Check ratios in models.

When we finish building our forecasts the very next step is to build some check ratios for our model. This ratios are essential in ensuring that the assumptions in the model hang together. The reason this is important is that evaluation that uses this model is only going to be as good as the assumptions that it is based on a common error is for analysts to forecast incredible growth. But the model then doesn't appropriately consider the investment requirements and financing that is needed to achieve this growth the ratios that analysts usually use to check their model our first of all margins the main margins being ebitda ebit and possibly also nopat. Although margins are a common assumption used in the actual model build the forecast are usually built at the segment level. We therefore need a sense check on total business margins if there's an unusual trend here do we understand what is driving this? The second check ratios that we use are for capital efficiency. Difficult key ratio used here is cattle turnover. That's revenue compared with invested capital. This could also be split into revenue compared with property plants equipment and revenue compared with operating working capital. These check ratios are critical for sense checking that our capex and operating working capital assumptions or adequate to support our revenue growth assumptions. The next check ratios we use are for leverage this usually focuses on net debt to ebitda and net debt to equity. But if you know that the company has debt covenants which rely on other leverage metrics. You should also include these these leverage metrics not only tell us whether the company is likely to become over-levered during our forecast period it's also tells us whether maturing business is maintaining an efficient capital structure if there's too much cash retained in the forecast, then leverage metrics will become increasingly negative. Returns are the final check ratio return on invested capital and return on equity help us to link at income statement and balance sheet forecasts in essence. They tell us how well our forecasts imply that management is deploying the firm's capital. They are particularly useful for highlighting two things firstly any unusual Trends in returns highlight inconsistencies in that income statement and balance sheet is this trend coming from our margins our capital efficiency or leverage. Secondly, it tells us whether there are forecasts. Look out far enough one of the criteria for using our model in a DCF valuation is that with forecasted out to the terminal year at this point returns should have reached a stable level if returns in our final forecast year are very different to the returns in the penultimate year. Then your assumptions are either wrong or you need to forecast out further. So those are the key check ratios that we use from our models.