Financial Modeling I Part 2 - The Anatomy of a Plug

? The Role of Financial Modeling

Financial Models are used in decision making in every financial domain be it Business Planning/Budgeting,
Ratio/Performance Analysis, Loan Appraisal, Project Feasibility, Equity Valuation or M&A analysis. In each of
the above areas the quality of the Financial Model plays a crucial role in the final outcome/decision.
Hence, any errors made at this stage will get magnified at each step, resulting in a flawed outcome!

? Impact of incorrect modeling techniques on real time decision making

Financial Modeling as a subject is vastly unexplored, greatly under-researched & hence immensely esoteric!
Very few relevant studies or books have been published, leaving most to rely on trial & error. As a result
several incorrect techniques have become popular most of which are clear ‘shortcuts’ to oversimplify the
process and cut down on build time. However, such shortcuts result in fallacies, the cost of which would be
far more than the time saved on using them!
Common incorrect modeling techniques are –

Incorrect Modeling Technique Impact The right way

Following double effect will always

Use of Plugs Debt Analysis becomes impossible
lead to a self balancing model

Flawed Item logic resulting in

All Items tied to Sales
fixed ratios

All Items grown sequentially

Each item must be forecasted based
using CAGR or Average or Flat & unrealistic trends
on its specific driver/s
Moving Average

Items linked to incorrect Flawed Item logic resulting in

drivers unrealistic trends

Items tied to multiple drivers,

involving multiple inflows/outflows
No Schedules Flat & unrealistic results
over a period of time & requiring
customization must be scheduled
Flat or ‘Waterfall’ type schedules must
Incorrect Schedules Unrealistic results be built depending on item type,
flexibility & complexity desired

Certain items must be ratio driven

Ratio becomes an input instead of
Fully Ratio driven modeling while others are model driven while
an outcome of the model
some are scheduled
Note: the focus of this article is plugs alone
Financial Modeling I Part 2 - The Anatomy of a Plug

? What is a plug ?
The ‘plug’ is the most fundamental & popular incorrect technique used.
Take for e.g. the case of a company that wants to measure the fund requirement for a 5 year project. In
such cases, typically, the debt portion is forecasted as either the ‘deficit’ in the Cash Flow Statement or the
Balance Sheet. This is known as a ‘plug’ (a.k.a. Suspense Account by accountants). It may be hidden in the
Schedules, Balance Sheet or Statement of Cash Flows and is usually called Excess Cash, Balancing debt etc.
We at Finatics, define a plug as –
“A ‘Plug’ is an equation resulting from circular reasoning to forcefully tally the Balance sheet. ”
In its simplest form the idea is to overrule any anomaly resulting from Asset-Liability mismatch. However,
we believe, it runs a lot deeper. The problem is a result of an incorrect item forecast resulting into
subversion of the double entry bookkeeping system. This occurs when certain items do not directly flow
through the Cash Flow Statement & Balance Sheet resulting in a gap i.e. a plug!
Example1 – Using the ‘IF’ function without circular reasoning (usually in Balance Sheet)
The simplest example involves the ‘IF’ function in Microsoft Excel – If Assets are more than Liabilities plug
the difference in Liabilities (usually under Debt), and if Liabilities are more than Assets plug into Assets
(usually as Excess Cash or Surplus Funds).
Example2 – Using the ‘MAX’ & ‘MIN’ functions without circular reasoning (usually in Balance Sheet)
Another popular equation involves the ‘MAX’ & ‘MIN’ functions in Microsoft Excel where – The equation
in both sides (assets and liabilities) is linked to the difference in the Balance Sheet excluding the plugs
itself.
Example3 – Using Circular Reasoning (usually in Balance Sheet using either of the above formulas)
Called ‘Circular Referencing’ by Microsoft Excel, this method involves using the same cell as an input as
well as an output! Sounds confusing? It is! That is why Excel calls it an error. Although one can
conditionally turn on this functionality, it works on iterations to get to a result. Whereby, it uses the
difference in the Total Assets & Liabilities (including the Plugs as well!) to determine the magnitude and
direction of the plug. Needless to say one must use either the ‘MAX’-‘MIN’ or ‘IF’ functions to get results.
Note: Although this method, in this context, is equally damaging/incorrect, it is a must in Complex LBO
models when calculating interest (which is of paramount importance) and cannot be calculated reliably in
any other way!
Example4 – Hidden in Schedules or Cash flow statement
If cash flow statement gets negative, make it positive and then add min required cash to it. Basically,
what this does is assumes that the deficit will be funded using short term debt (i.e. revolver) after the
cash flow statement is made (?!). E.g. if cash flow statement total is Rs.-100 and minimum required cash is
Rs.200. Short term debt raised will be Rs.300.
All these approaches are counter intuitive and create what accountants call – Suspense Account which is
then dumped in the Balance Sheet, Statement of Cash Flows or Schedules

? What’s the big deal about it ?

Many believe that a plug has no real consequence on the ‘Final Answer’ (?!). Unfortunately, a Financial
Model has no Final Answer, just an array of possible answers (when the right questions are asked!).
So what is a model used for? – Business Planning, Performance Analysis, Valuation and the list goes on…
Take Business Planning for example. A Financial Model may be used to determine funding requirement for a
project at different phases of its lifecycle. Now, forecasting a realistic funding requirement is just one part
of the story, the more important one is, which items caused a funding deficit and how (if it all it can) be
mitigated. A plug will simply eliminate the possibility of answering such questions and hence it is a ‘black
box’. At a decision making level one is not interested in effects alone but causes & remedies as well and this
is where a plugged model will disappoint!
Secondly, for a Loan Appraisal or Performance Analysis the resulting ratios from a model will be far from
realistic, as the components of the ratio will not be consistent as a result of the plug. More so, for the
Turnover and Capital Structure related metrics. A model must result in dynamic ratios rather than be ratio
driven itself!
Financial Modeling I Part 2 - The Anatomy of a Plug

? Can it be avoided ? How ?

Yes. Put simply, using double effect (a.k.a. double entry!). The process is not a simple one and involves
every component to be made the right way. Especially structuring the debt schedule (The most complicated
part!), and following an item-by-item effect of Balance Sheet on the Cash Flow and/or vice-versa. Debt
structuring is beyond the scope of this article and far too complicated to explain through theory alone!
Before we get to an item-by-item check on the Balance Sheet & Cash Flow let’s solve a fundamental
question – Does the Balance Sheet drive the Cash Flow Statement or is it the other way around?

? So what is the Cash Flow Balance Sheet link ?

Many believe (and practice) that the Cash flow must drive the Balance Sheet. Meaning that items are first
forecasted in the Cash Flow statement and then their effects are made on the Balance Sheet. We believe
this approach is grossly incorrect as majority of the items should flow from the schedule while the rest will
come from the Balance Sheet!

? Why? What’s wrong with the ‘Cash-Flow-drives-Balance-Sheet’ approach ?

As mentioned above, each item must have a logical driver attached to it, when 2 or more drivers affect an
item a good practice is to create a schedule. Basically, the schedule is a major driver for both the Balance
Sheet & Statement of Cash Flows! For some items, it clearly is the Balance Sheet. Take for example Working
Capital, one school of thought recommends using change in working capital as an input in the Cash Flow
and using it as a basis to forecast the Balance Sheet equivalent. For e.g. Year 0 Balance Sheet figure for
Debtors is = Rs.100 while forecasted change in Cash Flow Statement in Year 1 is Rs.50 giving us a Year 1
Balance Sheet figure of Rs.150. Although mathematically correct, this approach suffers from a serious
shortcoming! In the real world, forecasting change (i.e. the Cash Flow Statement figure) is far tougher to
forecast as compared to the closing balance (i.e. the Balance Sheet figure). For e.g. Debtors (Credit Sales)
are related to Sales, the ratio of which is determined by industry norms & company policy. Now, if Sales of
Rs.1,000 are made and Credit Sales accounts for 30%, the Closing balance must be Rs.300 (being a ‘current’
item Debtors of previous period are assumed to be pay in full in the current period after accounting for bad
debts under provisions). This Rs.300 forms a part of the Balance Sheet usually under the heading Accounts
Receivable or Sundry Debtors. Suppose, the previous period figure in the Balance Sheet was Rs.200, the
difference i.e. Rs.100 will come as a cash outflow in the Cash flow Statement under the heading Cash Flow
from Operations. Forecasting change directly in the Cash flow Statement is not just counter intuitive but
also logically impossible. It can always be done mathematically by assuming a percentage of Sales or Cost of
Goods Sold but will only result in a stark deviation from reality!
Secondly, all other items i.e. under CFO, CFI & CFF flow, completely from schedules or our driven by the
Income Statement!

? The bottom-line ?
 A plug is an incorrect (albeit easy) approach to modeling.
 The most commonly used plug in the Asset side is Excess Cash and Debt in the Liability side.
 Plugs will thwart the analysis process making debt structuring and analysis an impossible task.
 It will also result in a flawed ratio/performance analysis making every other attachment on the
model flawed (e.g. Equity Valuation, Budgeting & Loan Appraisal).
 A plug can be avoided by following double effect at every stage of the Balance Sheet & Cash flow
linking and ‘pre-structuring’ debt (as opposed to Balance Sheet driven debt)
Download: the supporting Excel file here. You may also like to read this related article by Mr. Velez Pareja

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