What is a financial model?

One of the main tasks of an analyst is to prepare a robust and complete financial model for the investment for which he is doing analysis, which can be an existing business or a new project. In most simple terms, a financial model depicts the outgo (s) for investment and the revenues/cash flows from the investment. A financial model necessarily has to inculcate the business model of the investment - whether it is selling a product or a service.

typically a financial model should answer the following questions:

1. When and how much needs to be invested?
2. How the funds for investment will be raised (debt or equity or both)?
3. Life of project?
4. Major assumptions which will have a bearing on the numbers - like inflation rate, market interest rate, taxes, customers, etc.
   
5. What will be the recurring cash flows (due to various reasons including different accounting policies adopted by companies, artificial inflating of revenues, etc. cash flows are most preferred tool for an analyst for adjudging an investment)?
6. How much will be the cost of operations?
7. What will be the return to various stakeholders - debt providers, government (in form of taxes), shareholders?
   
8. What are the sensitive areas of which analyst has to take note?
9. What are risks which can affect the future cash flows?

The above list is not at all exhaustive. There can be countless variables which can be built in within the model.

Though, a financial model gives information only quantitative outcomes for an investment, it is the most pertinent task for an analyst in investment analysis. Once the model is complete, he should be able to know the NPV (the net of PV of Cash inflows and PV of investment (s) / IRR (annualized effective compounded return rate which can be earned on the invested capital) and other metrics for measurement of return from investment.

Scenario Analysis and Sensitivity Analysis are major tools for assessing the vunerability of investment. Former involves changing many variables (affecting the future cash flows) and then observing the outcome of these changes to the return on investment (or equity). In sensitivity analysis, analyst changes one variable at a time to know the result. For e.g. what will be the effect of a 1% rise in inflation rate or how much would the cash flows rise with 5% increase in number of customers. By these two excercises, one gets to know the trigger areas which could lead to fall of the project.

Some pointers I remember while preparing financial models:

• Put (or try to put) all assumptions on a single sheet
• Highlight the cells which have entered value (instead of calculations) - standard is to use blue color
• Separate sheets for tax calculations, revenue detail, cost detail and outcomes (with scenario category - worst, most likely or best)
• Focus on what the output should be and what the users of model like to see.
• Try to complete the revenues, costs, cash flows, etc for a year and then extend to future years based on the assumptions.
  
• Minimum number of sheets not only helps the analyst but the readers of the model too.
• Make use of comments feature to highlight important information.

Which is the Best Investment Destination?

After 2006-07 which saw enormous growth in Merger & Acquisition Deals (including LBOs) in ‘BRIC’ economies – Brazil, Russia, India & China- both quantitatively & in value, now the question which has gathered attention is that which is the most promising economy in terms of investment returns for 2007 or which market has become expensive or which country has better prospects taking into consideration its previous year’s performance.
Questions are many but answers not so simple. To begin with we can go through the some vital facts & figures as shown in the figure: -












Source: CIA Factbook 2007

After compiling the above data now its time for analysis.

• Starting with area, Russia has the largest area of around 17 million sq km which is more than half of the combined area of its peers. So it has huge geographical advantage in terms of land though the whole of it may not be usable for industrial purposes.



• In case of population, China takes the lead which is followed by India. But in terms of ‘density of population’, India stands first with 333 persons per km!!! Whereas Russia though boasting with largest surface area has meagre density of just 8. We all can understand how this is beneficial for Russia as now each resident in Russia has greater share in natural resources. India is many a time compared with China in respects of population, but a point to be brought to notice is that though India is second to China in population but China is around three times in area than India.
  As far as growth rate is concerned, India having 1.38% is followed by Brazil with 1.04%. It is appreciable the way China has controlled its growth rate which has become one more reason of its enormous economic development in a short span of time. Russia has a decreasing growth rate of 0.37%. A low growth rate can indicate greater standards of living of people, better quality of workforce, more education, less disparities among population & so on. This ultimately leads to reaching the grade of developed nations in lesser time.
  The unemployment rate depicts the quality of population. Not only should a population be proportionate to its area covered but also it should be skilled & put to use in economic development. Brazil suffers from huge unemployment rate of around 10%. This is terrible as the population which is already employed is paying for the living of the unemployed public too. Moreover such a group of residents is not contributing to the national development but is consuming the natural resources which will disturb the balance. Again China steals the show with least rate of 4.2%.



• In terms of GDP & its growth rate, China tops the chart followed by India. Former has whooping 10.5% as GDP growth rate while India is following it with 8.5%. Brazil lies at the bottom with 2.8%. Though Russia has only 1.7 trillion which is a little ahead of Brazil but it has growth rate which is more than double (6.6%) of latter’s (2.8%). GDP is regarded as the biggest indicator of economic health of a country. For understanding it is the gross market value of goods & services provided by a country during a particular period (usually a year). It reflects how the country’s corporates-both public & private- have put to use its resources. So the more the GDP & its growth rate, the better for the nation.



• Public Debt is the money owed by government. It can be internal (where govt owes money to public or financial institutions within the country) & external (where it owes to foreign public & institutions). More of public debt can be because of heavy investment by govt in nation’s development (infrastructure, education, subsidies, forex reserves, etc). But more public debt as a % of GDP reflects the imbalance between govt spending & value creation. If more investment by a firm is backed by increased sales, then it is said to be utilising its operations well & there seems more growth. Same is the case with nations. In this context, India & Brazil may face great impact of imbalance of investment & return in future as their debt as % of GDP is around 50%. While Russia has this ratio standing at only 8%.



• Inflation rate has been the most talked about matter in India recently where RBI is tweaking the monetary policy frequently to tackle inflation. Inflation, for laymen, is the rate at which commodities get dearer after a particular period (usually a year). It hits the poor & fixed income groups badly. From economic point of view, a little bit of inflation is always desired. But high inflation makes resources expensive which may affect the growth aspects of economy. China has been able to keep its inflation at 1.5% lowest among developing countries. While India has moderate inflation of around 5.3% (which crossed 6% in first quarter of 2007) but Russia has hyper-inflation of 9.8%. Even Brazil enjoys low inflation of 3%. How come China has greatest GDP growth rate but least inflation rate is a question which has not been answered yet.



• Industrial production growth rate shows the pace with which the secondary sector of the economy is producing output. A country with more rate is said to have greater efficiency with which it puts to use its resources. Here also China is numero uno with 22.9% which is 3 times the growth rate of the runner up India having 7.5%. Brazil & Russia are still to touch the 5% mark.



• Forex reserves are the amount of foreign exchange lying with the Central Bank. These though are not great investments as the monies raised here are invested in other countries or provided to government at very nominal rates. But these reserves come to rescue when there is huge volatility in the international market. The Central Bank of a country sells foreign reserves to prevent the home currency falling beyond the comfort level. China has accumulated reserves exceeding $ 1 trillion. All other participants lag far behind. Russia comes 2nd with $ 314 million followed by India & then Brazil.



• One more indicator of nations’ performance can be the major market index. Though it is not a consistent measure of economic development & is often affected mainly by emotions of investor but still it can be used as a scale to measure the current investment outlooks of people & future prospects of corporate sector. Russia’s RTS Index has provided a return of 800% from Jan 1997 to Jan 2007, highest among BRIC countries. Runner up is Brazil’s Bovespa with 436% followed by India having BSE Sensex which gave return of 217%. Here China has not been able to score & lies at bottom with SSE Composite Index providing 80% since Jan 2000.

Apart from the above metrics, Foreign Direct Investment (FDI) already made is another factor that can have impact on decisions of International Investors. China allowed FDI in 1978. Now it is the largest receipient of foreign investment among developing countries & second in the world. In 2006, China's overall FDI inflows totalled $69.5 billion, most of which was for financial service sector. But 2006 saw a drop of 4% in the FDI investment since 2005. India is becoming liberal about its FDI policy lately by removing or reducing the caps on Foreign investments. For e.g. the cap in Air Transport Services was raised from 25% to 49%. Still there are limits on foreign investments in Banking, Asset Reconstruction, Broadcasting, Insurance, Defence Production, Infrastructure, Telecommunication and Newspaper. Apart from these sectors 100% FDI is permitted in all sectors. India received approx $ 11 billion in 2006 while FDI totalled US$18.78 billion in Brazil, higher than for 2005 (US$15.19 billion). Total Foreign Direct Investment in Russia in 2006 is estimated at US$ 31 billion. Here also China is number one.

Conclusion: Which would be the final investment destination is a question will the time will answer but there seems to be a great fight between China, India & Russia. If figures are to be believed then China & India have highest GDP growth rate & industrial production growth rate. Brazil is still huge unemployment rate, heavy public debt & least rate of growth. Apart from above factors - Political stability, high productivity, low costs of labour and good infrastructure are some of the key metrics to be kept in mind while making a foreign investment.

Inflation, Monetary Policy & Investor

During last few months we all have seen lot of movements in the money market & also in the share market. A hike in CRR or REPO rate brought a lot of volatality in the markets. There is a sharp rise in the inflation rate which, as some say, made the FM bring structural changes in the budget because inflation in our India is not only a economic but a political subject too. No one knows where will it all land. But knowing the basics of these terms would enable us to decide our future course of action.

INFLATION: General rise in prices measured against a standard level of purchasing power.
Simply put it is the percentage of our current price that we will have to pay on the current price in order to buy a commodity after a particular period. For e.g. if price of an item is Rs 100 today & inflation rate is say 6%, then we will have to shed Rs 6 apart from the basic price of Rs 100.
Inflation is measured by comparing two sets of goods at different points of time & computing the increase in cost not affected by increase in quality and qauntity. For e.g. if cost of one two-litre Pepsi is Rs 50 as against the price 3 months before which was Rs 45 for 1.5 litre, then we will have to make adjustment for contents.

It is measured through various indices like Wholesale Price Index (WPI) or Consumer Price Index (CPI). Usually inflation shown by an index is different from inflation bear by an individual. It is because index covers several items which are given different weights & so the change in prices of these items is depicted by the index and the spending of a household will not be done in the same pattern (as of the index). Also the Education Cess is not considered by the index.
A rise in inflation rate raises the cost of production for the business people & cost of living for the common man. Corporates pass their burden of inflation on the latter by raising the prices of commodities. As far as we as ultimate consumers are concerned, we should plan our expenditure accordingly & also keep inflation in mind while making investments. It can be explained as follows. We should make our budget of household expenditure keeping in mind the average rate of inflation i.e. a reserve for it should be maintained to bear the rising prices.
As regards the investments, we have to put in our money in such places which can earn a good return over & above the inflation rate (called real rate of return). For e.g. if we invest Rs 10,000 in a Fixed Deposit at 8% p.a. & inflation rate is 5%, then we don’t get a return of Rs 800 but after providing for inflation we left with just Rs 300 i.e. a real return of 3%.
MONETARY POLICY: Policy of the Central Bank (Reserve Bank of India, in India) through which it keeps the supply of money in control thereby constraining inflation or deflation, maintaining an exchange rate, achieving full employment or economic growth.
Tools of Monetary Policy:-

$ Bank Rate: It is the rate at which RBI lends money to banks.
Increase in this raises the cost of funds obtained by banks from RBI & vice-versa, the burden of which is in-turn passed on to the consumer.

$ REPO (Repurchase Option) & REVERSE REPO Rates are the main players here. Former is the rate at which RBI lends money to banks against government securities & infuses liquidity into the system. Reverse Repo is the rate at which RBI sucks excess money supply from the system by selling government securities to banks. Recently RBI hiked the rates which positions them at REPO:7.5% & Rev Repo at 6%.
If REPO rate is hiked then it means that now banks will have to incur more cost to obtain funds from Central Bank & so they increase their PRIME LENDING RATE (PLR), this results in increase in the rate at which the bank lends money to consumers.
On the other hand if REVERSE REPO rate is hiked then it reduces the overall liquidity available for lending to borrowers as banks may find it more attractive to lend to RBI. As a result the lending rate of banks to consumers may rise as now they would expect a rate of interest above the REPO rate to forgo RBI i.e. opportunity cost is increased.

$ Cash Reverse Ratio (CRR): It is the percentage of deposits which banks are required to keep with RBI under RBI Act. This serves dual purpose – (1) RBI gets control over lending capacity of Banks (2) a portion of deposits of public is secured with RBI.
A increase in the CRR produces similar effect as is observed on hike in REPO rate. In such a situation, banks have to keep more funds with RBI & the balance loanble funds are chased by same number of borrower. This raises the interest rates of banks. But some analysts believe that a hike in CRR does not bring an immediate impact on interest rates as the demand for loans by consumers may not pick up along with a hike in CRR & banks may still witness surplus liquidity for a temporary period.

$ Statutory Liquidity Ratio (SLR) is the statutory reserve that is set aside by banks for investment in cash, gold or unencumbered approved securities valued at a price not exceeding the current market price. SLR should not be less than 25% and not exceeding 40%. Currently it is at 25%.
A rise in SLR has the same affect as CRR i.e. it reduces the funds at disposal of banks & brings a halt on rising liquidity.. As a result banks raise their lending rates to maintain their margins.

Usually it is seen that a hike in CRR %, SLR or REPO rate brings a sharp decline in the prices of bank stocks. The main reason as it seems is fear in profitabilty of banking companies due to higher costs of borrowing from RBI or their ploying of funds into less profitable investments (government securities). So any news of RBI changing the aforesaid tools shall warn us for a market reaction.

Apart from the above repurcussions, a rise in the interest rates forces some changes in the market some of which can be enumerated as follows:-
Increased interest rates affect the whole economy as it brings a rise in prices of commodities which pulls the demand down.

Direct result of rising rates is beared by corporates who now face additional financial costs. A hike in interest rates brings cost of bonds down.
The prices of stocks falls as now the investors expect a greator return from the market as compared to the yield generated by bonds as seen above.
Though the sudden fall in stock market as a whole or financial sector in particular may give us chill bites but they also bring an opportunity for the investors to enter the market at low prices (if only the companies are fundamentally strong).


Conclusion: After the above analysis we can say that Rates – inflation & Interest both – have a direct bearing on an investor’s decision. Though the market may not always behave in the aforesaid fashion but for conservative investors these are warning signals.