Key metrics and drivers serve two main purposes when modeling.
- Forecasting: In absence of other information, historical figures can be used to forecast. For example, using a three year average as a forecast may be appropriate for a company in a mature industry with stable growth rates.
- Sanity Checking: When forecasting, it’s always important to ask “Are my numbers reasonable?” Looking at the balance sheet ratios for example can help determine whether the working capital forecasts you make are reasonable. Additional non-GAAP metrics such as EBITDA can also help with analysis.
These metrics measure how well a company manages its expenses in relation to its revenues. Margins are affected by factors that include industry, competition and target market. Grocery stores for example, will have very tight margins due to the high competition in the industry whereas a luxury goods manufacturer may enjoy higher margins.
The following metrics can be divided by revenues to calculate the margin numbers.
- Gross Profit
- Net Income
- Depreciation and Amortization
- Pretax Earnings
- Net earnings
Tax Rate is determined by dividing the income tax expense by the income before taxes.
These metrics can determine trends in different areas of the business. They are used to forecast and to determine potential problem areas. For example, if revenues are growing significantly, but the EPS of the firm is not, the company may be diluting earnings by issuing too many shares.
(Metric in current year – metric in previous year) / (metric in previous year)
- Net revenue
- Net earnings
- Interest Expense
The metrics on the balance sheet are mostly concerned with liquidity (a company’s ability to pay its bills) and leverage (a company’s dependence on creditors’ funding).
Current ratio = total current assets / total current liabilities
Quick ratio = (cash + government securities + receivables)/ total current liabilities
Leverage ratios = liabilities / net worth
Cash Flow Statement
The cash flow statement is used to derive free cash flow which represents the cash available for distribution to all securities holders in a firm.
It is calculated by subtracting capital expenditures from cash flow from operations. In theory, capital expenditures are discretionary, but businesses that are going concerns are required to continue investing in CapEx.
Example: Adding the Metrics to Cisco’s Income Statement
Step 1: We will be basing our forecasts on the projected revenues for the next three years. Add the historical growth metrics for each of the revenue streams.
Step 2: Next we will analyze the expenses as a percentage of revenues.
Step 3: Finally, we are going to add the margin metrics to see if there are any trends that we can spot.