FINANCIAL MODELING: What is it, Uses & Best Practices

Financial modeling is one of the skills in economic analysis that is most highly regarded yet poorly understood. Basically, a forecast of a company’s future performance is the goal of financial modelling, which combines accounting, finance, and business measurements.

Let’s find out more as we go over all the necessary information for financial modeling and its best practices.

What is financial Modeling?

Financial modeling estimates a project’s or company’s financial success by considering all pertinent variables, growth, and risk assumptions and thoroughly understanding the impact. The user may comprehend all the factors involved in economic forecasting thanks to it. It’s also crucial to remember how significantly the assumptions and inputs influence the outcomes’ accuracy.

For business executives, a financial model is sound. Financial analysts most frequently use it to assess and predict how upcoming developments or executive choices affect a company’s stock performance.

What Is the Purpose of Financial Modeling?

People inside and outside businesses use a financial model for financial analysis and decision-making. The need to obtain cash, expand the company organically, sell or divest business segments, allocate capital, budget, forecast, or evaluate a company are a few reasons a company would develop a financial model.

Guidelines for Financial Modeling

#1. Flexibility

It must be adaptable in every circumstance and flexible in scope (because contingencies are a standard component of any organization or sector). The ease with which a financial model can be modified whenever and anywhere is crucial to its adaptability.

#2. Factual

It shouldn’t be overly detailed or cluttered. When creating a financial model, you should know it should be a good depiction of reality.

#3. Structure

Logical integrity is of the utmost significance. The model’s author may change, so the system should be strict, and integrity should always be prioritized.

Programs that are Ideal for Financial Modeling

Predicting how a business will operate in the future can be difficult. Each firm is different and necessitates a particular set of calculations and presumptions. Unlike Excel, which is typically more accessible, other software tools could be overly stiff and specialized.

Who Creates the Financial Models?

Many different kinds of experts build financial models. Investment banking, equity research, corporate development, FP&A, and accounting (due diligence, transaction advisory, valuations, etc.) are among the job paths that are most frequently chosen.

What Details Should a Financial Model Contain?

Sections on assumptions and drivers, an income statement, a balance sheet, a cash flow statement, supporting schedules, valuations, sensitivity analysis, charts, and graphs should all be included in a usable and understandable model.

What Kinds of Companies Employ Financial Modeling?

Experts in a wide range of industries use financial modeling. Here are a few illustrations: Institutions use economic models for research, portfolio management, and private equity. Bankers use them for sales, trading, stock research, and commercial and investment banking. Public accountants use them for due diligence and appraisals.

Types of Financial Models

You should be aware of the different types of financial models. You can model your company’s financial requirements and make long-term plans using these models with a fundamental knowledge of corporate finance and effective templates.

#1. Option Pricing Model

While Excel has sophisticated functionality for data modeling, other models function more like basic calculators. The Black-Scholes model and the binomial tree are two examples of the option pricing model. Both depend on mathematical equations rather than user-defined, subjective standards.

#2. Outside Models

Financial analysts can use the following models to make business decisions affecting other firms: These models, for instance, aid in determining if merging with another company or organization is a wise financial move.

#3. Model of Discounted Cash Flow 

By discounting anticipated free cash flows to the present, the discounted cash flow (DCF) model considers the time value of money. Leveraged or unleveled free cash flows are also possible. 

The DCF depicts a company’s (1) enterprise value and (2) equity value in both situations. This approach shows if the company’s market value is currently overpriced or underpriced.

#4. The Sum of Parts Model

The sum of the components model comprises assets that don’t cleanly fit into a DCF analysis, unlike investments with a physical worth. Take market-based securities, like marketable securities, as an example.

Take the value of Business Unit 1 and multiply it by Business Unit 2, then by Investments 3. After that, you deduct Liabilities 4 to get the NAV.

#5. Leveraged Buyout Model

The three-statement model is one of the most popular financial models. However, the leveraged buyout model is more intricate and built on the company’s anticipated performance. For analysts working in private equity and investment banking, the leveraged buyout (LBO) model is helpful. 

#6. Initial Public Offering Model

The initial public offering (IPO) model is useful for investors and corporate organizations. According to the IPO model, analysts must compare their company’s potential value to similar businesses and assume the price that potential investors would be willing to pay for the company’s potential shares.

#7. Consolidation Model 

The consolidation model adds together each company unit instead of the sum of the parts concept. Each business unit is consolidated into a single model as a result.

#8. Budget Model 

Although a budget model is straightforward, it is essential to the business planning process at your organization. Depending on your financial cycle, you can add monthly or quarterly numbers. Like the three-statement model, the budget model incorporates the revenue statement and enables financial analysts to plan for upcoming years.

#9. Forecasting Model

The forecasting model allows financial planning and analysis professionals to compare future projections with current budget estimates. You can keep separate models or combine the prediction and the budget in one spreadsheet.

Prerequisites for Financial Modeling

Only when financial modeling software produces reliable and precise results will it help build these models. One should possess the requisite set of abilities to prepare a model effectively. Let’s look at what those abilities are:

#1. Accounting Concept Understanding

International Financial Reporting Standards (IFRS), US GAAP, and other specialized accounting principles are examples of global financial industry standards. These principles keep the presentation of financial data and events consistent. It is crucial to comprehend these guidelines and notions to maintain accuracy and quality while getting ready to construct an Excel model.

#2. Excel Abilities

A program like MS Excel is used as the primary tool for financial modeling in Excel, where a model is created. It consists of various intricate calculations scattered across numerous tabs that are linked to depict their relationships with one another. When creating a model, it’s essential to have a thorough working knowledge of Excel, including its formulas, keyboard shortcuts, presentation styles, VBA Macros, etc. The analyst has an advantage over others in his field of work by mastering these skills.

#3. Interlinking Financial Model Statements

This completes the interrelationship between the statements and gives us a complete picture of the company’s financial status. The interlinking enables vital figures in the model to flow from one account to the next.

#4. Prediction

The capacity to predict financial Since the goal of modeling is often to comprehend the future scenario of any economic issue, it is crucial. Both art and science go into forecasting. An analyst can get a good indication of how appealing the investment or firm will be in the future by making plausible assumptions while projecting the data. Strong forecasting abilities increase the dependability of a model.

#5. Presentation

The financial modeling process has intricate details, numbers, and algorithms. Various organizations use it, including management, clients, and operational managers. If the model appears disorganized and challenging to comprehend, these individuals cannot interpret its significance. Therefore, making the model rich in detail is crucial while keeping its presentation simple.

Pros and Cons of Financial Modeling

Pros of Financial Modeling

The following are some of the main pros of adopting the financial model:

#1. Improved Business Grasp

Building a financial model necessitates a thorough grasp of the company. Developing the model forces the company to consider and make a list of the factors that impact the many business characteristics.

The procedure also makes the company consider the numerous changes that could occur both internally and externally. Therefore, it is reasonable to say that corporations that develop financial models must conduct more due diligence than their competitors. This improves our comprehension of the company. Therefore, developing financial models has a knock-on impact that improves understanding of the underlying business.

#2. Aids in Selecting a Funding Strategy

Companies can better comprehend their cash flow status when using financial models. It is simple to determine the company’s cash flow needs, borrowing capacity, and ability to pay interest. This aids the business in selecting the best financial approach. For instance, the revenues of new businesses are unclear. However, their costs are essentially constant.

They can use financial modeling to determine how much cash they’ll need on hand to make it until revenues start coming in. As a result, start-up businesses can calculate the quantity of equity they should sell to attain their next goal.

#3. Aids in Reaching the Correct Valuation

Financial modeling enables businesses to recognize their genuine value. Some of these models erroneously assume that revenues and expenses have linear ties.

Using financial models, it is feasible to calculate the precise amount of free cash flow that will accrue to the company at various periods in time. Selling their stakes to outside investors like investment bankers and private equity groups lets businesses know their exact market value.

Cons of Financial Modeling

There are drawbacks to the financial modeling approach. The list below contains a few of the more significant ones.

#1. Time-consuming

It’s crucial to realize that financial modeling requires a lot of time. This is so that all the necessary duties can be completed for establishing a financial model. The model must be checked for technical and financial anomalies, the data must be gathered, and the underlying factors must be determined. Then, this model must be made user-friendly and intuitive.

It goes without saying that all of this takes time and money. Many businesses, especially smaller ones, might not have enough resources for this project. Financial models, therefore, have relatively little application in many situations.

#2. False

Financial models are utterly insufficient. Many people use the 2008 subprime mortgage crisis as an example to make this argument. However, it’s important to realize that the model itself is subject to error.

Nobody can accurately estimate variables like interest rates, tax rates, and market shares. If someone really possessed such a talent, they wouldn’t need to develop financial models because they would make a fortune trading stocks and derivatives!

#3. Soft Factors

Many mergers have failed due to soft factors such as challenges integrating the cultures of the two acquired organizations. On the one hand, models account for cost savings from the merger, which will result in synergies. On the other hand, they fail to account for the costs resulting from a lack of cultural compatibility. Even though the financial models indicated that these models would be successful, many mergers have already failed.

How do I Start Financial Modeling?

  • Identify the model’s objective.
  • Establish the KPIs for your business.
  • Get a template for a financial model.
  • Merge the template with the actual results.
  • Start making income projections.
  • Project headcount requirements.
  • Estimate other costs.

What is the Difference Between CFA and Financial Modeling?

By ensuring that you can apply your knowledge to problems in the real world, the CFA course aids in your development of high-level abilities. Financial modeling, on the other hand, teaches you how to break down and analyze unique economic conditions and corporate processes.

Is Financial Modeling Difficult?

The learn-by-doing approach is frequently used to acquire these abilities, though reading equity research studies can be helpful in the process. Even for those who work in the financial industry, financial modeling is seen as a challenging task. However, accounting is a skill that is considerably simpler to learn.

How Long Does It Take to Learn Financial Modeling?

To become proficient in this skill typically takes years. Depending on the project and its complexity, the time needed to develop a specific financial model also varies. When estimations are employed, particular models can be produced in a matter of days, but it’s more typical for the process to take several months.

What are Financial Modeling Skills?

The capacity to develop hypothetical scenarios for prospective financial decisions using accounting data and financial documentation is known as financial modeling. Understanding terms like revenue, cash flow, capital allocation, and amortization may be necessary for this.

Does Financial Modeling Require Math?

The intricate formula logic and hidden assumptions make financial modeling challenging to learn. In addition to problem-solving and decision-making capabilities, it necessitates technical and quantitative expertise.

Conclusion

Financial modeling is the process of using numbers to describe the operations of a business in the past, present, and anticipated future. These models are designed to be instruments for making decisions. Company executives might use them to forecast the costs and profits of a proposed new project.

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