Financial Modeling & Valuation

Module 1: Financial Statement Analysis for Modeling

Module Overview

Before you can build a financial model, you need to understand the raw materials. Financial statements aren't just historical records—they're the foundation for every projection you'll make. In this module, you'll learn to read financial statements through a modeler's lens, focusing on the relationships and drivers that make forecasting possible.

Learning Objectives:

By the end of this module, you will be able to:

Analyze financial statements to identify modeling drivers
Understand the linkages between the three financial statements
Calculate key ratios and metrics used in financial modeling
Normalize historical financials for comparability
Identify the assumptions needed for a 3-statement model

Estimated Time: 4-5 hours

1.1 The Modeler's Perspective

Thinking Like a Modeler

When accountants look at financial statements, they ask: "Are these accurate?" When analysts look at financial statements, they ask: "What does this tell us about the company?" When modelers look at financial statements, they ask: "How can I project this forward?"

The modeler's questions:

What drives this line item?
How does it relate to other items?
What assumptions would I need to forecast it?
How has it behaved historically?
What's a reasonable growth rate or margin?

This mindset shift is crucial. You're not just reading history—you're extracting the patterns and relationships that will power your projections.

The Three Statements Revisited

You know the three financial statements. Now let's understand them as a modeler does:

Income Statement

Measures performance over a period
Key outputs: Revenue, Gross Profit, Operating Income, Net Income
Modeler's focus: What drives revenue? How stable are margins?

Balance Sheet

Snapshot of position at a point in time
Key outputs: Assets, Liabilities, Equity
Modeler's focus: What's the working capital pattern? How much CapEx is needed?

Cash Flow Statement

Explains changes in cash
Key outputs: Operating, Investing, Financing cash flows
Modeler's focus: What's the cash conversion? How is the company funded?

The Critical Insight: These statements aren't independent. They're deeply interconnected. Understand the linkages, and you can build a model where one change cascades correctly through all three statements.

1.2 The Linkages Between Statements

How the Statements Connect

Understanding statement linkages is fundamental to financial modeling. Here's how they interconnect:

Income Statement → Balance Sheet

Net Income → Retained Earnings (Equity)
Depreciation Expense → Accumulated Depreciation (PP&E)
Interest Expense → Accrued Interest (Current Liabilities)

Balance Sheet → Cash Flow Statement

Change in Working Capital → Operating Cash Flow
Change in PP&E (net of depreciation) → Investing Cash Flow
Change in Debt → Financing Cash Flow
Change in Equity → Financing Cash Flow

Cash Flow Statement → Balance Sheet

Net Change in Cash → Cash on Balance Sheet

The Circular Reference: Interest Expense

Here's where it gets interesting. Interest expense depends on debt levels. But debt levels depend on cash flow. And cash flow depends on interest expense.

This creates a circular reference:

Interest expense reduces net income
Lower net income reduces cash flow
Lower cash flow may require more debt
More debt increases interest expense
Return to step 1

In Excel, you'll handle this with iterative calculations. For now, understand that this circularity is why building integrated models requires careful thought.

The Balancing Act

The balance sheet must balance: Assets = Liabilities + Equity

In a financial model, you typically:

Project all asset items except cash
Project all liability items
Project equity (including retained earnings from net income)
Cash becomes the "plug" that balances the balance sheet

Alternatively, some models use debt as the plug (the "revolver" approach), where the company draws or repays a credit facility to balance.

Key Insight: If your balance sheet doesn't balance, something is wrong. This is your primary error-check in financial modeling.

1.3 Income Statement Drivers

Revenue Drivers

Revenue is the most important—and often most uncertain—projection. Different businesses require different approaches:

Volume × Price

Revenue = Units Sold × Price per Unit

Best for: Product companies, manufacturing, retail

Example:

Year 1: 1,000,000 units × $50 = $50,000,000
Year 2: 1,100,000 units × $52 = $57,200,000
Growth: 14.4%

Same-Store Growth + New Stores

Revenue = Existing Store Revenue × (1 + Same-Store Growth) + New Store Revenue

Best for: Retail chains, restaurant groups

Recurring + New Business

Revenue = Beginning ARR × (1 - Churn) + New ARR

Best for: SaaS companies, subscription businesses

Market Size × Market Share

Revenue = Total Addressable Market × Market Share

Best for: Market analysis, competitive positioning

Segment Build-Up

Revenue = Segment A Revenue + Segment B Revenue + Segment C Revenue

Best for: Diversified companies, conglomerates

Cost Drivers

Cost of Goods Sold (COGS)

COGS typically relates to revenue:

COGS = Revenue × COGS %

Or for more detail:

COGS = Direct Materials + Direct Labor + Manufacturing Overhead

Key metrics:

Gross Margin = (Revenue - COGS) / Revenue
COGS as % of Revenue

Operating Expenses

Operating expenses often have fixed and variable components:

Selling, General & Administrative (SG&A)

SG&A = Fixed Costs + (Variable % × Revenue)

Research & Development (R&D)

Often modeled as % of revenue
Or as headcount × cost per employee

Depreciation & Amortization

Modeled from the asset base
Depreciation = PP&E / Average Useful Life
Or use detailed depreciation schedule

Margins to Watch

Gross Margin

Gross Margin = (Revenue - COGS) / Revenue

Reflects pricing power and cost efficiency
Typically stable for mature companies
Watch for trends and industry comparisons

Operating Margin (EBIT Margin)

Operating Margin = Operating Income / Revenue

Shows operational efficiency
Excludes financing effects
Key for comparing companies with different capital structures

EBITDA Margin

EBITDA Margin = EBITDA / Revenue

Approximates cash operating margin
Popular in leveraged finance
Useful for capital-intensive industries

Net Margin

Net Margin = Net Income / Revenue

Bottom-line profitability
Includes all costs including interest and taxes
Varies significantly with capital structure

1.4 Balance Sheet Drivers

Working Capital

Working capital items are typically driven by revenue or COGS:

Accounts Receivable

A/R = Revenue × (Days Sales Outstanding / 365)

Or:

A/R Turnover = Revenue / Average A/R

Inventory

Inventory = COGS × (Days Inventory Outstanding / 365)

Or:

Inventory Turnover = COGS / Average Inventory

Accounts Payable

A/P = COGS × (Days Payable Outstanding / 365)

Or:

A/P Turnover = COGS / Average A/P

Net Working Capital

NWC = Current Assets - Current Liabilities

(Excluding cash and debt)

The Cash Conversion Cycle

CCC = DSO + DIO - DPO

This tells you how long cash is tied up in operations. Lower is better.

Capital Expenditures and PP&E

Capital Expenditures (CapEx)

CapEx can be modeled several ways:

As % of Revenue:

CapEx = Revenue × CapEx %

Maintenance vs. Growth:

CapEx = Maintenance CapEx + Growth CapEx
Maintenance CapEx ≈ Depreciation
Growth CapEx = function of expansion plans

As % of Depreciation:

CapEx = Depreciation × CapEx/D&A ratio

PP&E Roll-Forward

Ending PP&E = Beginning PP&E + CapEx - Depreciation

This is a critical schedule in your model. Get it right, and your balance sheet will reconcile. Get it wrong, and nothing will balance.

Debt and Interest

Debt Schedule

A proper debt schedule tracks:

Beginning balance
New borrowings
Repayments (scheduled and voluntary)
Ending balance
Interest expense

Interest Expense = Average Debt Balance × Interest Rate

Or for more precision:

Interest Expense = Beginning Debt × Interest Rate

(This avoids circularity but is less accurate)

Types of Debt to Model:

Revolving credit facility (the "revolver")
Term loans
Senior notes/bonds
Subordinated debt
Capital leases

Each may have different interest rates and repayment terms.

1.5 Cash Flow Statement Drivers

Operating Cash Flow

The cash flow statement starts with net income and adjusts for non-cash items and working capital changes.

Non-Cash Adjustments:

Add back Depreciation & Amortization
Add back Stock-Based Compensation
Adjust for Deferred Taxes
Add back other non-cash charges

Working Capital Adjustments:

Decrease in A/R = Cash Inflow
Increase in A/R = Cash Outflow
Decrease in Inventory = Cash Inflow
Increase in Inventory = Cash Outflow
Increase in A/P = Cash Inflow
Decrease in A/P = Cash Outflow

Key Formula:

Operating Cash Flow = Net Income + Non-Cash Charges - Increase in Working Capital

Investing Cash Flow

Components:

Capital Expenditures (outflow)
Acquisitions (outflow)
Asset Sales (inflow)
Investment Purchases (outflow)
Investment Sales (inflow)

In most models:

Investing Cash Flow = -CapEx + Asset Sales - Acquisitions

Financing Cash Flow

Components:

Debt Issuance (inflow)
Debt Repayment (outflow)
Equity Issuance (inflow)
Share Repurchases (outflow)
Dividend Payments (outflow)

In models:

Financing Cash Flow = ΔDebt + ΔEquity - Dividends - Buybacks

Free Cash Flow

Free Cash Flow to Firm (FCFF)

FCFF = EBIT × (1 - Tax Rate) + D&A - CapEx - ΔNWC

This is the cash available to all capital providers (debt and equity).

Free Cash Flow to Equity (FCFE)

FCFE = Net Income + D&A - CapEx - ΔNWC - Net Debt Repayment

This is the cash available to equity holders after debt service.

Why It Matters: FCFF is used in DCF valuation (discounted at WACC). FCFE is used for equity valuation (discounted at cost of equity).

1.6 Normalizing Historical Financials

Why Normalize?

Historical financials contain noise:

One-time charges
Non-recurring gains/losses
Accounting changes
Unusual events

Before modeling, you need to understand the underlying performance.

Common Adjustments

Non-Recurring Items

Restructuring charges
Litigation settlements
Impairment charges
Gains/losses on asset sales
Natural disaster impacts

Accounting Adjustments

Operating lease adjustments (pre-ASC 842)
Stock option expense normalization
Pension adjustments
Changes in accounting policies

Pro Forma Adjustments

Full-year impact of acquisitions
Full-year impact of divestitures
Removing discontinued operations

Example Normalization

Reported EBITDA: $100M

Adjustments:

Add back: Restructuring charges $5M
Add back: Litigation settlement $3M
Remove: Gain on asset sale ($2M)
Add back: One-time consulting fees $1M

Adjusted EBITDA: $107M

This adjusted figure is what you'd use for forecasting and valuation multiples.

Red Flags in Normalization

Be skeptical when companies:

Add back "non-recurring" items every year
Have adjustments that always increase earnings
Provide minimal detail on adjustments
Use aggressive definitions of "adjusted" metrics

Rule of thumb: If an expense recurs, it's not non-recurring.

1.7 Key Metrics for Modeling

Profitability Metrics

Metric	Formula	What It Tells You
Gross Margin	(Revenue - COGS) / Revenue	Pricing power, cost efficiency
EBITDA Margin	EBITDA / Revenue	Operating cash profitability
Operating Margin	EBIT / Revenue	Core operating efficiency
Net Margin	Net Income / Revenue	Bottom-line profitability
Return on Assets	Net Income / Total Assets	Asset efficiency
Return on Equity	Net Income / Shareholders' Equity	Return to shareholders
ROIC	NOPAT / Invested Capital	Returns vs. cost of capital

Efficiency Metrics

Metric	Formula	What It Tells You
Asset Turnover	Revenue / Total Assets	Revenue per dollar of assets
Inventory Turnover	COGS / Average Inventory	How fast inventory sells
Receivables Turnover	Revenue / Average A/R	Collection efficiency
Payables Turnover	COGS / Average A/P	Payment timing
Days Sales Outstanding	(A/R / Revenue) × 365	Collection period
Days Inventory Outstanding	(Inventory / COGS) × 365	Inventory holding period
Days Payable Outstanding	(A/P / COGS) × 365	Payment period

Leverage Metrics

Metric	Formula	What It Tells You
Debt / Equity	Total Debt / Total Equity	Capital structure
Debt / EBITDA	Total Debt / EBITDA	Leverage relative to cash flow
Net Debt / EBITDA	(Debt - Cash) / EBITDA	Net leverage
Interest Coverage	EBIT / Interest Expense	Ability to service debt
Fixed Charge Coverage	(EBIT + Leases) / (Interest + Leases)	Broader coverage

Valuation Metrics

Metric	Formula	What It Tells You
EV / Revenue	Enterprise Value / Revenue	Revenue multiple
EV / EBITDA	Enterprise Value / EBITDA	Cash flow multiple
P/E	Share Price / Earnings per Share	Earnings multiple
P/B	Share Price / Book Value per Share	Asset-based multiple
PEG	P/E / EPS Growth Rate	Growth-adjusted P/E

1.8 Building Your Historical Analysis

Step-by-Step Process

Step 1: Gather Data

Download 3-5 years of annual financial statements
Get quarterly data for seasonality analysis
Source: Company filings (10-K, 10-Q), financial databases

Step 2: Input Historical Data

Create a clean historical tab in Excel
Standardize formatting
Ensure proper sign conventions (expenses as positive or negative)

Step 3: Calculate Metrics

Compute all relevant ratios and margins
Calculate year-over-year growth rates
Look for trends and anomalies

Step 4: Normalize

Identify non-recurring items
Adjust for comparability
Document all adjustments

Step 5: Identify Drivers

What's driving revenue growth?
Are margins stable or trending?
What's the working capital pattern?
How much CapEx is required?

Step 6: Document Findings

Summarize key observations
Note questions and areas of uncertainty
Identify assumptions for the forecast

Example Historical Analysis

Company: TechCorp Inc. (hypothetical)

5-Year Summary:

                    2020      2021      2022      2023      2024
Revenue ($M)         800       920     1,060     1,210     1,390
  Growth %                    15.0%     15.2%     14.2%     14.9%

Gross Profit         480       560       650       740       860
  Margin %          60.0%     60.9%     61.3%     61.2%     61.9%

EBITDA               160       192       233       278       333
  Margin %          20.0%     20.9%     22.0%     23.0%     24.0%

Net Income            80        96       117       139       180
  Margin %          10.0%     10.4%     11.0%     11.5%     13.0%

CapEx                 64        74        85        97       111
  % of Revenue       8.0%      8.0%      8.0%      8.0%      8.0%

DSO (days)            45        47        48        47        46
DIO (days)            30        32        31        30        30
DPO (days)            40        42        43        42        42

Key Observations:

Consistent ~15% revenue growth
Expanding margins (positive operating leverage)
CapEx stable at 8% of revenue
Working capital metrics stable
Strong and improving profitability

These observations become the foundation for forecasting assumptions.

1.9 Practical Exercise: Analyzing a Real Company

Exercise Instructions

Choose a public company and perform a historical analysis:

Step 1: Download Financials

Get the last 3 annual 10-K filings from SEC EDGAR
Focus on the financial statements and MD&A

Step 2: Create a Historical Summary

Input Income Statement data
Input Balance Sheet data
Input Cash Flow Statement data

Step 3: Calculate Key Metrics

Revenue growth
Gross margin
EBITDA margin
Operating margin
Net margin
DSO, DIO, DPO
CapEx as % of revenue
Debt/EBITDA

Step 4: Identify Trends

Is revenue growing or declining?
Are margins expanding or contracting?
Is working capital efficient?
How is the company investing?

Step 5: Document Your Findings

Write a one-page summary
Note any non-recurring items to normalize
List questions you'd want to answer before forecasting

What to Look For

Positive Signs:

Consistent revenue growth
Stable or expanding margins
Efficient working capital management
CapEx aligned with depreciation
Manageable debt levels
Strong free cash flow generation

Warning Signs:

Revenue volatility or decline
Margin compression
Working capital bloat (rising DSO, DIO)
Heavy CapEx requirements
Rising leverage
Weak or negative free cash flow

1.10 Key Takeaways

The Modeler's Mindset

Look for drivers, not just numbers
Think about relationships and linkages
Ask "how can I forecast this?"

Statement Linkages

Net Income → Retained Earnings
D&A → PP&E roll-forward
Working Capital changes → Cash Flow
Cash is the "plug" that balances

Key Drivers

Revenue: volume × price, growth rates, segments
Costs: % of revenue, fixed vs. variable
Working Capital: days ratios (DSO, DIO, DPO)
CapEx: % of revenue, maintenance vs. growth
Debt: schedule with interest calculations

Normalization

Adjust for non-recurring items
Look for true underlying performance
Be skeptical of aggressive adjustments

Historical Analysis

Calculate key metrics for 3-5 years
Identify trends and patterns
Document observations and questions
Build foundation for forecasting assumptions

Looking Ahead to Module 2

You now understand financial statements through a modeler's lens. You know what drives each line item and how the statements connect.

In Module 2, you'll put this knowledge into action by building an integrated 3-statement model from scratch. You'll:

Structure your model for flexibility
Build the income statement forecast
Project the balance sheet
Connect the cash flow statement
Make everything balance

The historical analysis you've learned here will directly inform the assumptions you make in your model.

Summary

Congratulations on completing Module 1! You can now:

Analyze financial statements as a modeler
Understand the linkages between all three statements
Identify the key drivers for forecasting
Calculate essential financial metrics
Normalize historical data for comparability
Build a solid historical analysis

These skills form the foundation for everything that follows. Financial modeling is built on understanding the relationships within financial statements.

Ready to build? Proceed to Module 2: Building a 3-Statement Model to turn your analysis into a working financial model.

"Give me six hours to chop down a tree and I will spend the first four sharpening the axe." — Abraham Lincoln

You've sharpened your axe. Now it's time to build.

Financial Modeling & Valuation

Module 1: Financial Statement Analysis for Modeling

Module Overview

Learning Objectives:

By the end of this module, you will be able to:

Analyze financial statements to identify modeling drivers
Understand the linkages between the three financial statements
Calculate key ratios and metrics used in financial modeling
Normalize historical financials for comparability
Identify the assumptions needed for a 3-statement model

Estimated Time: 4-5 hours

1.1 The Modeler's Perspective

Thinking Like a Modeler

The modeler's questions:

What drives this line item?
How does it relate to other items?
What assumptions would I need to forecast it?
How has it behaved historically?
What's a reasonable growth rate or margin?

This mindset shift is crucial. You're not just reading history—you're extracting the patterns and relationships that will power your projections.

The Three Statements Revisited

You know the three financial statements. Now let's understand them as a modeler does:

Income Statement

Measures performance over a period
Key outputs: Revenue, Gross Profit, Operating Income, Net Income
Modeler's focus: What drives revenue? How stable are margins?

Balance Sheet

Snapshot of position at a point in time
Key outputs: Assets, Liabilities, Equity
Modeler's focus: What's the working capital pattern? How much CapEx is needed?

Cash Flow Statement

Explains changes in cash
Key outputs: Operating, Investing, Financing cash flows
Modeler's focus: What's the cash conversion? How is the company funded?

1.2 The Linkages Between Statements

How the Statements Connect

Understanding statement linkages is fundamental to financial modeling. Here's how they interconnect:

Income Statement → Balance Sheet

Net Income → Retained Earnings (Equity)
Depreciation Expense → Accumulated Depreciation (PP&E)
Interest Expense → Accrued Interest (Current Liabilities)

Balance Sheet → Cash Flow Statement

Change in Working Capital → Operating Cash Flow
Change in PP&E (net of depreciation) → Investing Cash Flow
Change in Debt → Financing Cash Flow
Change in Equity → Financing Cash Flow

Cash Flow Statement → Balance Sheet

Net Change in Cash → Cash on Balance Sheet

The Circular Reference: Interest Expense

Here's where it gets interesting. Interest expense depends on debt levels. But debt levels depend on cash flow. And cash flow depends on interest expense.

This creates a circular reference:

Interest expense reduces net income
Lower net income reduces cash flow
Lower cash flow may require more debt
More debt increases interest expense
Return to step 1

In Excel, you'll handle this with iterative calculations. For now, understand that this circularity is why building integrated models requires careful thought.

The Balancing Act

The balance sheet must balance: Assets = Liabilities + Equity

In a financial model, you typically:

Project all asset items except cash
Project all liability items
Project equity (including retained earnings from net income)
Cash becomes the "plug" that balances the balance sheet

Alternatively, some models use debt as the plug (the "revolver" approach), where the company draws or repays a credit facility to balance.

Key Insight: If your balance sheet doesn't balance, something is wrong. This is your primary error-check in financial modeling.

1.3 Income Statement Drivers

Revenue Drivers

Revenue is the most important—and often most uncertain—projection. Different businesses require different approaches:

Volume × Price

Revenue = Units Sold × Price per Unit

Best for: Product companies, manufacturing, retail

Example:

Year 1: 1,000,000 units × $50 = $50,000,000
Year 2: 1,100,000 units × $52 = $57,200,000
Growth: 14.4%

Same-Store Growth + New Stores

Revenue = Existing Store Revenue × (1 + Same-Store Growth) + New Store Revenue

Best for: Retail chains, restaurant groups

Recurring + New Business

Revenue = Beginning ARR × (1 - Churn) + New ARR

Best for: SaaS companies, subscription businesses

Market Size × Market Share

Revenue = Total Addressable Market × Market Share

Best for: Market analysis, competitive positioning

Segment Build-Up

Revenue = Segment A Revenue + Segment B Revenue + Segment C Revenue

Best for: Diversified companies, conglomerates

Cost Drivers

Cost of Goods Sold (COGS)

COGS typically relates to revenue:

COGS = Revenue × COGS %

Or for more detail:

COGS = Direct Materials + Direct Labor + Manufacturing Overhead

Key metrics:

Gross Margin = (Revenue - COGS) / Revenue
COGS as % of Revenue

Operating Expenses

Operating expenses often have fixed and variable components:

Selling, General & Administrative (SG&A)

SG&A = Fixed Costs + (Variable % × Revenue)

Research & Development (R&D)

Often modeled as % of revenue
Or as headcount × cost per employee

Depreciation & Amortization

Modeled from the asset base
Depreciation = PP&E / Average Useful Life
Or use detailed depreciation schedule

Margins to Watch

Gross Margin

Gross Margin = (Revenue - COGS) / Revenue

Reflects pricing power and cost efficiency
Typically stable for mature companies
Watch for trends and industry comparisons

Operating Margin (EBIT Margin)

Operating Margin = Operating Income / Revenue

Shows operational efficiency
Excludes financing effects
Key for comparing companies with different capital structures

EBITDA Margin

EBITDA Margin = EBITDA / Revenue

Approximates cash operating margin
Popular in leveraged finance
Useful for capital-intensive industries

Net Margin

Net Margin = Net Income / Revenue

Bottom-line profitability
Includes all costs including interest and taxes
Varies significantly with capital structure

1.4 Balance Sheet Drivers

Working Capital

Working capital items are typically driven by revenue or COGS:

Accounts Receivable

A/R = Revenue × (Days Sales Outstanding / 365)

Or:

A/R Turnover = Revenue / Average A/R

Inventory

Inventory = COGS × (Days Inventory Outstanding / 365)

Or:

Inventory Turnover = COGS / Average Inventory

Accounts Payable

A/P = COGS × (Days Payable Outstanding / 365)

Or:

A/P Turnover = COGS / Average A/P

Net Working Capital

NWC = Current Assets - Current Liabilities

(Excluding cash and debt)

The Cash Conversion Cycle

CCC = DSO + DIO - DPO

This tells you how long cash is tied up in operations. Lower is better.

Capital Expenditures and PP&E

Capital Expenditures (CapEx)

CapEx can be modeled several ways:

As % of Revenue:

CapEx = Revenue × CapEx %

Maintenance vs. Growth:

CapEx = Maintenance CapEx + Growth CapEx
Maintenance CapEx ≈ Depreciation
Growth CapEx = function of expansion plans

As % of Depreciation:

CapEx = Depreciation × CapEx/D&A ratio

PP&E Roll-Forward

Ending PP&E = Beginning PP&E + CapEx - Depreciation

This is a critical schedule in your model. Get it right, and your balance sheet will reconcile. Get it wrong, and nothing will balance.

Debt and Interest

Debt Schedule

A proper debt schedule tracks:

Beginning balance
New borrowings
Repayments (scheduled and voluntary)
Ending balance
Interest expense

Interest Expense = Average Debt Balance × Interest Rate

Or for more precision:

Interest Expense = Beginning Debt × Interest Rate

(This avoids circularity but is less accurate)

Types of Debt to Model:

Revolving credit facility (the "revolver")
Term loans
Senior notes/bonds
Subordinated debt
Capital leases

Each may have different interest rates and repayment terms.

1.5 Cash Flow Statement Drivers

Operating Cash Flow

The cash flow statement starts with net income and adjusts for non-cash items and working capital changes.

Non-Cash Adjustments:

Add back Depreciation & Amortization
Add back Stock-Based Compensation
Adjust for Deferred Taxes
Add back other non-cash charges

Working Capital Adjustments:

Decrease in A/R = Cash Inflow
Increase in A/R = Cash Outflow
Decrease in Inventory = Cash Inflow
Increase in Inventory = Cash Outflow
Increase in A/P = Cash Inflow
Decrease in A/P = Cash Outflow

Key Formula:

Operating Cash Flow = Net Income + Non-Cash Charges - Increase in Working Capital

Investing Cash Flow

Components:

Capital Expenditures (outflow)
Acquisitions (outflow)
Asset Sales (inflow)
Investment Purchases (outflow)
Investment Sales (inflow)

In most models:

Investing Cash Flow = -CapEx + Asset Sales - Acquisitions

Financing Cash Flow

Components:

Debt Issuance (inflow)
Debt Repayment (outflow)
Equity Issuance (inflow)
Share Repurchases (outflow)
Dividend Payments (outflow)

In models:

Financing Cash Flow = ΔDebt + ΔEquity - Dividends - Buybacks

Free Cash Flow

Free Cash Flow to Firm (FCFF)

FCFF = EBIT × (1 - Tax Rate) + D&A - CapEx - ΔNWC

This is the cash available to all capital providers (debt and equity).

Free Cash Flow to Equity (FCFE)

FCFE = Net Income + D&A - CapEx - ΔNWC - Net Debt Repayment

This is the cash available to equity holders after debt service.

Why It Matters: FCFF is used in DCF valuation (discounted at WACC). FCFE is used for equity valuation (discounted at cost of equity).

1.6 Normalizing Historical Financials

Why Normalize?

Historical financials contain noise:

One-time charges
Non-recurring gains/losses
Accounting changes
Unusual events

Before modeling, you need to understand the underlying performance.

Common Adjustments

Non-Recurring Items

Restructuring charges
Litigation settlements
Impairment charges
Gains/losses on asset sales
Natural disaster impacts

Accounting Adjustments

Operating lease adjustments (pre-ASC 842)
Stock option expense normalization
Pension adjustments
Changes in accounting policies

Pro Forma Adjustments

Full-year impact of acquisitions
Full-year impact of divestitures
Removing discontinued operations

Example Normalization

Reported EBITDA: $100M

Adjustments:

Add back: Restructuring charges $5M
Add back: Litigation settlement $3M
Remove: Gain on asset sale ($2M)
Add back: One-time consulting fees $1M

Adjusted EBITDA: $107M

This adjusted figure is what you'd use for forecasting and valuation multiples.

Red Flags in Normalization

Be skeptical when companies:

Add back "non-recurring" items every year
Have adjustments that always increase earnings
Provide minimal detail on adjustments
Use aggressive definitions of "adjusted" metrics

Rule of thumb: If an expense recurs, it's not non-recurring.

1.7 Key Metrics for Modeling

Profitability Metrics

Metric	Formula	What It Tells You
Gross Margin	(Revenue - COGS) / Revenue	Pricing power, cost efficiency
EBITDA Margin	EBITDA / Revenue	Operating cash profitability
Operating Margin	EBIT / Revenue	Core operating efficiency
Net Margin	Net Income / Revenue	Bottom-line profitability
Return on Assets	Net Income / Total Assets	Asset efficiency
Return on Equity	Net Income / Shareholders' Equity	Return to shareholders
ROIC	NOPAT / Invested Capital	Returns vs. cost of capital

Efficiency Metrics

Metric	Formula	What It Tells You
Asset Turnover	Revenue / Total Assets	Revenue per dollar of assets
Inventory Turnover	COGS / Average Inventory	How fast inventory sells
Receivables Turnover	Revenue / Average A/R	Collection efficiency
Payables Turnover	COGS / Average A/P	Payment timing
Days Sales Outstanding	(A/R / Revenue) × 365	Collection period
Days Inventory Outstanding	(Inventory / COGS) × 365	Inventory holding period
Days Payable Outstanding	(A/P / COGS) × 365	Payment period

Leverage Metrics

Metric	Formula	What It Tells You
Debt / Equity	Total Debt / Total Equity	Capital structure
Debt / EBITDA	Total Debt / EBITDA	Leverage relative to cash flow
Net Debt / EBITDA	(Debt - Cash) / EBITDA	Net leverage
Interest Coverage	EBIT / Interest Expense	Ability to service debt
Fixed Charge Coverage	(EBIT + Leases) / (Interest + Leases)	Broader coverage

Valuation Metrics

Metric	Formula	What It Tells You
EV / Revenue	Enterprise Value / Revenue	Revenue multiple
EV / EBITDA	Enterprise Value / EBITDA	Cash flow multiple
P/E	Share Price / Earnings per Share	Earnings multiple
P/B	Share Price / Book Value per Share	Asset-based multiple
PEG	P/E / EPS Growth Rate	Growth-adjusted P/E

1.8 Building Your Historical Analysis

Step-by-Step Process

Step 1: Gather Data

Download 3-5 years of annual financial statements
Get quarterly data for seasonality analysis
Source: Company filings (10-K, 10-Q), financial databases

Step 2: Input Historical Data

Create a clean historical tab in Excel
Standardize formatting
Ensure proper sign conventions (expenses as positive or negative)

Step 3: Calculate Metrics

Compute all relevant ratios and margins
Calculate year-over-year growth rates
Look for trends and anomalies

Step 4: Normalize

Identify non-recurring items
Adjust for comparability
Document all adjustments

Step 5: Identify Drivers

What's driving revenue growth?
Are margins stable or trending?
What's the working capital pattern?
How much CapEx is required?

Step 6: Document Findings

Summarize key observations
Note questions and areas of uncertainty
Identify assumptions for the forecast

Example Historical Analysis

Company: TechCorp Inc. (hypothetical)

5-Year Summary:

                    2020      2021      2022      2023      2024
Revenue ($M)         800       920     1,060     1,210     1,390
  Growth %                    15.0%     15.2%     14.2%     14.9%

Gross Profit         480       560       650       740       860
  Margin %          60.0%     60.9%     61.3%     61.2%     61.9%

EBITDA               160       192       233       278       333
  Margin %          20.0%     20.9%     22.0%     23.0%     24.0%

Net Income            80        96       117       139       180
  Margin %          10.0%     10.4%     11.0%     11.5%     13.0%

CapEx                 64        74        85        97       111
  % of Revenue       8.0%      8.0%      8.0%      8.0%      8.0%

DSO (days)            45        47        48        47        46
DIO (days)            30        32        31        30        30
DPO (days)            40        42        43        42        42

Key Observations:

Consistent ~15% revenue growth
Expanding margins (positive operating leverage)
CapEx stable at 8% of revenue
Working capital metrics stable
Strong and improving profitability

These observations become the foundation for forecasting assumptions.

1.9 Practical Exercise: Analyzing a Real Company

Exercise Instructions

Choose a public company and perform a historical analysis:

Step 1: Download Financials

Get the last 3 annual 10-K filings from SEC EDGAR
Focus on the financial statements and MD&A

Step 2: Create a Historical Summary

Input Income Statement data
Input Balance Sheet data
Input Cash Flow Statement data

Step 3: Calculate Key Metrics

Revenue growth
Gross margin
EBITDA margin
Operating margin
Net margin
DSO, DIO, DPO
CapEx as % of revenue
Debt/EBITDA

Step 4: Identify Trends

Is revenue growing or declining?
Are margins expanding or contracting?
Is working capital efficient?
How is the company investing?

Step 5: Document Your Findings

Write a one-page summary
Note any non-recurring items to normalize
List questions you'd want to answer before forecasting

What to Look For

Positive Signs:

Consistent revenue growth
Stable or expanding margins
Efficient working capital management
CapEx aligned with depreciation
Manageable debt levels
Strong free cash flow generation

Warning Signs:

Revenue volatility or decline
Margin compression
Working capital bloat (rising DSO, DIO)
Heavy CapEx requirements
Rising leverage
Weak or negative free cash flow

1.10 Key Takeaways

The Modeler's Mindset

Look for drivers, not just numbers
Think about relationships and linkages
Ask "how can I forecast this?"

Statement Linkages

Net Income → Retained Earnings
D&A → PP&E roll-forward
Working Capital changes → Cash Flow
Cash is the "plug" that balances

Key Drivers

Revenue: volume × price, growth rates, segments
Costs: % of revenue, fixed vs. variable
Working Capital: days ratios (DSO, DIO, DPO)
CapEx: % of revenue, maintenance vs. growth
Debt: schedule with interest calculations

Normalization

Adjust for non-recurring items
Look for true underlying performance
Be skeptical of aggressive adjustments

Historical Analysis

Calculate key metrics for 3-5 years
Identify trends and patterns
Document observations and questions
Build foundation for forecasting assumptions

Looking Ahead to Module 2

You now understand financial statements through a modeler's lens. You know what drives each line item and how the statements connect.

In Module 2, you'll put this knowledge into action by building an integrated 3-statement model from scratch. You'll:

Structure your model for flexibility
Build the income statement forecast
Project the balance sheet
Connect the cash flow statement
Make everything balance

The historical analysis you've learned here will directly inform the assumptions you make in your model.

Summary

Congratulations on completing Module 1! You can now:

Analyze financial statements as a modeler
Understand the linkages between all three statements
Identify the key drivers for forecasting
Calculate essential financial metrics
Normalize historical data for comparability
Build a solid historical analysis

These skills form the foundation for everything that follows. Financial modeling is built on understanding the relationships within financial statements.

Ready to build? Proceed to Module 2: Building a 3-Statement Model to turn your analysis into a working financial model.

"Give me six hours to chop down a tree and I will spend the first four sharpening the axe." — Abraham Lincoln

You've sharpened your axe. Now it's time to build.