Your Full Guide to the Concepts of Financial Modeling
Financial modeling is one of the most essential aspects of business management and accounting. With financial modeling, businesses can see their present revenue generation and predict the upcoming expenses in the business.
Financial models collect various kinds of financial information and data from reliable sources. After proper financial statement analysis, the data helps businesses in making sound financial decisions. Business organizations and companies are implementing this technique for planning business performance.
What is Financial Modeling?
Financial modeling is creating a summary of a company’s expenses and earnings in the form of a spreadsheet that can be used to calculate the impact of a future event or decision.
A financial model has many uses for company executives. For example, financial analysts often use it to analyze and anticipate how a company’s stock performance might be affected by future events or executive decisions.
In financial modeling, there are uses of different economic models. Analysts use these models for analyzing and predicting a business’s stock performance. The models play an important role in ascertaining vital business decisions.
Basics of Financial Modeling
In financial modeling and financial statement analysis, there is a numerical representation of the business’s past, present, and future operations. With these models, business executives can take important decisions regarding the brand positioning and finances of the organization.
Along with the financial analysis, financial modeling is used for other purposes like making estimations for budgets and profits of a newly proposed project.
Financial analysts use financial models for determining the company or business valuation. This data also comes in handy for gauging competitors’ performance in the market.
During strategic business planning, finance executives can use financial modeling to test different scenarios, decide on the company’s financial budget, and allocate corporate resources.
Some of the best examples of financial modeling include an in-depth appraisal, analysis of discounted cash flow, and sensitivity analysis.
What are Financial Models?
Financial models are building blocks of financial modeling. A financial model is nothing but a tool created in MS Excel or related spreadsheet software. It represents a company’s operations in the past, present, and forecasted future. For example, company executives might use them to estimate the costs and project profits of a proposed new project.
Financial analysts use them to explain or anticipate the impact of events on a company’s stock, from internal factors such as a change of strategy or business model to external factors such as a change in economic policy or regulation.
The forecasts that financial models make depend on various factors like the historical performance of the business and assumptions regarding the future. Executives also need to make other preparations like creating a balance sheet, income statement, supporting schedules, and cash flow statement.
Professionals can also build more advanced models from the basic models like leveraged-buyout (LBO) models, discounted cash flow analysis (DCF) models, sensitivity analysis models, and mergers and acquisitions (M&A) models.
Financial modeling helps businesses with financial planning and analysis and enables them to take data-backed business decisions.
What are the Uses of a Financial Model?
The main aim of creating a financial model is to enhance the decision-making process of the business along with carrying out financial analysis. Within a company, finance executives use a financial model for taking decisions on various matters. Some of them are:
- Looking to grow the business organically. This includes entry into new markets, opening new stores and outlets, etc.
- Raising finances and capital in the form of debt or equity
- Divesting or selling business units and related assets
- Making acquisitions in the form of assets or businesses
- Forecasting, budgeting, and planning for the years ahead
- Valuing a business
- Allocating capital to businesses as per the priority of projects
- Focusing on management accounting
- Working on financial statement analysis or ratio analysis
Financial Modeling Techniques
In finance, specific financial modeling techniques are commonly used for the organisation’s decision-making process. Some effective modeling techniques are as follows:
- Historical Data – This particular technique is vital in determining future trends. Since data is the foundation of future predictions, the collected data should be accurate and credible.
- Assumptions – In this technique, there is a thorough analysis of a company’s historical data. After analysis, executives develop a strategy for creating a suitable financial model.
In financial modeling, assumptions have to be well-defined and vivid. These assumptions are inputs for creating financial models and deciphering the realities and expectations of the business.
- Linkages or color-coding – A vital part of financial modeling involves formatting through color codes. The values in different cells correspond to varying parameters. Color coding the cells and the financial model as a whole helps in easy understanding of the model.
Common Types of Financial Modeling
There are different types of financial modeling used by businesses for collecting data. Companies can better understand their objectives and financial decisions by analysing the data. Mentioned below are some of the most common types of financial modeling:
Discounted Cash Flow Model
This model allows a business to display and determine its present net value. It also helps in equity research and analysis. The working of this model depends on predicted free cash flows, and the cash flows are discounted.
Three Statement Model
This mainly works on three statements – the statement of profit and loss, the balance sheet, and cash flow. This type finds connections among these three statements for developing a model. This model is considered the base model.
A kind of reporting model, the forecasting model, is mainly used for financial planning and analysis. It forecasts the data in comparison to the budget data.
Classified as a financial reporting model, the budget model is one of the most important financial modeling types. This model creates budgets for the future along with another capital spending. Monthly or quarterly data is used for preparing this model, ranging from 1-5 years.
Merger and Acquisitions Model
The use of the merger and acquisitions model is mainly for valuation purposes. This model is usually used when there is a company acquisition, or a merger of two companies is taking place. Generally, corporate development professionals and investment bankers use this advanced model.
Leveraged Buyout Model
This model is prominent for a leveraged buyout, where the primary funding source is debt. Private equity firms mainly use this model as they lend almost 70% for funding. There are multiple layers of data in this advanced financial modeling type.
Initial Public Offering Model
The use of this model comes when there is a need for valuing the business before going for listing. In addition, investment bankers use this model to understand the public’s demand for the shares of the company post-listing.
Option Pricing Model
This mathematical model is a pricing model and is incorporated in MS Excel. Black-Scholes and binomial trees are the two main types of this model.
Commonly Used Financial Modeling Tools and Concepts
When we talk of financial modeling tools and concepts, the first name that comes to mind is MS Excel. Notably, Excel templates and pre-built models are great as a starting point for performing analysis.
Apart from templates, there are other tools for financial modeling like software and programming languages such as VBA. These tools help improve automation, and the model quality and standards remain at the highest level.
There is another tool, which is a software program like SAP. Generally, large global corporations use these tools as they are pretty expensive. Unfortunately, software packages also come with expensive and extensive installations.
When compared to all the financial modeling tools, MS Excel seems to be the best for various reasons:
- It is dynamic and completely flexible
- It is affordable; everybody uses it
- You can start learning from the basic level without any training
- It is easy to edit and audit
- Most importantly, it integrates well with other types of finance and accounting work
Best Practices of Financial Modeling
The best financial models are accurate, easy to read, flexible, and most importantly, well-matched to the application so that the complex task is accomplished well. Here are some best practices that you must follow:
- Try understanding the central issue of the business. Now focus on the overall goal of the model and on the users who will be using the model.
- It is best to create the whole financial model on a single worksheet. Then, you can easily understand the model, and there will be minimum chances of user errors.
- Try grouping the sections for enhanced flexibility and clarity. For example, begin with assumptions, move to the balance sheet, and finally to the income statement. Keep the sections in logical groups in whichever financial model you are using. You can easily differentiate data with this setup.
- For color coding, always follow standard protocols. For example, for hard-coded numbers, use a blue font, use black for formulas, green for linking to other worksheets, and red for indicating links to other files.
- Maintain consistency with number formats throughout the financial model. In Excel, maintaining this consistency is easy.
- Make sure every value should have a cell and appear just once in the sheet. This will preserve the readability of the model and prevent errors. Never embed an assumption into any formula.
- Keep formulas simple. If possible, break the complex calculations into innumerable procedures.
- Check the numbers and formulas again and again. You will not get the correct output until you use the accurate data.
- Finally, test your model thoroughly. Try refining it as much as possible and find its limits.
Useful and Effective Tips and Tricks
Succeeding in financial modeling will take some time. But, to make the process easy and smooth, here are some practical and valuable tricks and tips that might be helpful:
- No hard-coded numbers should be embedded with formulas as they often become difficult to spot.
- Make sure that you adhere to the sign convention consistently throughout the model.
- Ensure that you do not have the same input in numerous locations.
- Do not hide sheets or rows; instead, group them.
- Refrain from using multiple, smaller tabs. Instead, use fewer but bigger tabs.
- Refrain from linking to other files as it might crash large Excel models.
- Try avoiding naming your cells. Then, you can leave the job to Excel’s grid logic.
- It is always good to avoid complicated formulas. Instead, break up the formula into simple steps.
- Make the practice of keeping just one formula in one row.
Demands for jobs in the financial modeling industry are surging. Many enterprises seek an able finance modeler to plan the company’s financial future well.
If you are seeking a career in finance, having an idea about financial modeling will significantly help. People who are involved in financial decision-making, like investment bankers, portfolio managers, accountants, risk managers, business planning and strategy deciders, equity researchers, and commercial bankers, can all benefit from financial modeling.
If you are interested in learning about financial modeling, having good knowledge of MS Excel will be a great advantage. It is also helpful if you understand accounting and finance concepts.
You can take a course on financial modeling from any well-reputed institute and learn the nitty-gritty of the subject. Enrol in Hero Vired’s Integrated Program in Finance and Financial Technologies and learn financial modeling from industry experts. Give your career a new direction with this amazing course.