Financial Modeling – A Complete Overview

Financial Modeling – One of the most frequently heard term if you’re either in Finance industry, or you aspire to be a part of it.

Let’s understand, what’s so special about this term?

I’ll take a very basic example so that you can relate it to your everyday life.

Suppose you own a grocery shop, what are the expenses that you incur? They can be cost of purchasing veggies, fruits etc. Also, the shop rent expenses, electricity bills, the store keeper’s salary etc. Note them down.

Likewise, what are the sources of revenue? In this case, revenue is sources from sale of grocery items. As simple as that. Note them down too.

Do this for past 5 years. Find out the trend in revenue growth and the factors responsible for it, after making realistic assumptions. Likewise, find out the trend in cost increase/decrease.

Now, based upon these trends (which are themselves an outcome of your assumptions) project the future expenses and revenue of the company.

This will help you draft a future Profit & Loss Account and Balance sheet of a Company.

What is Financial Modeling?

Financial Modeling is an activity of preparing any company/ entity’s future financials (Statement of Profit & Loss, Balance Sheet, Cash Flow Statements, Schedules, Valuation etc.) through estimation of numbers in MS Excel (Or any other calculation tool). 

Financial Modelling is a number game and is usually prepared through linking various tabs in MS Excel. It is important to separate assumptions (inputs) from the entire model which are used for projection of financials (output). Various models can produce different results based on the inputs and assumptions that go into it.

These future financials are known as financial models. To view a basic financial Model, click the button below.

Types of Financial Models

There are various types of financial models which exist in today’s world. All these are made for different purposes. Some of the major types of financial Models are –

• Three Statement Model
• Merger Model
• DCF (Discounted Cash Flow Model) Model, Sum of Parts Model
• LBO (Leveraged Buyout Model) Model
• Initial Public Offering (IPO) Model
• Consolidation Model
• Comparable Company Analysis

These models are generally prepared by Financial Analysts and their base salary ranges anywhere between $85,000 to $1,00,000 at an entry level. The demand of Financial Analysts is also rising with the increase in company’s preference on financial models for better management decisions. 

It is in Financial Analyst’s hands to control the numbers or the structuring of the model. He can increase or decrease the Profit or Loss in the model by changing the underlying assumptions.

Why Financial Modelling is Important?

The main question is, Why does Financial Modeling even matter to businesses?

Importance of Financial Modelling lies in its usage for various purposes by several growing companies.

Companies prepare a financial model to get private equity funding from investors. They prepare the Financial models to predict the future value of a company, based on which the investor will infuse money and decide the share.

Even investors can prepare the same model. However, they will try to lower down the valuation, by taking different assumptions from those taken by the company.

Let’s see a near exhaustive list of uses of Financial Models

What are the uses of preparing Financial Models?

• Understanding “Future Operational Performance” of an entity (e.g; number of employees required to hire, number of branches to open, number of quantities to be sold etc.)
• Understanding “Future Financial Performance” of an entity (e.g; estimation of revenue required to earn, profit margins to generate, costs to spend in future)
• Estimating the capital expenditure to be incurred in future (e.g; estimation of amount of machinery, furniture and building required)
• Estimating funds required to fulfill future obligations (e.g; working capital financing, long term or short term financing by way of Private Equity, Public Equity or Debt funding)
• Calculating cash flows/ free cash flows generated at the end of a given period (e.g; cash flow for operating, investing & financing activities, free cash flows to the firm and free cash flows to equity)
• Calculating Enterprise Value or Equity Value of a Company (Including Intrinsic Value)
• Analyzing certain ratios (e.g; profitability ratios, liquidity ratios etc.) 
• Depicting the trend of a business and relating it with the Industry’s performance (whether a business is depicting an upward growth trend, static growth trend, downward growth trend, no growth trend, negative growth trend)
• Performing study on multiple scenarios or sensitivity analysis 
• Other advanced uses (e.g; calculating price of a security, merged financial predictions of two entities, comparable analysis, comparable ratio analysis, comparable valuation analysis, ascertaining exit strategy and Investor’s return during exit etc.)  

Who Prepares Financial Models?

Financial Modelling is widely acceptable and is getting a lot of attraction these days, especially by growing companies, Private Equity Funds, Hedge Funds, Investment Banking Companies, Brokerage Firms, Credit Rating Agencies, Equity or Investment Research Companies, Management or Corporate Consultancy firms etc. 

Let’s see Why do they prepare it –

• Corporates – for Internal Management Decisions based upon Future Business Performance as predicted in Financial Models.
• Investment Banking Firms – on the behalf of both their clients and their investors for Company’s Valuation.
• Equity Research Firms – for publishing the reports on public sources to recommend buying or selling of any security.
• Management Consultancy, Portfolio Management Firms – for advising their clients on various growth prospects. 
• Private Equity Funds, Hedge Funds, Venture Capital Funds – for the calculation of their investment exit return.
• Transaction Advisory Firms – for their clients to advice them on any transaction such as a merger or an acquisition.
• Commercial Banks / Non Banking Finance Companies / MFIs – for estimating the performance of their lending portfolio.
• Financial Due Diligence firms – for judging the accuracy of the valuation and financial models prepared by any other party.
• Accounting or Chartered Accountancy Firms – for Financial Planning and Budgetingtheir own expenses and revenue.
• Research and Outsourcing Companies – to outsource project for their clients; client can be a corporate, or an Investor

What are the Best ways to learn Financial Modeling?

DIY, Do it Yourself

The best but lengthy way to learn Financial Modelling is to learn it yourself as nothing is better than self-learning. If you’re extremely good with numbers and have analytical mindset then it is suggested that you should learn preparing models on your own by giving enough time for studying various concepts.

You can choose any sector and pick any listed company in the selected sector and start from industry study, past financials of the company, ratio analysis, management growth strategy and then go on to future projections through assumptions and other schedules. Last step is to dive into valuation part, sensitivity analysis, ratios and graphs depiction.

Take up an online Financial Modeling Course

The much faster way to learn Financial Modeling is to buy any online Financial Modelling and practice. These Modelling Courses will help you in the structuring, fundamentals, linking and formula building of a model. 

Be wise to choose a preferred Financial Modelling course and read the course contents before choosing to buy any online course.

Join an Investment Banking (IB) firm at an entry level

The next way to learn Financial Modelling is to join any IB, Equity Research, Consulting or other companies at an entry stage either as an Intern or as a Junior Analyst. 

You will be working on the real world scenarios and live transactions which will require you to build complex models. Your job pressure and superior support will also help you to learn models much faster than required.

Frequently asked questions (FAQs) –