Financial Modeling Process

Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What Is The Financial Modeling Process?

The financial modeling process is a step-by-step approach that starts with populating the historical financial data in an excel sheet, performing financial analysis, making assumptions and forecasting, and finally assessing risk by performing sensitivity analysis and stress testing.

Financial Modeling Process

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Keeping the expenses and earnings properly arranged in the spreadsheet helps firms and their professional get a clear picture of the cash going out and moving in the business. As a result, making a decision and tracking the effect of that decision on the business become much easier.

Key Takeaways

  • The financial modeling process follows a systematic approach, commencing with inputting historical financial data into an Excel sheet. Subsequently, it involves economic analysis, assumption formulation, and forecasting and concludes with sensitivity analysis and stress testing to assess risk.
  • The process entails seven sequential steps: entering historical financial data, assessing past performance, gathering assumptions for future forecasts, evaluating potential risks to the organization, conducting sensitivity analysis, and finally, stress testing the predictions.
  • It’s crucial to recognize that assumptions significantly impact predictions. Analysts should delve into the patterns and underlying causes after identifying them to comprehend better the dynamics influencing the outcomes.

Financial Modeling Process Explained

The financial modeling process helps keeping the businesses’ earnings and expenses figures clearly readable. Based on the same, the financial performance is assessed, and companies can predict the stock value and its performance in accordance with the same.

The spreadsheet not only allows the executives keep track of the inflow and outflows but also serves to be the informative data leading to decision-making. The implementations of today can be assessed, depending on various parameters, in future for results. If the strategies adopted by the businesses seem to work, they continue with the same. Else, they get an idea that they need to change strategies to improve figures.

In addition, these figures help in the valuation of the firms and also allow them to have a clear comparison with the competitors in the market. However, to make this modeling process effective, it is important to follow few steps in a proper sequence.

Process Steps

The financial modeling process involves the following steps to ensure effectiveness. Let us look into these steps in details below:

  1. The entry of Historical Financial Data
  2. Analysis of Historical Performance
  3. Gathering of Assumptions for Forecasting
  4. Forecast the Three Statement ModelThree Statement ModelA 3 statement model is a type of financial modeling that connects three key financial statements: income statements, balance sheets, and cash flow statements. It prepares a dynamically linked single economic model used as the base of complex financial models like leverage buyout, discounted cash flow, merger models, and other financial models.read more
  5. Future Business Risk Assessment
  6. Performance of Sensitivity AnalysisSensitivity AnalysisSensitivity analysis is a type of analysis that is based on what-if analysis, which examines how independent factors influence the dependent aspect and predicts the outcome when an analysis is performed under certain conditions.read more
  7. Stress Testing of the Forecast

#1 – Entry of Historical Financial Data

Any financial model starts with the entry of historical financial statements. The analyst then inputs the historical information into an excel spreadsheet, which marks the start of financial modeling. Generally, analysts prefer the latest 3 to 5 years of historical data as it provides a fair bit of insight into the company’s business trend in the recent past. The analyst should be cautious while capturing the historical data from the three financial statementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more and the corresponding schedules. Any mistake in this step can potentially deteriorate the quality of the end model.

#2 – Analysis of Historical Performance

In this step, the analyst must apply all their knowledge of accounting and finance. Each line item of the historical income statementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.read more, balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more and cash flow statementCash Flow StatementA Statement of Cash Flow is an accounting document that tracks the incoming and outgoing cash and cash equivalents from a business.read more should be analyzed to draw meaningful insights and identify trends. For instance, growing revenue, declining profitabilityProfitabilityProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance.read more, deteriorating capital structure etc.

It is important to note that this analysis will strongly influence the assumptions for forecasting. Once the trend has been identified, the analyst should try and understand the underlying factors driving the trend. For instance, the revenue has been growing due to volume growth; the profitability has been declining in the last three years owing to a surge in raw material prices; capital structureCapital StructureCapital Structure is the composition of company’s sources of funds, which is a mix of owner’s capital (equity) and loan (debt) from outsiders and is used to finance its overall operations and investment activities.read more has deteriorated on the back of debt-laden capexCapexCapital Expenditure is the total amount that a Company spends to buy & upgrade its fixed assets like PP&E (Property, Plant, Equipment), technology, & vehicles etc. You can calculate it by adding the net change in PP&E value over a given period to the depreciation expense for the same year. read more plan etc.

#3 – Gathering of Assumptions for Forecasting

Next, the analyst has to build the assumptions for the forecast. The first method to draw assumptions is using the available historical information and their trends to project future performance. For instance, forecast the revenue growth as an average of the historical revenue growth in the last three years, project the gross marginGross MarginGross margin is derived by deducing the cost of goods sold (COGS) from the net revenue or net sales (gross sale reduced by discounts, returns, and price adjustments). Gross margin formula (in absolute term) = Net sales – COGSread more as an average of the historical period, etc. This method is useful in the case of stable companies.

On the other hand, some analysts prefer to use forecast assumptions based on the current market scenario. This approach is more relevant in the case of companies operating in a cyclical industryCyclical IndustryCyclical industries refer to those businesses whose performance efficiency is highly correlated with or sensitive to the economic cycles. These companies grow when the economy is in the growth or expansion stage and declines with an economic recession or depression—for instance, automobiles, aviation, construction industries.read more, or the entity has a limited track record. Nevertheless, the assumptions for some of the line items in the balance sheet, such as debt and CAPEX, should be drawn from the guidance provided by the company to build a reliable model.

#4 – Forecast the Financial Statements using the Assumptions

Once the assumption is decided, it is time to build the future income statement and balance sheet based on the assumptions. After that, the cash flow statement is linked to the income statement and balance sheet to capture the cash movement in the forecasted period. At the end of this step, there are two basic checks –

#5 – Future Business Risk Assessment

Next, the analyst should create a summary of the output of the final financial model. The output is usually customized as per the requirement of the end-user. Nevertheless, the analyst must provide their opinion on how the business is expected to behave in the upcoming years based on the financial model. For instance, the analyst can comment that the company will be able to grow sustainably and service its debt obligations without any real risks in the near to medium term.

#6 – Performance of Sensitivity Analysis

This step aims to determine at what point the performance of the company will start to decline and to what extent. In this step, the analyst must build scenarios into the model to perform sensitivity analysis. In other words, the resilience of the business model will be tested based on scenarios. This step is beneficial as it helps assess variation in performance in case of an unanticipated event.

#7 – Stress Testing of the Forecast

Here the analyst assumes the worst-case (extreme) scenario based on some unfortunate event during a specific period, say a decade. For instance, the recession of 2008-09 is used for stress testing the forecasting models of US-based companies. This step is also crucial as it helps understand how a company will behave in such an extreme scenario and whether it can sustain itself.

Example

Let us consider the following instance to understand the concept better:

Company A, given its consistent growth from a start-up to a full-fledged business in a couple of years, decides to track its sales growth and also compare itself with its own performance every year. Hence, it decides to follow a financial modeling process.

To achieve this, it lists down how to segregate the cells in the spreadsheet. It dedicates cell A to record the sales figures of the previous year, cell B for the sales figures of the current year, and cell C to find the average sales with respect to the sales figures A and B.

For cell C to work, the company professionals incorporate a formula – (A-B)/A. Hence, for every value of cell C, the spreadsheet carries out the respective average calculation. When the entries were made, company A observed an increase in its figures and hence it decided to go public given the progress it has been making over the past few years. This format becomes a standard one for the company and is likely to help it record the figures every year, enabling them to study the drop or rise in the sales figures.

Importance

Following this financial modeling process step-by-step and then preparing a spreadsheet is, of course, a time consuming affair, but once the standard format is prepared, entering, organizing, and managing data becomes easier. However, there are financial modeling templates available to save one’s time. It offers an in-built format to store, and use data from.

No matter which format one uses, manual or system-built, the organized data is of great importance. Let us have a quick look at some of them below:

  • It helps give a clear picture of expenses and earnings a business has.
  • Knowing the difference helps businesses assess the real position of the business. In turn, the firms also know how the stock performance would be.
  • The figures become a ready reference for investors, who many have a look at it to decide whether making investments in the assets would be fruitful.
  • The businesses, through this spreadsheet or template information, get to know how effective the strategies implemented for business growth have been. If they are found working well, the firms continue with the same. Else, they modify the strategies for better results.
  • As the businesses learn about the expenses, they may make smart asset allocation and cost management decisions, accordingly.

Frequently Asked Questions (FAQs)

1. What is the importance of the financial modeling process? 

Financial modeling is crucial for making informed business decisions and strategic planning. It helps assess the potential impact of various scenarios on financial outcomes, aiding in budgeting, forecasting, investment analysis, and risk management. By quantifying future possibilities, financial modeling guides companies in allocating resources effectively and setting achievable goals.

2. What are the common tools used for the financial modeling process? 

Several financial modeling tools are popular, including Microsoft Excel, Google Sheets, specialized financial software like Bloomberg Terminal, and financial modeling platforms like Quantrix. These tools provide the necessary functions, formulas, and features to build and analyze complex financial models.

3. What are the skill sets required for the financial modeling process? 

Effective financial modeling demands a blend of skills. Proficiency in spreadsheet software, particularly Excel, is essential. Understanding accounting principles, financial statements, and valuation methods is crucial. Strong analytical skills, attention to detail, and the ability to interpret and present results are vital. Moreover, a good grasp of finance concepts and business acumen enhances the quality of the financial model’s outcomes.

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