Financial Modeling

Updated on April 11, 2024
Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

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.

What is Financial Modeling

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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 –

Uses of Financial Modeling

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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.

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

Three Statement LBO Financial Model Example

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.Alibaba Financial Modeling Template

Example #3

LBO Financial Model Example

Example #4

M&A Financial Modeling Example

Example #5

Sum of Parts Financial Model Example

Example #6

Comparable Comp Financial Model Example

Example #7

SaaS M&A Transaction Comps

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

Accounting Frauds

#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.

Floating Chart

 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 –

Financial Modeling

Please note the following –

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:

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.

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
Colgate Historical Balance Sheet

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 –

Reader Interactions

Comments

  1. Liztra Matadeen says

    You are too young to have so much knowledge. I wish I was smart like you are.

    Any ways, I just want to let you know how grateful I am to you for sharing all your knowledge. I refer back to your ration analysis.

    Thank you very much.
    Liz

    • Dheeraj Vaidya says

      Thanks for your kind words!

  2. Tseegii says

    thank you very much