An Introduction to Financial Modeling: Definition, Tips, and Illustrations

If you have ever used a basic Excel formula to evaluate the impact of modifying a variable on your income, then you have essentially created a rudimentary financial model. Financial models, often constructed using spreadsheets, are essentially intricate calculators that make predictions about probable results based on financial forecasts. A range of business evaluations, including valuations and credit risk analyses, are reliant on financial models.

Video: What is Financial Modeling?

What Is Financial Modeling?

Financial modeling is a technique utilized to determine probable financial outcomes based on a company’s past performance and presumptions regarding future revenue, expenditures, and other variables. To forecast financial outcomes, financial modeling relies on financial projections. It employs a company’s financial statements to illustrate how those statements may appear in the future by extrapolating the forecast’s assumptions. Financial models usually generate results for a month, quarter, or year since they are built using financial statements.

Most financial models are generated in Excel spreadsheets and necessitate manual data entry. The most straightforward form of financial modeling, the three-statement model, merely requires an income statement, balance sheet, cash flow statement, and supporting schedules. However, the use cases for models differ widely, resulting in more sophisticated models. Firms often customize models to suit their specific needs.

There is software that enables users to optimize their forecasting estimates using a rigorous, pre-built statistical modeling engine. Predictive modeling can gather historical data, match it to industry-standard statistical models, and produce a dashboard that forecasts future financial results with just a few clicks. This enables users to apply anticipated values directly into their plan or forecast. This software can be integrated with spreadsheet tools like Excel to enable users to manipulate data as they see fit. It can also operate on its own, processing historical data through pre-built models to produce financial predictions without user input.

What Is a Financial Model Used for?

Financial models have a broad range of applications, including:

  1. Valuations and capital raising – Financial models are frequently used to determine the worth of a company when seeking funding from investors or raising capital through public offerings.
  2. Budgeting and forecasting – Budget and forecasting models enable finance teams to evaluate the performance of various components within a company. By consolidating individual budgets from various departments and business units, finance teams can create an overall financial model that can be used to allocate resources and predict financial outcomes for the forthcoming year.
  3. Assessing the impact of management decisions – Financial models can be used to predict how changes in various factors, such as a price increase on a popular product, could affect a company’s revenue.
  4. Credit analysis – Financial models are used by investors to assess the creditworthiness of a company and its ability to repay its debts when considering lending funds.

Why Are Financial Models Important?

Financial models play a crucial role in helping companies to understand their current financial position, past performance, and future prospects. They enable businesses to compute performance metrics, such as profitability and cash flow, and project likely outcomes based on different scenarios.

In addition, financial models can provide valuable insights into the level of risk associated with specific business decisions, allowing companies to make informed choices about how to allocate resources and pursue growth opportunities.

Financial models are also useful for generating accurate financial statements that reflect the financial health and operational activities of a company. This information is essential for attracting investors, securing loans, and calculating insurance needs.

Overall, financial models are an invaluable tool for businesses of all sizes and industries, providing insights that can be used to drive strategic decision-making and achieve long-term success.

Who Uses Financial Models?

Financial models can be used by anyone who is interested in understanding the financial performance and future prospects of a company. While there are courses available for learning how to develop financial models, professionals in various fields, such as business development, accounting, financial planning and analysis (FP&A), equity research, private equity, and investment banking, often use financial models as part of their regular job responsibilities.

These professionals may use different types of financial models depending on the specific needs and focus of their business. For example, an equity research analyst may use a model to evaluate the fair value of a company’s stock, while a private equity analyst may use a model to assess the potential return on investment for a particular project. Regardless of the specific application, financial models are a versatile tool used by many different professionals in the finance industry.

Who Uses Financial Models?

Financial models can be used by anyone who is interested in understanding the financial performance and future prospects of a company. While there are courses available for learning how to develop financial models, professionals in various fields, such as business development, accounting, financial planning and analysis (FP&A), equity research, private equity, and investment banking, often use financial models as part of their regular job responsibilities.

These professionals may use different types of financial models depending on the specific needs and focus of their business. For example, an equity research analyst may use a model to evaluate the fair value of a company’s stock, while a private equity analyst may use a model to assess the potential return on investment for a particular project. Regardless of the specific application, financial models are a versatile tool used by many different professionals in the finance industry.

Examples of Financial Models

Financial models come in various forms and serve different purposes. The most basic type is the three-statement model, which projects a company’s financial statements into the future and enables users to test different assumptions. It provides a comprehensive view of the company’s past, present, and future. For instance, it can answer questions such as what will happen if the company sells more units or reduces labor costs by a certain percentage.

Another common type of financial model is the discounted cash flow model, which is often used to evaluate the value of a company, a specific project, or investment. This model provides an estimate of the current value of the company and predicts its future performance. Financial professionals, including business analysts, accountants, financial planners, equity researchers, private equity firms, and investment bankers, frequently use these models depending on the nature of their work.

Important Points to Remember

  • Financial models should be clear and appropriate for their intended use.
  • With fundamental accounting knowledge and proficiency in Excel, one can construct a basic financial model.
  • Financial models differ in design and function, but adhering to industry standards on formatting and color-coding is crucial.
  • It is crucial to thoroughly verify the assumptions and formulas used in a financial model, as its accuracy relies on them.
  • Avoid embedding assumptions in formulas, and refrain from duplicating dates within the same worksheet. If assumptions change, all outputs on the sheet should automatically update.

Examples of Financial Modeling in Practice

Let’s consider a scenario where a bakery is acquiring a candy company. In order to add the valuation of both companies and present a new valuation of the combined entity, the bakery could use a complex financial model for mergers and acquisitions.

Another example could be when a company is seeking investments from investors. In this case, the company might prepare financial models that demonstrate the potential growth investors could expect to see based on the projected sales or improvements in overhead due to economies of scale.

Similarly, when a print shop seeks to construct a new store with financing from a loan, the bank will use financial models to determine the creditworthiness of the company and the likelihood of success for the new location.

Financial Modeling Best Practices

Despite the various types and customization of financial models, there are some general best practices that are followed in the industry. Good financial models should be clear, accurate, tailored to the intended purpose, and flexible enough to handle complex tasks. Here are some best practices to follow:

  1. Understand the problem, the users of the model, and the overall goal of the model.
  2. Whenever possible, create the entire financial model on a single worksheet to reduce the risk of errors.
  3. Organize your model into logical sections, such as assumptions, balance sheet, and income statement, depending on the type of financial model you are using.
  4. Use standard color-coding conventions, such as blue for assumptions, black for formulas, green for links to other worksheets, and red for links to other files.
  5. Keep consistent number formats throughout the model, such as using parentheses for negative dollar values and choosing a uniform number format for financial values.
  6. Avoid embedding assumptions in formulas to ensure that every value has a cell to itself and appears only once in the sheet.
  7. Keep formulas simple and break complex calculations into multiple formulas to improve readability.
  8. Double-check your numbers and formulas for accuracy.
  9. Test your model with various scenarios to identify potential flaws and refine or adjust it accordingly.

12 Steps to Building a Financial Model

These are the 12 steps to follow when building a basic financial model in Excel. This will help you develop your Excel skills and learn about formula logic and conventions required for more complex models. You can also experiment with different assumptions and see how they impact the output. Here are the steps:

  1. Open a new spreadsheet and label the first row as “Assumptions”. Label columns B, C, and D with three future fiscal years. This is where you will make predictions about your company’s performance for various metrics in the upcoming years.
  2. Label the rows with revenue, units, price, cost of goods sold (COGS), and operating expenses such as marketing, labor, or any other expense categories relevant to your business.
  3. Fill in the assumptions with values based on financial forecasts and your current financial statements. Use a blue font to distinguish the assumptions from other values. Also, format any dollar figures with the accounting number format by right-clicking the cells, going to “format cells,” and selecting “accounting” in the “numbers” tab.

At this point, your worksheet should resemble something like this:

  1. Improve the readability of your worksheet by freezing the panes. To do this, select cell B4 or its equivalent in your worksheet, go to the “View” tab in the taskbar, and click “Freeze Panes.” This will keep your labels visible as you scroll through the sheet. You will notice an improvement in readability as we proceed to the next steps.
  2. Move down a few rows to start calculating projections for your income statement, starting with net revenue. Use black font for these values. To calculate net revenue, multiply units by price using a formula (=B6*B7 in the sample above). Copy and paste the formula to the next two cells to the right. Excel should automatically apply the formula correctly for the year you’re working on, but double-click on the cell to verify the formula. Check that the column letter matches that of the cell. Format your numbers to “accounting.”
  3. Calculate COGS by multiplying units by unit costs (=B6*B10 in our example). Copy and paste the formula to the next two cells to the right, verifying that it’s applied appropriately for each column. Format your numbers to “accounting.” Your worksheet should now look similar to this:
  1. Within the income statement section, determine gross profit by subtracting COGS from net revenue (=B18-B20 in the given example). Replicate and paste the formula to the next two cells to the right, ensuring that the formulas and the number formatting match the appropriate column and “accounting.”

At this stage, our model would appear like this:

  1. To view margins, divide the gross profit by revenue using the formula =B22/B18. You can then change the number format to percentage by selecting the cells, right-clicking, choosing “Format Cells,” selecting the “Percentage” category, and choosing the appropriate decimal places.

The resulting format should look like this:

  1. Continuing with the income statement, let’s calculate the operating expenses. In our sample, we assumed labor and marketing costs, and we’ll include these expenses in the income statement. It’s important to avoid duplicating data, so we’ll use formulas to link the numbers from the assumptions to the income statement. For instance, to calculate labor costs for 2020, we’ll enter the formula =B13, since we obtained that value from the assumptions section. If we modify the assumption values later, the income statement will automatically update. Repeat this step for the remaining five cells in the operating expenses section, and don’t forget to check the number formatting.

Remember to refer to our assumptions section for the operating expenses figures:

  1. Calculating the total operating expenses by adding up all the costs in this section. If you have more than two items, use the sum formula to add them up. For our sample, we can simply add labor and marketing together. Be sure to check the number formatting to ensure consistency.
  1. Now it’s time to calculate the operating income. In this step, you’ll subtract the operating expenses from the gross profit. To do this, enter the formula “=B22-B28” in the cell to the right of the “Operating Income” label, and then copy and paste it to the other two cells to the right. Double-check the formula and the number formatting.
  2. To calculate the operating income margins, you’ll divide the operating income by the revenue. Enter the formula “=B30/B18” in the cell to the right of the “Operating Income Margins” label, and then copy and paste it to the other two cells to the right. Check the formula and change the number format to “Percentage.”

Congratulations! You have successfully created a basic yet effective financial model using the best practices mentioned. By changing the assumptions, you can now easily see how it affects the gross and operating margins. This is just one of the many models available to help you set targets and make informed decisions for your business.

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An Introduction to Financial Modeling: Definition, Tips, and Illustrations
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An Introduction to Financial Modeling: Definition, Tips, and Illustrations
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If you have ever used a basic Excel formula to evaluate the impact of modifying a variable on your income, then you have essentially created a rudimentary financial model.
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ABJ Cloud Solutions
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