The FP&A Guy

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Episode 5 - Becoming A Better Financial Modeler With Chris Reilly

Paul Barnhurst
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Show Notes

Welcome to Financial Modeler's Corner (FMC) where we discuss the art and science of financial modeling with your host Paul Barnhurst. Financial Modeler's Corner is sponsored by Financial Modeling Institute (FMI), the most respected accreditations in Financial Modeling globally.

In this episode, Paul Barnhurst is joined by Chris Reilly, who is the founder of Financial Modeling Education. Chris spent many years working in private equity, and today, he runs his own business focused on providing financial modeling education and financial modeling consulting services.

 Chris is very passionate about Financial Modeling and helping others learn to build robust financial models focused on the 3-financial statements.

 Listen to this episode as Chris shares:

  • The worst model he ever built; hint it involves using his phone :)

  • His journey and background into Modeling

  • The importance of simple, uncomplicated model design

  • How being a part of a financial modeling community like FMI can help modelers

  • The revolver approach for managing cash and why it is important in modeling

  • The benefits and challenges of using EBITDA to value a company

  • His position on controversial modeling issues, including circular references, dynamic arrays, modeling standards, and more

Sign up for the Advanced Financial Modeler Accreditation or FMI Fundamentals Today and receive 15% off by using the special show code Podcast.

Visit www.fminstitute.com/podcast and use code Podcast to save 15% when you register.

Go to https://earmarkcpe.com, download the app, take the quiz, and you can receive CPE credit.

Follow Chris:    

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Follow Paul:

Quotes:

“ A poor design leads to a poor output. ”  

“ Schedules feed the structure. Once you have that dialed in your head you can build whatever you want. ”

“ It’s nice to have a community where you can get some live feedback on your search as opposed to going down the internet rabbit hole. ”

“To learn to be a modeler you need to model. Spend time finding ways to improve your modeling skills.”

In today’s episode:

(00:22) Intro;

(00:47) Welcoming Chris Reilly;

(01:00) The worst financial model Chris has ever seen ;

(03:01) Chris’s takeaway from the worst financial model ;

(05:56) Chris ’s background;

(07:40) What Chris wished he had known that he knows now;

(11:52) FMI’s Premier Modeling Community;

(14:33 - 15:20) Validate your Financial Modeling Skills with FMI’s Accreditation Program (ad);

(15:21) Hardest concept for people to grasp;

(18:23) Reasons why balance sheets do not work;

(20:00) The Revolver Approach;

(21:48) The most important skill to build a Financial Model;

(23:22) The value of EBITDA and its pitfalls;

(29:07) Rapid Fire;

(31:35) Chris’s take on Circular References

(33:23) Nugget on how to become a better modeler;

(36:36) Connect with Chris;

(37:48) Paul’s best picks- how Chris learned from his initially not so perfect models and how those mistakes helped him become the best educator.

(38:56) CPE Credit with this episode;

(39:07) Outro. 

Transcript

Host: Paul Barnhurst

Welcome to Financial Modeler’s Corner, where we discuss the art and science of financial modeling with your host, Paul Barnhurst. Financial Modeler’s Corner is sponsored by Financial Modeling Institute.

Welcome to Financial Modeler’s Corner. I am your host, Paul Barnhurst. This is a brand new podcast where we will talk all about the art and science of financial modeling with distinguished financial modelers from around the globe. The Financial Modeler's Corner Podcast is brought to you by the Financial Modeling Institute. FMI offers the most respected accreditation in financial modeling.

I am excited to welcome on the show, Chris Reilly. Chris, welcome to Financial Modeler's Corner!

Guest: Chris Reilly

Thank you, Paul. I am thrilled to be here. Thanks for having me.

Host: Paul Barnhurst

Yeah. Really excited to have you. So this is the first question we start with all our guests. Tell me about the worst financial model you ever saw.

Guest: Chris Reilly

I've seen a couple. I've also, I've also built a couple. The two short stories on this - one is just a model I was working on for a VC company where there were thousands and thousands of rows, I think it was over six or seven thousand rows to drive some basic inputs trying to do some population growth, and it was such a poorly designed file that my computer couldn't handle it. And we ended up rebuilding the entire thing. I probably rebuilt it on just a couple of tabs. And it was one of these overly sophisticated, what I'll call big four kind of files that was tried to be good by being complicated, but was just a disaster at the end of the day and the founders hated it, you know, and they didn't even want to work with the person who built it originally because it was just so poorly designed and cumbersome.

So, that was one that always stuck with me, but I've also built my share of very poorly designed files as part of learning and I had, one time I was working on an M&A deal in oil and gas and they had two distinct business segments and the model got so clunky and large that I had two separate models that I had to build at once but I couldn't have them both open at the same time, so I would run them, then I would take a screenshot with my phone and then open the other file and make the edits into the other file and then just try to like bring them together in some sort of relationship down the road.

So, lesson learned from that, and that wasn't all that long ago. I guess it was in the last decade. You live and learn. So, I've seen a few.

Host: Paul Barnhurst

You definitely do, you definitely live and learn. I know I've built a few, I like to call them Franken models sometimes. You know, like out of the Frankenstein, you're just duct-taping things together. I once worked with one that was 1.3 gigabytes, and I was just like, no, this isn't going to continue.

Guest: Chris Reilly

Your poor machine, your poor computer.

Host: Paul Barnhurst

Yeah, the guy's like, well, I have a 64-gigabyte gaming machine, doesn't take too long to open. And I'm like, yeah, I think by too long it was minutes, not seconds, just to open.

Guest: Chris Reilly

Not surprised.

Host: Paul Barnhurst

We went to work on that thing, but those two models you mentioned, what made them so bad?

Guest: Chris Reilly

Oh, you know, at the end of the day, it really came down to probably poor design as one and then over-complication for its own sake. And the one that I can speak of is the one that I built that was so bad, it was, it was lack of business understanding a little bit at first. Like there's this initial sense of like, I got to have every input and every line needs all these multiple triggers and stuff, and really, you know, founders, CFOs, CEOs, they just kind of want to know a handful of core information of like revenue growth, margin EBITDA and cash and the rest you can kind of just fill in as you go and you add the one-off detail as needed, but back when I was newer and still learning, there's this like over intricacy that you feel like you have to engineer sometimes and I was just guilty of that. So it's poor design and trying to be complicated because it's this perception that complication equals good and it doesn't, it's actually usually the opposite. So, lessons learned on just poor best practices and I've improved them over time, from that experience.

Host: Paul Barnhurst

Thanks. I think you hit on two things there that are probably the biggest problems with models. First is design, right? If you don't design them properly, they're hard to work. They're cumbersome. And second is over-complication. I've overcomplicated some models. I know I have. And one of my favorite sayings that I've really used a lot over the last years, I started to train more and do things is, complex is easy, simple is hard. Right? And to get something really clean and simple that everybody can use or to explain something in a simple way is often much harder and more work, but we think, especially early on in our careers, and I was guilty of it, complex means it's better. Like it's fancy. Like I thought of every little thing! Okay, that made no difference to the bottom line, so why did you, why does it matter?

Guest: Chris Reilly

Right. I agree. I think it all comes down to design. You know, there's a whole underlying model architecture, just like a house has a foundation that sits in the ground, but you can't build the roof until you have the foundation. But you know, bad financial models are trying to model out every single shingle, and you just don't, you don't need that level of complexity. It comes down to design and architecture first, and the rest falls into place pretty nicely from there.

Host: Paul Barnhurst

Yeah, when you talk about design, the example I like to use is I'll ask people when I'm training, how many of you have built a house? And there's usually somebody's hand that goes up. If not, how many know somebody who built a house? And it's like, how many of you would have a house built without blueprints, without having a plan? Yeah, how many of you have started a model without even thinking about how you're going to build it? And it's just, it's amazing how often we do that. I mean, I've been guilty of it on plenty of models and going, oh, this thing is a cumbersome mess when I'm done. And then you try to rebuild it before you pass it on to the new person.

Guest: Chris Reilly

Right. Yeah. I'm not, I'm not surprised. I've been there too.

Host: Paul Barnhurst

Well, thanks for telling us a little bit about those models and the lessons learned there. Let's go ahead and start with you telling us a little bit more about your background, just a little bit about yourself for our audience so they can understand how you ended up where you're at today.

Guest: Chris Reilly

Yeah, sure. So I originally started in consulting, in New York City, right during the financial crisis. I worked on the Lehman Brothers bankruptcy, ResCap bankruptcy, and a couple other like high-profile bankruptcies at the time. Then I switched over to a corporate finance and treasury role at Hilton, which is based in Virginia. Did that for a handful of years and then we relocated to Colorado to be closer to family and I was able to secure a position in private equity.

That was probably the favorite chunk of my career because I just learned so much doing that. A smaller company, I learned all about ownership, acquisition, modeling, and FP&A. So that's like, the real core chunk of my career. That's probably one of my favorite parts. And I spent a better part of a decade doing that, and then just a couple years ago, I went out on my own as a FP&A or M&A contractor where I did some hourly work doing modeling, which is kind of what I do best for PE-backed companies and just PE firms in general. And then I also do a lot of financial modeling, teaching and education, which is where I'm kind of going in the future.

I love to help people build these complicated M&A, FP&A models because I have so much experience doing it from my private equity days. And so that's my focus going forward- financial modeling education for people who are trying to improve their skills.

Host: Paul Barnhurst

Yeah, and I've definitely seen a lot of that on LinkedIn if anyone doesn't know, Chris is very active there, has a great following, has multiple courses, and we've talked about some of those, and you have a lot of great material out there. So I think it's great what you're doing to help educate people, because the more we can do, the better.

Kind of speaking around that, on the education part, let's say, go back, you know, 10-15 years, when you started in PE or kind of started building models, what would you tell yourself? What do you wish you had known, that you know now?

Guest: Chris Reilly

I'm glad you raised that question. I think it would be, it would really come down to some core business knowledge first because that would help me simplify a lot of places where I got overly complicated.

If I had just known in my head more of a time series-based model that has some dates going across the top, and the basic financial statements of income statement, balance sheet, cash flow, and just how to link the pieces together, I mean, that really, really would have helped me because I spent a lot of time doing analysis that was, you know, layer 2, 3, 4, 5, 6 of one line item that was so deep in the P&L, and I didn't really know where it fit into the big picture.

And as I got more experience in my career, I realized, well, this is probably feeding into a certain line item in the P&L, or this is feeding into some kind of line item in the balance sheet, both of which will affect cash at some point, or may affect EBITDA in some way, which will affect valuation. And having that big-picture context would have really helped me from like a bunch of overcomplications in my early days. But I mean, that's learned with time, so, I don't know if that could have waved a magic wand for something like that, but the core business knowledge helps you simplify a lot of the complex I find, especially today as I do my work.

Host: Paul Barnhurst

You're working with a lot of different industries. So, when you say that core business knowledge, you're talking about the industry or more general?

Guest: Chris Reilly

It's more general because I tend to think in terms of the three statements, you know, at the end of the day, every company basically sells some kind of box, right, and it's just how much does that box cost to make? And then what are the support costs that we do to sell those to even get the business running, and software companies are just a different kind of box at the end of the day, I don't necessarily mean inventory. So you can model industry-specific things into that three-statement structure and it should, for the most part, always flow so long as you know some of the accounting differences between those industries.

Host: Paul Barnhurst

Got it. So you're really talking, really understanding the general principles of business, the idea of unit economics, and how that all flows through the P&L, not necessarily what the specifics are of that business and the deep knowledge of individual businesses within the industry.

Guest: Chris Reilly

Yeah, exactly. Because if I know that structure, then the industry-specific things I can work with the CFO, CEO at that company, we can build that detail into a rolled-up model that I can trust and that I know works.

Host: Paul Barnhurst

Got it! That makes a lot of sense and I would agree. It's hard to know in day one. It's kind of a little bit of a learn skill. Yes, there's things that can be done to accelerate that if you go back to your younger self, but some of it just comes through learning and trial and error and some of those things. That's why we often say experience is the best teacher.

Guest: Chris Reilly

Right. It definitely is.

Host: Paul Barnhurst

You can only pick up so much from a book or a podcast or whatever it might be. Of course, as good as they are and they definitely help by themselves, they don't do it. It's why everybody says if you really want to learn, go practice something.

Guest: Chris Reilly

Right. Yeah, you just got to do the work and kind of do it the hard way and ideally have some guardrails out there to help you so you don't, you know, steer off the path too much.

Host: Paul Barnhurst

Yeah, definitely gone off the path a few times. Those guardrails… You know, for me, those guardrails have been learning design principles. Obviously, there's the business side, but understanding that, hey, you should have a clean input sheet, an output sheet, an executive summary, schedules, I feel like I'm continuing to learn a lot more of that and getting better as I really talk to more people that came from a background where they had a lot of modeling experience versus me where I kind of, you know, I started in procurement, did an MBA, switched to a role where I was doing report writing, and then switched over to FP&A and just kind of figured out modeling as I went. I had a big company and it was never doing a three-statement model. So the stuff I built was just garbage for years. I look back now and I'm sure if I looked at some of those things, I would be embarrassed.

I remember a few years ago, I look back at a paper I'd kept from my freshman year of college. I think I got like a B or an A minus on it or something. I read it and I'm like, “You gave me an A minus on this? This thing's horrible”. Like, I wouldn't gave me an A minus.

Guest: Chris Reilly

I think any look back, even three to five years, is sort of cringe-worthy of our own work, right? And I guess if you feel that way, that means you're at least improving as you go.

Host: Paul Barnhurst

Yeah, it shows improvement.

So, you know, you and I have talked a little bit about Financial Modeling Institute, and as you know, they're the sponsor of the podcast, and one of the things they're really working on building, in addition to the accreditation, the fundamentals course they have, is what I will call the premier modeling community globally. They have over a thousand people in their community, they do a lot of webinars, and they have forums, opportunity to communicate.

You know, early on in your career, how helpful do you feel it would have been to have a community like that, that you could go to to ask questions or attend a webinar on a subject? You know, to help as you're trying to develop and grow your modeling skills.

Guest: Chris Reilly

Yeah, I think I really would have enjoyed something like that for a couple of reasons, one being, you don't always want to necessarily ask a colleague for something that maybe you think you should know. And I think it would be helpful to also have access to like a decentralized community like that where there's a lot of different expertise in one place. And so, you could share a question that you're working on and get a lot of good live feedback from people that have a skill set that you're trying to achieve yourself, and I think it'd be a way to educate yourself behind the scenes.

And then you can sort of cross reference what you've learned with your colleagues as opposed to always going to colleagues for help, and I think it's not that you don't ever want to go to them, right, there's a little bit of a give and take there, but I feel like that would have really helped me a lot, and short is, yes.

I think harboring that skill set would have just helped me early on with some of the stuff, and, yeah, I've gone down a lot of Google rabbit holes of like forums, how do I do this, this, this and that and I'll like, you know, I'll find it good enough, but that article might be gone or it changes or whatever. So that's what I was going to say, like, since you're already online searching for stuff anyway, it would be nice to have a community where you get some live feedback on your search as opposed to just going down the internet rabbit hole and kind of hoping it works.

Host: Paul Barnhurst

Yeah, exactly. Google is our best friend until it isn't.

Guest: Chris Reilly

Right.

Host: Paul Barnhurst

Or, it misguides us or you can't find what you want or, sometimes being able to talk to somebody because you never know, is this the right way to do it? Especially early on, you're reading on Google, if you only find one or two hits on something you're looking for. Or one or two that are really addressing what you want. You're probably going to get a million results returned. So having one where, you know, you can go talk to someone, okay, this guy's been in the PE, he's been in the middle market, he's been doing it for 20 years, hey, can I ask you a couple of questions about something?

You can feel much more confident in the answer and it's nice to get other people's perspective. Like you said, sometimes you may not want to bother the boss because they're busy, they may be out of town, maybe you've gone to them 10 times today and you're like, I don't want to go to him 11th time, whatever the reason may be, it's always nice to have that outside perspective.

Guest: Chris Reilly

Yeah, I agree. It's a cool thing they're working on. I definitely would have liked something like that in my early days.

Host: Paul Barnhurst

Yeah, and I'm excited to see how they continue to build that and some of the things they're doing.

Commercial break

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Host: Paul Barnhurst

You've mentioned you primarily do education today. You know, that's your big focus. So when you teach modeling, what do you find is the hardest concept for people to grasp when building a model?

Guest: Chris Reilly

You know, it's funny, it all, it always sort of comes back to design at the end of the day, because with poor structure, you're going to get a poor output and so I think it's just basic education on layout foundation, formula best practices, error checking best practices, because if you have the solid foundation, the rest of it should flow just fine, but it's hard to teach that. So I would honestly say that's number one because the business skills come with time, the Excel skills come with repetition. It's really about driving home core design principles, and then once you get a little bit better at Excel or Google Sheets, whatever you're using, and you know some of the scalability of the more advanced functions, it's about laying the groundwork in your model in the first place to be able to receive those functions.

And by advanced, that just means something like a SUMIFS, or INDEX MATCH, or XLOOKUP whatever it may be tagging your dates appropriately, mapping your data so that you can quickly build executive summaries, especially as data changes, your mapping and design will make your outputs easy as opposed to like being married to a specific chart of accounts and if one number is gone, you know, your whole model explodes. But that all comes back to design principles. That's teaching a brand new habit to somebody that might not be familiar with it, and so that's usually what takes the longest to implement.

Host: Paul Barnhurst

I'm glad you said that. I thought you might say something around the hardest thing people have is getting the balance sheet to balance or understanding that concept.

Guest: Chris Reilly

Well, there's that too.

Host: Paul Barnhurst

Cause I know for me, that's one that's been a pain. I remember one time, you and I talked a little bit about that, and the first three statement model I built for work, spending hours trying to get the balance sheet to balance and finally figured out, you know, what mistakes I had made. Rarely is it the data. Cause it balanced before, and now it doesn't balance when you build out the model. You can pretty much say, “Okay, what did I do wrong?”

Guest: Chris Reilly

Right, right.

Host: Paul Barnhurst

That was exactly the case. I agree with you, design is so important and it is something that takes time to learn, but also I think it's something that's not taught early enough. I have not had a finance role yet in my career where they're like, “Hey, we're going to get you a course about how to design a model.” You see a lot of investment banking, you see companies getting better at that, and I think that's why that's needed, that's why I like things like FMI and what you're doing and, you know, training and accreditation and different things because they focus on that design.

And it's just so critical because if you get the design wrong, you're going to struggle forever with the model. It's going to be hard to update, like you said, it's going to be clunky, it's going to have all those challenges. It's going to be one of those where the boss goes, “Hey, what happens if we change this? Well, let me come back to you in three days. Wait, I asked you to change one number. Well, it's linked to this, and there's that, and there's these four different files”, and, you know, the story goes on and on. So, I agree with you. Helping people really understand design, I think, is the biggest thing we can do to enhance the quality of models, is getting people to use good design practices.

Guest: Chris Reilly

Yeah, I agree. And you know, you brought up the balance sheet, which I'm glad you brought up because that is, in terms of like a day-to-day thing, that is something that drives a lot of people nuts and it's hard to get it to balance.

And so I could speak to that a little bit of like the most common reasons I see why it doesn't work is because the net income from the income statement doesn't necessarily match the change in retained earnings, which it should. Oftentimes the depreciation expense from the income statement doesn't match the change in accumulated depreciation in your balance sheet. And so those are the two bugs that I probably see 80% of the time. And then if you're trying to get it modeled out, once you flip over from an actual to a forecast, your retained earnings is going to be the prior period plus the net income from your income statement, and the cash is now going to link to the bottom of your statement of cash flows. Those two pieces will get your model to balance. And then it's about filling in the details for it to make sense, right? Because your cash can just go like wildly negative, which it's not supposed to, but that's the first part of getting the, you know, coupling the train together.

But again, I see that balance sheet frustration all the time. Depreciation and net income just not tying out between the income statement and the balance sheet, I would say fixes about 80% of the errors that I see in that section.

Host: Paul Barnhurst

Yeah, that was my error mostly, those two items that took me a few hours to figure out that one time. So I would agree. Those are two of the most common.

I really liked something you said there about the cash and going negative. Are you a fan of always having a revolver, something in there, you know, to manage that on your cash? So you have that formula to go, okay, if it goes negative, make sure we flag that immediately versus, you know, some models, you don't put that, you just have the cash line, and I've seen them where they go negative, and it's like, okay, that's not possible.

Guest: Chris Reilly

Right. Yeah. Glad you asked that. So I'm a fan of the revolver approach. If I see negative cash in my head, I think the model's broken. So I just don't like seeing that at all. I prefer to build a cash flow sweep around the revolver that always solves for a cash minimum so that it's, you know, if we're negative, we're going to at least draw to hit the minimum. And if we're positive, we can sweep to pay down to the minimum if we want.

But I always want to know what would we potentially need to finance from a debt perspective, because ultimately that's what you would have to do. You could raise equity too, but the short solution is to raise debt, which would also create an interest expense for your business that you want to flow through the P&L.

So, by just letting the cash run negative, you're not really giving a good read on the picture of what you'd need other than the shortfall, but you're not capturing the incremental expense that comes with that. You're also not capturing some of the debt market in terms of what you could raise in terms of revolver or term loan and the corresponding covenants. So I'm a huge fan of just let's get the revolver in there and that's going to be my indicator, and if I exceed the capacity that I need, then I just want some form of validation or check to go off so I know, okay, I'm exceeding what I think I could even get in the debt markets. And now I've got a strategic tool that I can use as opposed to, well, I've got like bazillion negative dollars in cash and I don't know what to do with it, you know.

Host: Paul Barnhurst

Great point there. I love how you said a strategic tool. Right? Now you can have that conversation with the business and say, “Hey, based on the assumptions we've built, you're going to go negative in cash and we believe you're going to have difficulty raising in the debt market. What assumption should we change?” And it may be, “Hey, they think we can raise more debt, go ahead and run with it and maybe let's slow the growth” or whatever, because we know high growth, one of the biggest challenges is, it takes a lot of cash, right? More than one business has ran out of cash that's profitable because they're growing too fast, and all of a sudden they can't raise the capital they need. Oh yeah,I think that's a great point there.

So next question, I'm curious, what skill do you think is most important for building a financial model? And I realize all are important that I'm going to ask. So of them, which one would you say is most important? Understanding the financial statements, a strong, you know, strong accounting background, strong Excel skills, or other?

 And if it's other, explain what that is.

Guest: Chris Reilly

It's the financial statements for me. I think that's a pretty clear winner. I'm not an accountant, I don't have a CPA, but I understand the financial statements, and ultimately, that's what makes me a good modeler. That I can build very basic three-statement models, I can build multi-roll-up LBO kind of add-on models, all because I just know how to build the correct schedules to feed the three statements. And knowing that is really the difference maker to me. I know it in my head, so I know how to build it, and so I don't get overwhelmed even though the ask might be extremely complicated.

So clear winner for me, the financial statements.

Host: Paul Barnhurst

Got it. I would agree with you, especially the way you laid that out. I like how you said that. Even if it's really complex, I don't get overwhelmed because I know the basic building blocks. I know I can start somewhere and then I'll figure out those complexities as I go.

Guest: Chris Reilly

Exactly. Yeah. Once you know it, you realize it's just- part one is structure and then part two is schedules and the schedules feed the structure. And once you have that dialed in your head, you can build whatever you want.

Host: Paul Barnhurst

I like how you said that structure and schedule.

So, next, I want to ask about EBITDA. You know, there's been a lot of discussions on LinkedIn about that. I see you laughing, you know, I know you and I have talked a lot about it. It's a very common metric standard in PE, you know, very common in many M&A deals. You've talked about it. We've talked about adjusted EBITDA and the importance of each.

I want to get your thoughts. Why do you think EBITDA is such a popular metric? And what are some of the common pitfalls you deal with when you're modeling or working with EBITDA and or adjusted EBITDA?

Guest: Chris Reilly

So it's a good question, I think, to break it into two parts. So the reason it's helpful, is because it helps normalize businesses across other companies in their industry. Because what it does is it neutralizes the capital structure, it neutralizes the corporate structure, and it effectively neutralizes the accounting policies. Because it strips out the interest, which is the debt piece, that's the capital structure, because a company could be acquired by all equity, and it wouldn't have an interest expense. It strips out the tax because from an entity structure perspective, some entities are passed through, whereas some have a corporate expense like a C Corp compared to a pass-through. So you're stripping out the tax impact because that can always change in an acquisition.

And then depreciation and amortization are ultimately subject to the accounting policy of the company, which can affect the net income, so you're going to strip that back out as well. It also serves as a proxy for the operating cash flow of the business. So it's kind of a two-fold exercise. So, you're basically trying to strip out the things that could change the most that are tangent to the core operations, but not necessarily the core operations to get a normalized profitability.

So, that's the thesis, right? If a bunch of other companies are in the M&A market and trading at some multiple EBITDA, you want to calculate that same thing for the company you're looking at to normalize it and compare it to similar companies.

Now the problems with it are tenfold because it's not a gap metric, which means you can make up whatever you want in it, you know, it's not really real. And then what happens is people get carried away. There's EBITDA as defined, which is what we just talked about of, you know, before taxes and the definition. Then you get into management adjustments where it starts getting all willy-nilly, like, well, we spent a little more here than we wanted to and we shouldn't have, so we're going to give ourselves credit for that cost. And then we're going to give ourselves credit for this.

And before you know it, you've got 20 different adjustments to say, well, if we hadn't made like all these hundreds of mistakes, we would have been, you know, much better business.

Host: Paul Barnhurst

If I hadn't missed every shot in that basketball game, I would have been really good.

Guest: Chris Reilly

Yeah, exactly. It's like my golf score, right? “Oh, I missed that putt. Well, if I'd made it, that would have been a lot better”.

So, that's kind of what like management adjustments are. Then you get to diligence adjustments, which are a little bit more justifiable because they are truly one-time in nature, like a transaction expense, private equity management fee, that sort of thing that is truly one-time, and so I'm okay adding that stuff back, again to just get a normalized profitability. But if it does not cash, doesn't factor in working capital, doesn't factor in capital spend, so, it's like, in my mind, it's a first shot across the bow, normalize the profitability of the company that you're analyzing to see like, “Okay, can it take on a certain debt load that we may bring on to it to acquire it?”

So, I like it. Obviously, I use it a lot in my PE world, all different EBITDA schedules. It was good for us for valuation. It was good for lenders. But I understand every single gripe that exists with it. I also agree with those gripes, but I understand at the end of the day, the fundamental reason why it exists, and so I'm an EBITDA supporter.

Host: Paul Barnhurst

Yeah. And I knew you're a big fan of it. I tend to be a little bit on the other end and it probably comes from, with my first company, we never used it. You know, I worked at American Express, and if you've ever read anything about Warren Buffett, he rails against EBITDA. He said the number of times I'll buy a company puts EBITDA on its financial statements is the equivalent of zero. I'm not going to do it. And, you know, he's had another, a lot of other statements he's made about it and Charlie Munger.

So, I think the first company I went to that we started doing EBITDA, I had a very negative view from having spent eight years at American Express and just never really seeing it. And also having a professor, my finance professor, always railed against EBITDA. He hated it. So, it was drilled in from a very, you know, he was a big economic value add, economic profit approach.

And so, that's kind of where my background's come from, but I get it and I can see the value of it more, and I've, I've come a long way to I don't hate it now. I'm not a huge proponent of it, but I get it and I can understand and it can add value. But I think where you hit the nail on the head is this adjusted EBITDA sometimes. If you remember WeWork, right? Community adjusted EBITDA.

Guest: Chris Reilly

Yes, the community.

Host: Paul Barnhurst

Yes. Let's just take all the good stuff, take out all the bad stuff, and we got a great business.

Or the other one I've heard is EBITDA C. You know, earnings before interest, tax, depreciation, amortization, and COVID. COVID actually happened, and so it's finding that right balance, especially given, like you said, it's not a gap measure. So there's no strict rules. Everybody can be doing different things with EBITDA, so you got to be real careful if you're doing any kind of comparisons that you're comparing apples to apples. They all got that apples to orange.

Guest: Chris Reilly

And I think, you know, from a modeling perspective, can't hurt to build the EBITDA schedule below your income statement. Just have it there ready to go. You may never know when the company might test the market, and it's just good to get in the habit of building something like that. But at the end of the day, it's not cash. And I remember one of my favorite quotes, from somebody I used to work for, she said, “Everybody around here cares about EBITDA and nobody cares about cash”. But she was in charge of managing all the cash. So, like it was a common gripe. and refrain that we would hear that, you know, the PE owners just wanted the EBITDA number, but like, hey, we actually have to pay bills with dollars.

And so that was always a big differentiation between the two. But yeah, again, modeling-wise, can't hurt to just have it there. You know, at least EBITDA is defined, all the other adjustments you can save that for, if and when you go down the M&A route.

Host: Paul Barnhurst

Great point there. And I agree with you about that gripe. I've heard that more than once where people are like, “Oh, we don't care what that costs, it's below the line.” There is a catch, it's a real cost. If this was your money, would you care? I mean, just because it's below the line on my P&L doesn't mean I don't care about it.

Like taxes. I care about taxes. I want to minimize them. Whether it's an EBITDA or not. There's a balance there and it's helping people understand, so, I'm with you.

So this next section is probably one of my favorite. It's our rapid-fire questions. So we go through, we have about seven of them. Here's how the rules work. So, I'm going to give you the ground rules here and we'll see how well you do.

Some people have been pretty good at following them. Others have struggled a little. I know how modelers are. So there's no,” It depends” as an answer.

Guest: Chris Reilly

Oh, okay!

Host: Paul Barnhurst

Because you could add that to all of them.

Guest: Chris Reilly

Yeah!

Host: Paul Barnhurst

We could have a show on each of these just to discuss both sides. So, I'm going to ask, and this is, in general, you know, which one would you pick if you had to pick one. Then at the end, I'm going to give you two minutes, you pick the one you want to discuss, why you gave the answer you gave, and you can add all the nuance you want to it. If you want to discuss two in the two minutes, that's fine too.

So you're ready?

Guest: Chris Reilly

Yes, I can handle those rules.

Host: Paul Barnhurst

All right, perfect!

Circular or no circular references?

Guest: Chris Reilly

No.

Host: Paul Barnhurst

VBA or no VBA?

Guest: Chris Reilly

No VBA at all.

Host: Paul Barnhurst

Horizontal or vertical models?

Guest: Chris Reilly

Definitely vertical.

Host: Paul Barnhurst

Excel dynamic arrays, yes or no?

Guest: Chris Reilly

Yes.

Host: Paul Barnhurst

Named ranges versus no named ranges?

Guest: Chris Reilly

Yeees..

Host: Paul Barnhurst

That's named ranges you're saying?

Guest: Chris Reilly

Yes, yes for named ranges.

Host: Paul Barnhurst

I can tell there’s a little hesitation there.

Do you need to follow or should you follow formal standards boards for modeling? So some of the big standards out there like, uh, CORAL or FAST or some of the others. You think it’s smart?  

Guest: Chris Reilly

I actually don't know enough about them to answer, so I guess I'll go with no.

Host: Paul Barnhurst

That's a no then?

Guest: Chris Reilly

That's a no.

Host: Paul Barnhurst

What is your lookup function of choice? VLOOKUP, INDEXMATCH, XLOOKUP, or something else?

Guest: Chris Reilly

 INDEXMATCH.

Host: Paul Barnhurst

INDEXMATCH. I figured that one. I knew that one. I asked those to, uh, you know who Dim Early is? He's won the Modeling World Cup a couple times. And he goes, “You do realize there's a lot of others?” And he started doing all this, and I'm like, yes, I realize there can be others. It was, you know, I was like, alright, here's his level of Excel, and here's mine.

Guest: Chris Reilly

Right!

Host: Paul Barnhurst

All right. So which one do you want to elaborate on?

Guest: Chris Reilly

I will elaborate on the circular references actually.  So, best practices, just leave them out. But I will often include a circular reference in an LBO model by taking the average debt balance to calculate the interest expense and rolling that back into the P&L. And so, as long as you properly know how to break the circularity with a circularity breaker, it can actually work just fine, and it will give you a more accurate model.

So that's my preference to use it in a very debt-heavy model, where you want to be a little bit more precise, but I would say, generally speaking, exclude them. And if you're going to build that same LBO model without circularity, you can just reference the beginning balance of the debt instead of the average balance.

Host: Paul Barnhurst

And so my question would be there, when you say a circularity breaker, let's say somebody's listening, they want to use circular references, but they don't know what that means.

Any advice on learning about that?

Guest: Chris Reilly

Yeah, definitely. So, broken down at its core, circular reference just means that the calculation is dependent on something that it is trying to produce. So it works in a circle. And the way you can break it is you just have, you make a separate cell somewhere that's either a 1 or a zero and then the part of your model that is circular, you will then multiply it by the 1 or the zero. And so when you flick your switch to a zero, it will zero out the circular portion and then you can flick your switch back to one again and it will turn it back on and it will fix the model. If you want to be fancier, you can make it a drop-down list like an on-off toggle. That's typically what I do.

So it's a little bit more of a protected by data validation, but that's the issue, you need to zero out your circularity in the model. You could just type a zero on it and hard code it, but that's you might forget to fix it.

So the circularity breaker is a quick way to just turn something from a live number to zero and then back again, and that's how you build a breaker.

Host: Paul Barnhurst

That makes sense. I have not built a breaker in one of my models, so that's good to know. That sounds relatively simple, but yes, I can see the complexity that I think everybody that I've had on so far has answered no circular reference, because they know the pain of what happens if you don't know how to understand it and make sure you're not having it in other places.

Guest: Chris Reilly

Right! The real danger comes from, once you have iterative calculations turned on, then if you have another circular reference, you might not know about it. And then you don't attach it to your breaker. So you have to really, really know what you're doing, which is why the best practice is to just exclude them altogether.

But if you know where they all are, attach them to your breaker, you'll be just fine.

Host: Paul Barnhurst

Makes sense.

Next one we have for you here is, if you could provide one nugget you have learned about financial modeling over your career that you could share with our audience, what would that nugget be?

Guest: Chris Reilly

Uh, yeah, here's a cool one. Leveraging SUMPRODUCT. So SUMPRODUCT is such an awesome function that probably gets left out of the conversation of like INDEX MATCH and SUMIFS and all that. But if you do SUMPRODUCT, you can build a horizontal and vertical lookup at the same time. Basically, you're taking advantage of SUMIFS in almost both directions. And so you can do a date-based LOOKUP on a Horizontal axis, as well as a Vertical LOOKUP if you're like tagging chart of accounts or something, reference the corresponding range, and you can build a bunch of dynamic reports that way.

If you want to like model out Headcount Spend by Department by Month, you can use SUMPRODUCT and grab your department tags in one column and your date-based tags in a horizontal row.

So it does use a little bit more computing power, but it's a really powerful function if you can constrain the ranges in the right way. And I will often use it for a rolling cash flow forecast so that every time I update the cash flow forecast, I have 10 weeks of history plus a new 13 weeks of forecast, and I use some product to roll all that together by category and by date. And that's something I've picked up in like the last two years or so. I didn't use SomeProduct a whole lot. And I found it's just a really powerful function that is probably underappreciated.

Host: Paul Barnhurst

I would agree with that. I remember I used to see SUMPRODUCT in people's models and I'd be like, all right, they're an advanced Excel user. I'm just going to ignore that and move on.

Guest: Chris Reilly

Just plug that.

Host: Paul Barnhurst

Yeah, exactly. Just whatever, yeah, that SUMPRODUCT, that looks complex. But I've heard how it works now, and I agree with you. There's a lot you can do with it. You know, it's a very robust formula, it does a lot more than just what it was, so to speak, designed to do.

Guest: Chris Reilly

Right. No, exactly, it has a lot of advanced functionality, and I would say to piggyback on a little bit of what you said, you see some product for the first time, and you think, “Well, that's complicated, right?” And it is. So I think the other, like, nugget there is keep your audience in mind. Right, if you don't need to use a fancy SUMPRODUCT function, then don't do that.

Do some simpler things where you can, so that a different user that is not the designer of the model can also understand it. You know, I mean, I love to leave a blank placeholder row at the end of all my subtotals and use the SUM function so that if I insert new rows, my sum function comes with me. Very simple. I can be fancier and I can build it with the offset function and not need that row. Who understands the offset function? That's a newer user, right? It's just more complicated.

So if you can take micro steps to simplify for a different user, I think that's also a really important nugget for anybody that's working on a model. It doesn't have to be complicated. I would use the simplest formula you can to achieve the objective.

Host: Paul Barnhurst

Exactly. I asked somebody on, you know, the other podcast, FP&A Today once I asked a person, “What's your favorite Excel model?” He was like “The easiest one that gets the job done”. And I was like, “That's the way we should model.”

We don't always, I mean, I will admit sometimes it's fun to get fancy with a model, but it doesn't help when you have to turn it over to somebody else.

So we're coming up on our time here. I've really enjoyed chatting with you. I love the experience and the knowledge you're able to share. It's very clear you have a passion and understanding for modeling that's been built over years of experience.

So, the last question I have for you, before we let you go, if our audience wants to learn more about you or the resources you offer, what's the best way to get in touch?

Guest: Chris Reilly

So my primary, you know, social media network of choice is probably LinkedIn, I post on there a lot to build the business and just kind of spread my financial modeling knowledge as best I can. I also did start a newsletter recently that goes more in-depth on all that content, if somebody just wants a deeper understanding, than kind of what can be absorbed in a social media post. Dabbling with a few other networks right now, but nothing serious enough to mention, I would say.

So. LinkedIn is the number one and I try to be hyper-responsive, you know, if people message me, I always try to respond, and if you're on my email list, I definitely will always try to respond and be in touch.

And, that's really the best way to get, get to know me better.

Host: Paul Barnhurst

Alrighty. Well, thank you for that, Chris. And we'll make sure to put your LinkedIn profile in the show notes so people can find you there, and if there's anything else you want to include, let me know, but thanks for carving out some time for us. Really enjoyed chatting with you today and can't wait for our audience to get to listen to this episode.

Guest: Chris Reilly

Yeah, no, thanks so much, Paul. Always a pleasure to be here. Thanks for, thanks for having me really, really appreciate it.

Host: Paul Barnhurst

Not much I can add to that episode, so we're gonna keep this really brief.

First, I'd just like to say if you're not following Chris Reilly on LinkedIn, you should be. He has over 70,000 followers and he's currently building a modeling course for LinkedIn. He has a number of other great courses and he leaves financial modeling advice on a daily basis.

And what I want to talk about just real quick is one thing that stuck out to me from that episode that gets to the modeling education. Remember him talking about how he's built a lot of horrible models and he shares the one where he had to close the one model after taking a picture and then manually input the data in the other model. Now he's one of the best educators out there. And so what I want the takeaway to be is when you practice, you can become good at something. We don't just naturally wake up one day and all of a sudden be good. To learn to be a modeler, you need to model. So, you know, consider doing FMI, take a course, sign up for the FMI certification or the fundamentals. But spend time finding ways to improve your modeling skills. Don't expect them to just naturally happen, but focus on it and spend time becoming better and learn the business as you learn to be a better modeler.

So as a reminder, you can earn CPE credit for having listened to this episode. All you need to do is go to earmarkcpe.com, download the ap, and answer a few questions.

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Thanks again for joining us on this episode, because we could not do it without you. And a special thanks goes to the Financial Modeling Institute for sponsoring this podcast.

Until next time, thank you.

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