Practical financial modelling the development and audit of cash flow models

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Practical Financial Modelling The Development and Audit of Cash Flow Models Third Edition Jonathan Swan AMSTERDAM • BOSTON • CAMBRIDGE • HEIDELBERG LONDON • NEW YORK • OXFORD • PARIS • SAN DIEGO SAN FRANCISCO • SINGAPORE • SYDNEY • TOKYO Butterworth-Heinemann is an imprint of Elsevier Butterworth-Heinemann is an imprint of Elsevier The Boulevard, Langford Lane, Kidlington, Oxford OX5 1GB, UK 225 Wyman Street, Waltham, MA 02451, USA Copyright © 2016 Operis Group PLC, Published by Elsevier Ltd All rights reserved Previous editions copyrighted: 2008, 2005 No part of this publication may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or any information storage and retrieval system, without permission in writing from the publisher Details on how to seek permission, further information about the Publisher’s permissions policies and our arrangements with organizations such as the Copyright Clearance Center and the Copyright Licensing Agency, can be found at our website: www.elsevier.com/permissions This book and the individual contributions contained in it are protected under copyright by the Publisher (other than as may be noted herein) Notices Knowledge and best practice in this field are constantly changing As new research and experience broaden our understanding, changes in research methods, professional practices, or medical treatment may become necessary Practitioners and researchers must always rely on their own experience and knowledge in evaluating and using any information, methods, compounds, or experiments described herein In using such information or methods they should be mindful of their own safety and the safety of others, including parties for whom they have a professional responsibility To the fullest extent of the law, neither the Publisher nor the authors, contributors, or editors, assume any liability for any injury and/or damage to persons or property as a matter of products liability, negligence or otherwise, or from any use or operation of any methods, products, instructions, or ideas contained in the material herein ISBN: 978-0-08-100587-3 British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging-in-Publication Data A catalog record for this book is available from the Library of Congress For information on all Butterworth-Heinemann publications visit our website at http://store.elsevier.com/ Publisher: Nikki Levy Acquisition Editor: J Scott Bentley Editorial Project Manager: Susan Ikeda Production Project Manager: Nicky Carter Designer: Mark Rogers Typeset by TNQ Books and Journals www.tnq.co.in Printed and bound in the UK Dedication To Rebecca, Jack, and Jeremy: Modelling is nothing to with catwalks About the Author Jonathan is the director of training at Operis TRG Ltd, the training division of Operis Group plc He has extensive experience of skills and knowledge transfer in this field and has been involved in delivering modelling training since the early 1990s He has since developed the Operis portfolio of financial modelling courses, which he has delivered to finance and management professionals around the world He is a member of the European Spreadsheet Risks Interest Group (EuSpRIG), the international financial modelling thought leaders’ forum Jonathan holds an MBA from the East London Business School, and a Bachelor of Education degree He was appointed as a Visiting Fellow at the Lord Ashcroft International Business School in 2011 xvii Preface to the Third Edition There are far more books on the subject of financial modelling now than when the first edition of this book appeared back in 2005 Ranging from academic tomes full of financial algorithms, to books on company valuation, modelling risk, cash flow forecasting, corporate finance, through to applied Excel techniques and VBA programming, the financial analyst now has a good chance of finding a book relating directly to their modelling needs The financial modelling environment has also matured: a range of methodologies are now available, such as the Operis method as set out in this book, and the very similar FAST, SMART and BPM systems, amongst others These methodologies are used by the increasing number of specialist financial modelling firms, such as Operis, Financial Mechanics, F1F9 and Corality, as well as by the large accounting and consulting firms Although the financial regulators are still unwilling to provide guidance, here in the United Kingdom we have recently seen the publication of the ‘Review of Quality Assurance of Government Analytical Models’ (the Macpherson report, HM Treasury 2013) with guidelines for spreadsheet modelling practice across the whole of the UK public sector The Institute of Chartered Accountants of England and Wales is promoting its Twenty Principles for Good Spreadsheet Practice Financial modelling practitioners are generally better trained and have greater experience than before Industry groups and forums such as the European Spreadsheet Risks Interest Group (EuSpRIG) have reinforced the message that modelling is an inherently error-prone activity and good modellers routinely employ a range of checks and controls in their work The focus has shifted away from model development and much more into model audit and review The question posed in the preface of the first edition of this book remains the same: is this model right? Previously we answered this question by exploring and understanding the modelling methodology needed to develop our own model This time we work more on the assumption that someone else has produced the model It may or may not conform to a standard methodology, but now we need the tools and techniques to provide the assurance to the model owners or sponsors xix Preface to the Second Edition There have been two main incentives to produce a second edition of this book The first and perhaps most obvious reason is the introduction of Microsoft Excel 2007, with its radical new appearance Microsoft’s market research suggested that the vast majority of Excel users appear to treat the software as a gloried tool for producing tables, and the new ‘results-oriented user interface’ is designed to make them far more efficient at doing so Unfortunately for anyone with a reasonable level of competence in Excel there is a substantial learning curve, and some of the most straightforward commands have become frustratingly obscure Although the underlying Excel functionality remains largely unchanged, the new command sequences and shortcuts have entailed a substantial revision of many of the command sequences used in this book The second reason for a new edition is rather less obvious but I believe of greater significance I have previously been critical of the way in which organisations and individuals are able to generate financial spreadsheets and models in an uncontrolled way and it would now seem that there is a growing recognition of this problem by the regulatory authorities In the United States, the Sarbanes–Oxley Act (2002) sets out a legal framework for financial reporting and the use of risk controls and this is having a major impact on the way organisations manage their spreadsheets Historically, European regulators operate by principles rather than by rules but there are already signs that the Financial Services Authority and its European Union equivalents are being influenced by this legislation It has been gratifying to note that the modelling methodology set out in this book is effectively a compliance process, and that the risk controls can be mapped directly to the model structure discussed in Chapter I am grateful for the very positive feedback that I have received from a number of readers and I have taken account of several suggestions for improvements I have revised and updated a number of examples, including a cash cascade treatment I have included self-test exercises to help readers apply and extend the techniques covered in each chapter (these are now on the Elsevier website) I am delighted that my publishers have decided to use full colour for the illustrations and examples xxi Preface to the First Edition Most of the books on financial modelling that I have read tend to go long on the financial and short on the modelling Most of them are full of genuinely useful financial calculations and algorithms but they offer little insight into setting up and working with robust and reliable models, in much the same way that a dictionary helps you with your spelling but does not help you write good prose To stay with this analogy for a moment, I would describe this book as a grammar that will provide you a structural and conceptual basis for your financial modelling I shall assume that you have a good working vocabulary, or the ability to refer to the appropriate dictionary, as needed This book is not a financial text book, nor is it an Excel manual – it sits between the two on your bookshelf My intended reader is the financial analyst – a catch-all term covering the wide range of people like you who are involved, in some way, in the preparation and use of financial models and spreadsheets You may be preparing cash flow forecasts, project evaluations or financial statements You may be working on your own, or in a finance department, or in an investment bank or multinational financial institution You may be a student, or a part-qualified accountant, or a practitioner, or you may be in a position where you don’t actually to modelling yourself anymore but you want to keep up with developments I should state at the outset that there is no agreed ‘best practice’ in financial modellingthe methodology and techniques are those best suited to the task in hand In this book, we will examine some of the common, generic, approaches that you will encounter in financial models today, with a view to understanding the technical background You will appreciate that the same problem can be often solved in several ways, some of which appear better or more reliable than others, and some of which appear counterintuitive and less satisfactory The intention is to encourage you to reflect on your own practice in the light of these suggestions and examples, and I am confident that you will be able to generate your own solutions to the problems and issues that follow Even if you are not convinced by my arguments, by engaging with them you will have greater confidence in your own modelling abilities You have picked this book from the shelf because at some point you asked yourself the fundamental question – is this model right? xxiii Acknowledgements I would like to express my gratitude to my colleague and mentor, David Colver, from whom I have learnt so much over the two decades we have worked together Thanks also to my many colleagues who contributed to my thinking about the subject, and of course to my many students, who, through their questions and enthusiasm, continue to stimulate and challenge me every step of the way xxv About Operis Group Over the last 25 years, Operis has established itself as a leading advisor in ­project finance, specialising in the analytical aspects of financial transactions The firm was established in 1990 and now has a headcount of over 40, making it one of the largest teams devoted to its particular discipline As a financial advisory firm, our key activities fall into three areas and they are explained below CONSULTING AND ADVICE Operis has significant experience in model auditing, modelling and other advisory work for project and transaction funders in respect of financial models, associated legal documentation, taxation and accounting matters We are one of the market leaders in this field and, internationally, the only firm outside the leading accountancy firms to hold a reputation for world-class model assurance We have been mandated by most of the leading banks and bond arrangers around the world We are well known by the key funding guarantor bodies and have been mandated and approved by major export credit agencies, multilateral and supranational bodies and monoline insurers FINANCIAL MODELLING TRAINING Operis offers financial modelling training to analysts and finance professionals from the banking and finance industry and many other sectors from the City of London and internationally We teach a robust and transparent modelling methodology which we use ourselves in developing some of the most complex financial models used by lenders and investors in projects around the world Course delegates benefit from our wide-ranging perspective on state-of-the-art modelling in the financial sector Our portfolio of courses covers project finance, PPP/P3, company valuation, cash flow forecasting, model analysis and financial model audit In addition, we have written and delivered financial modelling courses on solar energy, wind farms, waste and other client-specific operations xxvii xxviii  About Operis Group OPERIS ANALYSIS KIT Operis Analysis Kit (OAK) is a set of spreadsheet analysis, audit, review and reporting tools developed by our analysts for developing and checking large spreadsheet models It is an Excel add-in and works with all versions of Excel It is used by almost all of the large accounting firms and by major financial institutions around the world and is under continual development to ensure that it remains relevant and compatible with current versions of Excel For more information see www.operis.com ... commitments The modelling compliance officer is the link between the modelling environment and the modelling process Modelling Environment Both the SRO and the modelling compliance officer determine the. .. Preface to the First Edition Most of the books on financial modelling that I have read tend to go long on the financial and short on the modelling Most of them are full of genuinely useful financial. .. provide these models to a nonmodelling audience There is an increasing recognition on the part of management and others that they simply don’t understand what the model does, and they possess few of
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