Financial Modeling

What is Financial Modeling?

Financial modeling is the process of estimating a project or business’s financial performance by considering all relevant factors, growth and risk assumptions clearly understand the impact. It enables the user to clearly understand all the variables involved in financial forecasting. It is also important to remember that the results’ accuracy heavily relies on the assumptions and inputs.

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Financial modeling and analysis play a crucial role in decision-making for businesses and investors. It provides a structured framework to forecast financial performance, assess investment opportunities, and evaluate risk. Scenario analysis aids in making informed choices, optimizing resource allocation, and maximizing profitability, contributing significantly to informed financial planning and strategic decision-making in various industries.

Financial Modeling Explained

Financial Modeling is either building a model from scratch or maintaining the existing Model by implementing newly available data to it. As you can notice, all the above financial situations are of a complex and volatile nature. It helps the user to gain an in-depth understanding of all the components of the complex scenario.

In Investment Banking, it is used to forecast the potential future financial performance of a company by making relevant assumptions of how the firm or a specific project is expected to perform in the forthcoming years, for instance, how much cash flow a project is likely to produce within five years from its initiation.

It is easily possible to work on different individual parts of the Model without affecting the whole structure and avoiding huge blunders. It is useful when the inputs are volatile and are subject to change with newly available data. Therefore, there is a certain flexibility one can have with the structure when working on Financial Modeling as long as they are accurate.

Though financial modelling and analysis sounds complicated, it can be learned by steady practice and the appropriate know-how.

It can be done for various situations, e.g. valuation of a company, valuation of an asset, pricing strategies, restructuring situations (merger & acquisition), etc.

Below are the areas in which Financial Modeling is generally used for –

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Best Financial Modeling Courses by Wallstreetmojo

Who builds Them?

Let us understand who is bestowed the responsibility of building these models through traditional means or through financial modelling softwares through the explanation below.

• Investment BankersInvestment BankersInvestment banking is a specialized banking stream that facilitates the business entities, government and other organizations in generating capital through debts and equity, reorganization, mergers and acquisition, etc.read more
• Equity Research Analysts
• Credit Analysts
• Risk Analysts
• Data Analysts
• Portfolio ManagersPortfolio ManagersA portfolio manager is a financial market expert who strategically designs investment portfolios.read more
• Investors
• Management/Entrepreneurs

Majorly modeling is used for determining reasonable forecasts, prices for markets/products, asset or enterprise valuationEnterprise ValuationEnterprise value (EV) is the corporate valuation of a company, determined by using market capitalization and total debt.read more (Discounted Cash Flow AnalysisDiscounted Cash Flow AnalysisDiscounted cash flow analysis is a method of analyzing the present value of a company, investment, or cash flow by adjusting future cash flows to the time value of money. This analysis assesses the present fair value of assets, projects, or companies by taking into account many factors such as inflation, risk, and cost of capital, as well as analyzing the company's future performance.read more, Relative Valuation), the share price of companies, synergies, effects of merger/acquisition on the companies, LBOLBOLBO (Leveraged Buyout) analysis helps in determining the maximum value that a financial buyer could pay for the target company and the amount of debt that needs to be raised along with financial considerations like the present and future free cash flows of the target company, equity investors required hurdle rates and interest rates, financing structure and banking agreements that lenders require.read more, corporate finance models, option pricingOption PricingOption pricing refers to the process of determining the theoretical value of an options contract. read more, etc.

How can you learn Financial Modeling?

1. Free Financial Modeling in Excel (Basic) – This is a step by step tutorial. Here you will learn to prepare a model of Colgate.

Examples

Various financial modeling examplesFinancial Modeling ExamplesExamples of financial modeling include three statement modeling, DCF, merger, IPO, LBO and option pricing.read more are different in type and complexity as the situation demands. They are widely used for valuation, 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, and comparative analysis. There are other uses, like risk prediction, pricing strategy, effects of synergies, etc. Different examples cater to their own set of specialties, requirements, and users.

Following are some of the examples that are widely used in the Finance Industry:

Example #1

• This type of financial ModelType Of Financial ModelFinancial models are used to represent the forecast of a company’s financials based on its historical performance and future expectations to use for financial analysis. The most common financial models include the Discounted Cash Flow model (DCF), Leveraged Buyout model (LBO), the Comparable Company Analysis model, and Mergers & Acquisition model.read more represents the complete economic scenario of a company and projections. This is the most standard and in-depth form.
• As the name suggests, the Model is a structure of all the three financial statements (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 Statement) of a company interlinked together.
• There are also schedules supporting the data. (Depreciation schedule, debt schedule, working capital calculation schedule, etc.).
• The interconnectivity of this Model sets it apart, which allows the user to tweak the inputs wherever and whenever required, which then immediately reflects the changes in the entire Model.
• This feature helps us to get a thorough understanding of all the components in a model and its effects thereof.
• The actual uses of this Model are forecasting and understanding trends with the given set of inputs.
• Historically the Model can stretch back as long as the conception of the company and forecasts can try up to 2-3 years depending requirement.

Example #2

Through this financial Model, you will learn Alibaba’s 3 statement forecasts, interlinkages, DCF Model – FCFF FormulaFCFF FormulaFCFF (Free cash flow to firm), or unleveled cash flow, is the cash remaining after depreciation, taxes, and other investment costs are paid from the revenue. It represents the amount of cash flow available to all the funding holders – debt holders, stockholders, preferred stockholders or bondholders.read more, and Relative Valuation.

• The most widely used method of valuation in the finance industry is the Discounted Cash Flow analysis method, which uses the concept of Time Value of MoneyTime Value Of MoneyThe Time Value of Money (TVM) principle states that money received in the present is of higher worth than money received in the future because money received now can be invested and used to generate cash flows to the enterprise in the future in the form of interest or from future investment appreciation and reinvestment.read more.
• The concept working behind this method says that the value of the company is the net present valueNet Present ValueNet Present Value (NPV) estimates the profitability of a project and is the difference between the present value of cash inflows and the present value of cash outflows over the project’s time period. If the difference is positive, the project is profitable; otherwise, it is not.read more (NPV) of the sum of the future cash flows generated by the company discounted back today.
• The discounting factor does the discounting of the projected future cash flows. One rather important mechanic in this method is deriving the ‘discounting factor.’ Even the slightest error in calculating the discounting factorDiscounting FactorDiscount Factor is a weighing factor most often used to find the present value of future cash flows, i.e., to calculate the Net Present Value (NPV). It is determined by, 1 / {1 * (1 + Discount Rate) Period Number}read more can lead to enormous amounts of change in the results obtained.
• Usually, the + [Cost of Debt * % of Debt * (1-Tax Rate)]” url=”https://www.wallstreetmojo.com/weighted-average-cost-capital-wacc/”]Weighted Average Cost of Capital”Weighted”The (WACC) of a company is used as the discounting factor to discount the future cash flows.
• DCF helps to identify whether a company’s stock is overvalued or undervalued. This proves to be a rather important decision making factor in case of investment scenarios.
• In simplicity, it helps to determine the attractiveness of an investment opportunity. If the NPV of the sum of future cash flows is more significant than its current value, then the option is profitable, or else it is an unprofitable deal.
• The reliability of a DCF model is vital as it is calculated on the base of Free Cash Flow, thus eliminating all the factors of expenses and only focusing on the freely available cash to the company.
• As DCF involves the projection of future cash flows, it is usually suited for working on financials of big organizations, where the growth rates and financials have a steady trend.

Example #3

• In a leveraged buyoutLeveraged BuyoutLBO (Leveraged Buyout) analysis helps in determining the maximum value that a financial buyer could pay for the target company and the amount of debt that needs to be raised along with financial considerations like the present and future free cash flows of the target company, equity investors required hurdle rates and interest rates, financing structure and banking agreements that lenders require.read more deal, a company acquires other companies by using borrowed money (debt) to meet the acquisition costs. The cash flows from the assets and operations of the acquired company are used to pay off the debt and its charges.
• Hence, LBO is termed as a very hostile/aggressive way of acquisition as the target company is not taken under the sanctioning process of the deal.
• Usually, cash-rich Private Equity firmsPrivate Equity FirmsPrivate equity firms are investment managers who invest in many corporations' private equities using various strategies such as leveraged buyouts, growth capital, and venture capital. The top private equity firms include Apollo Global Management LLC, Blackstone Group LP, Carlyle Group, and KKR & Company LP.read more are seen to be engaged in LBOs. They acquire the company with a combination of Debt & Equity (where a majority is of debt, almost above 75%) and sell off after gaining substantial profit after a few years (3-5 years).

• So the purpose of an LBO model is to determine the amount of profit that can be generated from such a deal.
• As there are multiple ways debt can be raised, each having specific interest payments, these models have higher levels of complexity.
• The following are steps that go into making an LBO model;
  • Calculation of purchase price based on forward trading multipleTrading MultipleWhen a company is being valued, sometimes all the values essential for a discounted cash flow valuation is not available, and hence it is imperative for the analyst to take a comparative company, find out the multiple of financial values and use them in our analysis to find the proper metric are called trading multiples.read more on EBITDA
  • Weightage of debt and equity funding for the acquisition
  • Building a projected income statement and calculate EBITDA
  • Calculation of cumulative FCF during the total tenure of LBO
  • Calculating Ending exit values and Returns through IRRReturns Through IRRInternal rate of return (IRR) is the discount rate that sets the net present value of all future cash flow from a project to zero. It compares and selects the best project, wherein a project with an IRR over and above the minimum acceptable return (hurdle rate) is selected.read more.

Example #4

• The M&A model helps to figure out the effect of merger or acquisition on the earnings per shareEarnings Per ShareEarnings Per Share (EPS) is a key financial metric that investors use to assess a company's performance and profitability before investing. It is calculated by dividing total earnings or total net income by the total number of outstanding shares. The higher the earnings per share (EPS), the more profitable the company is.read more of the newly formed company after the completion of the restructuring and how it compares with the current EPS.
• If the EPS increases altogether, then the transaction is said to be “accretive,” and if the EPS decreases than the current EPS, the transaction is said to be “dilutive.”
• The complexity of the model varies with the type and size of operations of the companies in question.
• Investment Banking, corporate financing companies generally use these models.
• The following are steps that go into making an M&A model;
  • Valuing Target & Acquirer as standalone firms
  • Valuing Target & Acquirer with synergies
  • Working out an Initial offer for the target firm
  • Determining combined firms ability to finance transaction
  • Adjust cash/debt according to the ability to finance the transaction
  • Calculating EPS by combining Net income and figuring out an accretive/dilutive situation.

Example #5

• Valuing of huge conglomeratesConglomeratesA conglomerate in business terminology is a company that owns a group of subsidiaries conducting business separately, often in distinct industries. It reflects diversification of operations, product line and market to allow business expansion.read more becomes challenging to value the company as a whole with one single valuation method.
• So, valuation for the different segments is carried out separately by suitable valuation methodsValuation MethodsDiscounted cash flow, comparable company analysis, comparable transaction comps, asset valuation, and sum of parts are the five methods for valuing a company.read more for each element.
• Once all the segments are valued separately, the sum of valuations is added together to get the valuation of the conglomerate as a whole.
• Hence, it is called the “Sum-of-the-partsSum-of-the-partsSum of the Parts Valuation is a valuation method wherein each of the subsidiary or segment of a Company is separately valued & then all of them are added together to estimate the business’s total value. read more” valuation method.
• Usually, SOTP is suitable in the case of a spin-off, mergers, Equity carve-outsCarve-outsCarve-out refers to the business strategy where a parent company decides to partially divest one of its business units by selling minority interests of the subsidiary to an outside investor or a group of investors.read more, etc.

Example #6

• Analysts, while working on a comparative valuation analysisComparative Valuation AnalysisComparable comps are nothing but identifying relative valuations like an expert to find the firm's fair value. The comparable comp process starts with identifying the comparable companies, then selecting the right valuation tools, and finally preparing a table that can provide easy inferences about the fair valuation of the industry and the company.read more of a company looking for other similar companies that are equal in terms of size, operations, and peer group companies.
• By looking at the numbers of its peers, we get a ballpark figureBallpark FigureA ballpark figure is a rough estimate given to understand the value of something, which can help make important decisions. It is considered a logical measurement that accounts for a margin of error.read more for the valuation of the company.
• It works on the assumption that similar companies will have comparable EV/EBITDAEV/EBITDAEV to EBITDA is the ratio between enterprise value and earnings before interest, taxes, depreciation, and amortization that helps the investor in the valuation of the company at a very subtle level by allowing the investor to compare a specific company to the peer company in the industry as a whole, or other comparative industries.read more and other valuation multiples.
• It is the most basic form of valuation done by analysts in their firms.

Example #7

The transaction multiplesTransaction MultiplesTransaction multiples or Acquisition Multiple is a method where we look at the past Merger & Acquisition transactions and value a comparable company using precedents. The method assumes that a company's value can be estimated by analyzing the price paid by the acquirer company's incomparable acquisitions.read more Model is a method where we look at the past Merger & Acquisition (M&A) transactions and value a comparable company using precedents. The steps involved are as follows –

• Step 1 – Identify the Transaction
• Step 2 – Identify the right transaction multiples
• Step 3 – Calculate the Transaction Multiple Valuation

Prerequisites

Building these models using a Financial model software will only be fruitful when it is giving out results that are accurate and dependable. To achieve efficiency in preparing a model, one should have a required set of necessary skills. Let’s see what those skills are:

#1 – Understanding of Accounting Concepts

Building it is a pure financial document that uses financial numbers from a company or market. There are specific accounting rulesAccounting RulesAccounting rules are guidelines to follow for registering daily transactions in the entity book through the double-entry system. Here, every transaction must have at least 2 accounts (same amount), with one being debited & the other being credited. read more and concepts that are constant in the financial industry worldwide, e.g., US GAAP, IFRS (International Financial Reporting Standards), etc. These rules help in maintaining the consistency of the presentation of financial facts and events. Understanding these rules and concepts are of extreme importance to maintain accuracy and quality while preparing to build a model in excel.

Our primary focus in Accounting is also to identify and predict the accounting malpractices by companies. These are typically hidden away. You can see the confessions in Satyam Fraud Case

#2 – Excel Skills

The primary financial Modeling in excel where is where a model is prepared is an application like MS Excel.  It involves a wide range of complex calculations spread over multiple tabs interlinked to show their relationships with each other. Having an in-depth working knowledge of excel like formulas, keyboard shortcutsKeyboard ShortcutsAn Excel shortcut is a technique of performing a manual task in a quicker way.read more, presentation varieties, VBA Macros, etc. are a must while preparing a model. Keeping knowledge of these skills gives the analyst an edge in his working skills over others.

#3 – Interlinking of Financial Model Statements

A 3 statement financial modeling3 Statement Financial ModelingA 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 needs to be interlinked together. The interlinking allows vital numbers in the Model to flow from one statement to the other, thus completing the inter-relationship between them and showing us the complete picture of the financial situation of the company. Example of interlinking: 1) Net change in cash (from Cash Flow StatementCash (from Cash 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) must be linked to Cash in Balance Sheet. 2) Net Income from Income statement should be linked to Retained EarningsRetained EarningsRetained Earnings are defined as the cumulative earnings earned by the company till the date after adjusting for the distribution of the dividend or the other distributions to the investors of the company. It is shown as the part of owner’s equity in the liability side of the balance sheet of the company.read more in Statement of Stock Holder’s Equity.

#4 – Forecast

The skill of forecasting financial Modeling is important because usually, the purpose of it is to arrive at an understanding of the future scenario of any financial situation. Forecasting is both an art and a science. Using reasonable assumptions while predicting the numbers will give an analyst a close enough idea of how attractive the investment or company will be in the coming period. Good forecasting skills increase the dependability of a model.

#5 – Presentation

Financial Modeling is full of minute details, numbers, and complex formulas. Different groups use it like operational managers, management, and clients. These people will not decipher any meaning from the Model if the Model is looking messy and hard to understand. Hence, keeping the Model simple in presentation and at the same time rich in detail is of great importance.

 How do you build a Financial Model?

Financial Modeling and analysis are easy, as well as complicated. If you look at the Model, you will find it involved; however, it has smaller and simple modules. The key here is to prepare smaller modules and interconnect each other to train the final financial model.

You can refer to this step-by-step guide on Financial Modeling in Excel for detailed learning.

You can see below various Schedules / Modules –

Please note the following –

• The core modules are the Income Statement, Balance Sheet, and Cash Flows.
• The additional modules are the depreciation schedule, working capital schedule, intangibles schedule, shareholder’s equity schedule, other long-term items schedule, debt scheduleDebt ScheduleA debt schedule is the list of debts that the business owes, including term loans, debentures, cash credit, etc. Business organizations prepare this schedule to know the exact amount of the company's liability to others and manage its cash flows to prevent the financial crisis and enable better debt management.read more, etc.
• The different schedules are linked to the core statements upon their completion.

Full-Scale Modeling is a lengthy and complicated process and hence disastrous to go wrong. It is advisable to follow a planned path while working on a financial model to maintain accuracy and avoid getting confused and lost. Following are the logical steps to follow:

• A quick review of Company Financial Statements: A short review of the company financial statements (10K, 10Q, Annual reports, etc.) will give the analyst an overview of the company, as in, the industry of the company, segments, history of the company, revenue drivers, capital structure, etc. This helps plan the layout of financial Modeling by setting a guide path, which can be referred to from time to time as we progress.
•  Historical Numbers: Once a fair idea is generated about the company and the types of financial models to be prepared, it is advisable to start with inputting Historical data. Past Financial Statements of the companyFinancial Statements Of The CompanyFinancial 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 can be found on the company website. Data from as long as the conception of the company is available. Usually, the past three years data is added to the historical side, called actual numbers. Color code the cells so that historical and formulas can be quickly identified separately.
• Ratios and Growth rates: Once the historical numbers are added, the analyst can calculate the required Financial ratios (Gross Profit RatioGross Profit RatioThe gross profit ratio evaluates the proportion of the direct profit a company generates from its net sales. Here, the gross profit is the returns acquired after considering the cost of goods sold, trade discounts and sales returns for deduction from the total revenue.read more, Net Profit Ratio, etc.) and growth rates (YoY, QoQ, etc.). These ratios help in identifying a trend for high level strategizing and also forecasting.
• Forecasting: The next step after historical and ratios is implementing projections and forecasting. It is usually done for 3 to 5 years. Line items like Revenue are generally projected on Growth rates. Whereas cost items likeCOGSCOGSThe Cost of Goods Sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company. read more, R&D, Selling General & Admin exp. Etc. are projected on the base of revenue margin (% of sales). The analyst should be careful while making the assumptions and should consider the trends of the market.
• Interlinking of Statements: For the Model to reflect the flow from one statement to another, they must be linked together dynamically and accurately. If done correctly, the Model should balance out all the words, thus giving it a finalized outlook.

Tips for creating a seamless Model

While we have discussed the structures, types, and examples of financial modeling softwares, let us have a sneak peek into the ways to build a fool-proof model through the discussion below.

• Planning & Outlining: Before you rush into putting the historical numbers and start with your Model, always plan the whole project outline. Decide a timeline, the extent of the years of historical numbers, projection years, read about the industry and the company. Do an in-depth run of the recent Annual reportAnnual ReportAn annual report is a document that a corporation publishes for its internal and external stakeholders to describe the company's performance, financial information, and disclosures related to its operations. Over time, these reports have become legal and regulatory requirements.read more or the situation at hand. This helps in giving you a steady head start.
• Quality: As you proceed through the complex process of financial modelingProcess Of Financial ModelingCreating financial modeling 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.read more, do not forget about maintaining the quality of the same. At the start, it may look like an easy task, but once the Model gets chunky and complicated, it becomes difficult for an analyst to maintain their nerves about it. Be patient and work with confidence. Take breaks if required. There is a saying that “Trash in-Trash out.” It means if you are putting the wrong data, you will get the incorrect results.
• Presentation: The amount of effort you are putting in for financial Modeling will only be fruitful when used and understood by others easily. Color coding, font size, sectioning, names of line items, etc. are all included under the presentation. These may sound very basic, but the combined effects of all these make an enormous difference in the lookout of the Model.
• Assumptions: What we project in financial Modeling is only as good as the assumptions we are basing it on. If the premises are awry and lacking a good base, the projections will be useless considering the inaccuracy. Setting assumptions should have realistic thinking and reasonability in it. It should go with the industry standards and general market scenario. They shouldn’t be too pessimistic or too optimistic.
• Accuracy Checks: As the Model flows longer and longer, with multiple sections and parts, it becomes difficult for the analyst to check on the accuracy of the whole. So, it is essential to add Accuracy Checks wherever necessary and possible. It helps in keeping the modeling process under constant quality checks and avoids huge blunders at the end.

Financial Modeling Best Practices

• Flexibility: It should be flexible in its scope and adaptable in every situation (as contingency is a natural part of any business or industry). The flexibility of a financial model depends on how easy it is to modify the Model whenever and wherever it would be necessary.
• Appropriate: It shouldn’t be cluttered with excessive details. While producing a financial model, you should understand what a financial Model is, i.e., a good representation of reality.
• Structure: The logical integrity is of utter importance. As the author of the Model may change, the system should be rigorous, and integrity should be kept at the forefront.
• Transparent: It should be such and based on such formulas that can be easily understood by other financial modelers and non-modelers.

COLGATE BALANCE SHEET HISTORICAL DATA

Also, note the color standards popularly used in Financial Modeling  –

• Blue – Use this color for any constant that is used in the Model.
• Black – Use Black color for any formulas
• Green – Green color is used for any cross-references from different sheets.

Recommended Articles

This has been a guide to what is Financial Modeling. Here we discuss how to build a financial model along with examples (DCF, LBO, M&A, SOTP, Comps, Transaction Model), its uses, prerequisites, tips, and best practices. You can learn more about Financial Modeling from the following –

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