What Is A Financial Model

A financial model or financial modelling is the process of constructing a spreadsheet that contains a summary of a company's expenses and earnings and may be used to evaluate the impact of a future event or decision.

For business executives, a financial model can be useful in a variety of ways. It is most commonly used by financial analysts to examine and forecast how future events or executive choices will affect a company's stock performance.

Financial Modelling

Financial modelling is a numerical representation of a business's operations in the past, present, and predicted future. Models like these are meant to be used as decision-making aids. They could be used by company leaders to estimate the expenses and profitability of a proposed new project. Inside a company, executives will use financial models to make decisions about:

  • Raising capital (debt and/or equity)
  • Financial statement analysis/ratio analysis
  • Selling or divesting assets and business units
  • Budgeting and forecasting (planning for the years ahead)

Features of a Financial Model

A financial model is a lot more than just an excel spreadsheet. It has certain components that are universal to all sorts of financial models created globally by businesses:

  • A Universal Structure. Inputs, outputs, calculations, and scenarios are all part of a financial model's variable assumptions. It frequently contains a set of typical financial forecasts based on those assumptions, such as a profit-and-loss statement, a balance sheet, and a cash flow statement.
  • Flexible To Outcomes and Numbers. When inputs are modified in a financial model, the calculations and, as a result, the outputs are affected. A financial model is always flexible enough to show varied outcomes or final computations depending on a few critical inputs.
  • Shows Relationships Between Variables. A chain reaction frequently arises when the user modifies any of the input assumptions. Changing the growth rate, for example, will affect the sales volume, which will vary the income, sales commissions, and other variable expenses. An alteration in one variable will change the other and a financial model will indicate that based on the relationship between these variables.
  • Shows Forecasts and Projections. Financial models are almost always looking into the future. Financial modellers often want to know what their financial projections will look like down the road. For example, if you continue growing at the same rate, what will your cash flow be in five years?
  • Estimates Using Hypothetical Outcomes. A well-built financial model can readily do scenario and sensitivity analysis since it looks forward rather than backward. What would happen if interest rates climbed higher? How much can we discount before we begin to lose money?

Who Uses Financial Models?

Many different types of people create and use financial models for various purposes and objectives. Financial models are typically created to address real-world issues, and there are as many distinct types of financial models as there are real-world issues to address. Anyone who uses Excel for financial purposes will, in most cases, create a financial model for himself or others at some point in their careers.

Financial models are frequently used by bankers, CFO's, Startup founders, particularly investment bankers. Because of the nature of financial institutions, modelling is ingrained in their culture – the business's foundation is founded on financial models. Accountants, outside of the banking business, are heavy consumers of financial models. Bankers frequently assess other businesses for credit risk and other factors. The models of an accountant, on the other hand, are frequently inward-looking, focusing on internal operations reporting and analysis, project appraisal, pricing, and profitability.

Types of Financial Models

There are easily more than 10 financial models that are being used today however this section will discuss only a few in detail and the rest are listed in the infographic provided below.

Three-Statement Model

The three statement model is the simplest basic financial modelling configuration. The three statements (income statement, balance sheet, and cash flow) are all dynamically linked with Excel formulas in this model, as the name implies. The goal is to integrate all of the accounts such that a set of assumptions can trigger changes across the entire model. It's crucial to understand how to connect the three financial sectors.

There are several steps required to build a three statement model, including:

  1. Input historical financial information into Excel
  2. Determine the assumptions that will run the forecast
  3. Forecast the income statement
  4. Forecast capital assets
  5. Forecast financing activity
  6. Forecast the balance sheet
  7. Complete the cash flow statement

The two models below are based on the three statement model, DCF is more towards valuation whereas budget model is quite self-explanatory, relates to budgeting.

Discounted Cash Flow Model

The DCF model builds on the three-statement approach to value a firm based on its future cash flow's Net Present Value (NPV). The DCF model uses Excel features to discount the cash flows from the three-statement model back to today at the company's Weighted Average Cost of Capital (WACC).

This applies to decisions made by investors in companies or securities, such as acquiring a company, investing in a technology startup, or purchasing a stock, as well as capital budgeting and operating expenditures decisions made by business owners and managers, such as opening a new factory or purchasing or leasing new equipment.

The goal of a DCF analysis is to calculate how much money an investor would get from a given investment after accounting for the time value of money. Because money may be invested, the temporal value of money assumes that a dollar today is worth more than a dollar tomorrow. As a result, a DCF analysis is suitable in any case where a person is spending money now in the hopes of obtaining more money in the future.

These types of financial models are used in equity research and other areas of the capital markets. A DCF is not best for startups but works best for businesses and companies that have stable cash flows and are in their later stage of development. Initially, startups won't have that.

financial model
Courtesy of Corporate Finance Institute

Budget Model

This is used to model finance for financial planning and analysis (FP&A) specialists who are putting together the budget for the following year(s). Budget models are often based on monthly or quarterly data and place a strong emphasis on the income statement.

You can find more types of financial models here by the Corporate Finance Institute.

Skills You Require For Financial Modelling

Practice is the most effective technique to learn financial modelling. To become an expert at constructing a financial model, you'll need years of experience and a lot of practice. Reading equity research reports can be a good approach to practice because you can compare your results to theirs. Using a mature company's past financials to develop a flat-line model into the future and practising calculations. Some of the key things to practice are mentioned below:

  • Excel Tips and Tricks. To increase speed and efficiency in preparing financial models, knowledge and experience in excel formulas and spreadsheet is highly important. In a financial model, it's critical to distinguish between inputs (assumptions) and outputs (calculations). Formatting conventions, such as making inputs blue and formulas black, are commonly used to accomplish this. Other conventions, such as shading cells or using borders, can also be used.
  • Layout and Design. It's vital to lay out a financial model in a clear and straightforward manner. This usually entails creating the entire model on a single worksheet and then grouping it into pieces. This makes it simple to extend and contract the model, as well as move it about. The main sections to include in a financial model (from top to bottom) are assumptions and drivers, income statement, balance sheet, cash flow statement, supporting schedules, valuation, sensitivity analysis, charts and graphs.
Source: CFI

Essentials To Build A Financial Model

The process of financial modelling is ongoing. You have to work on different portions until you can finally tie everything together.

  1. Every financial model begins with a company's past performance. Begin by downloading three years of financial statements and entering them into Excel to create the financial model. Then, for the historical period, you reverse the assumptions by calculating revenue growth rate, gross margins, variable costs, fixed costs, inventory days, and so on.
  2. With the forecast assumptions in place, you can start with the income statement and compute sales, Cost of Goods Sold (COGS), gross profit, and operating expenses all the way down to EBITDA at the top of the income statement. Calculating depreciation, amortisation, interest, and taxes will have to wait. The second step would be preparing the balance sheet, you can begin filling up the balance sheet now that the top of the income statement is complete. Calculate accounts payable and inventories and so on.
  3. Followed by any supporting schedules, you must first develop a schedule for capital assets such as Property, Plant & Equipment (PP&E), as well as debt and interest before you can finish the income statement and balance sheet. The PP&E schedule will add capital expenditures and deduct depreciation from the historical period.
  4. All steps above complete, preparing the cash flow statement followed by a sensitivity and scenario analysis. The goal of this analysis is to see how much changes in underlying assumptions will affect the company's worth (or some other statistic). This is quite important for determining the risk of an investment or for business planning (for example, would the company need to seek money if sales volume reduces by x per cent?).
  5. Lastly, the ability to communicate results clearly distinguishes excellent financial analysts from merely competent ones. Charts and graphs are the most effective approach to display the outcomes of a financial model.

On A Final Note

Financial models are useful anywhere there are financial problems or circumstances in the real world that need to be solved, analysed, or translated into a numerical representation. Sometimes all that is required is the conversion of an idea or concept into a business case or feasibility plan. A professional financial modeller may give the idea solidity by adding enough information to create a workable model that can be used to make choices, raise funding from investors, or hire staff.

For example, financial models can help investors decide which project to put their money into, an executive track which marketing campaigns have the highest return on investment, or a factory production manager decide whether to purchase a new piece of machinery.

The video below summarises financial modelling by the Corporate Finance Institute.

References

What Is Financial Modelling

Types of Financial Modelling

Overview of a Financial Model

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Written by Meerat Qureshi

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