother with a password. This stops any editing
of the sheet.
• Selective protection – see Protecting the model
Repeat previous action
• Ctrl+Y, or F4
Replace
• Ctrl+H
Reveal / hide formulas
• Ctrl+` (i.e. the top left key on the standard UK keyboard

know as Tilde). This toggles between showing the results
of formulae in the cells and the formulae themselves
Right click mouse button menu
• Shift+F10 (often there is a right click mouse button on

the bottom row of keyboard)
Row selection
• Shift+space bar
• Place cursor on row header – left mouse button
• Ctrl+- to then delete selected row; or
• Ctrl++ to then insert a row
Save model (often)
• Ctrl+S
Save model as…
• F12 – useful to do at the start of each major change as a

new version
Select
• Ctrl+Shift + any arrow Selects cells to start/end of
next/current series
• Shift + any arrow increase the selection one cell

at a time in that direction
• Ctrl+A; or All of current sheet
• Ctrl+shift; space bar; All of current sheet
• Ctrl+space bar; Column
• Shift+space bar Row
• Ctrl+Page Down/Up Select next sheet/previous

sheet
• Ctrl+Shift+Page Down/Up Select sheets (file name now

includes [group])
Alternatively, Right mouse on a sheet tab - Select All Sheets
Sensitivity table creation
• Ensure it is on the same sheet as the inputs to be varied
• Data; What-If Analysis; Data Table (see notes)
Switch creation
For example
• Open the Forms toolbar (Developer; Insert; Form

Controls)
• Select the check-box and create its text
• Using the right mouse, Format Control; Control; Cell Link

(giving cell reference for an unused cell which will now
switch between reading either TRUE or FALSE)
Switching between sheets
• Ctrl+Page Up/Down
Switching between split sheets
• Shift+F6
Switch to other open workbooks/documents
• Ctrl+F6
Spell-check
• F7
View multiple workbook/sheets
• Open required workbook(s)
• View; New window – more than one version of the

current model has been created
• View; Arrange All; Horizontal (if only want views of

current model ensure “Windows of active workbook” is
selected)
• Ctrl+F6 switch between workbooks/sheets
Excel function keys
Other shortcuts
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The Corporate Finance Institute Investment Banking Manual

Investment Banking Manual

About Corporate Finance Institute®

About CFI’s Investment Banking Manual

Copyright © 2018 CFI Education Inc.

Corporate Finance Institute

12 Accounting and analysis fundamentals

88 Accounting and analysis for mergers and acquisitions

144 Discounted cash flow techniques

175 Cost of capital

208 Comparable company analysis

242 Precedent transaction analysis

257 Financial Modeling

259 Best practice financial modeling

This section aims to provide investment bankers with the

• Create meaningful and appropriate forecast financials.

The intention of this manual is to furnish investment

Accounting rules provide the guidance and requirements for

At the time of writing (early 2009) there is a concerted effort to

There are still many differences between IFRS and US GAAP,

This manual generally avoids talking specifically about IFRS or US

Accounting effect on key metrics

The focus of the manual is the analysis impact of accounting

Current vs. non-current

Impairment tests and write downs √ √ √

Goodwill – group / individual entity level √

Impairment tests and write downs √ √ √

Research and development √ √ √ √

Other internally generated intangibles √ √ √ √ √

Capitalisation of software cost √ √ √ √ √

Brands, licenses, copyrights √ √ √ √ √

Net debt definitions √ √ √

Leasing – finance / capital and operating √ √ √ √ √ √ √

Sale and leaseback transactions √ √ √ √ √ √ √

Obligation vs. prudence √ √ √ √ √ √

Deferred retirement benefits √ √ √ √ √ √

Debt vs. equity √ √ √ √ √

Incomes statement items

Events after the balance sheet date √ √ √ √

Treatment of capitalised costs √ √ √ √ √

Share based payments √ √ √ √ √ √

Foreign exchange rates √ √ √ √ √ √

The 2nd income statement √

Cash flow statements

Categories of cash flows √

Free cash flows √

Mergers and acquisitions

Associates – equity method √ √ √ √ √ √ √

Joint ventures – equity √ √ √ √ √ √ √

Goodwill/fair value accounting √ √ √ √

Special purpose entities √ √ √ √ √ √ √

The derivations of key metrics are subject to accounting issues

As ever with analysis, the key is to ensure consistency of

For example, if joint ventures (JVs) are deemed to be core to the

More information is available on each adjustment in the relevant

Accounting and analysis

Although this may seem a very basic way to commence an

As a starting point we shall briefly examine the basic

Past event ➞ present Past event ➞ present