An essential skill for anyone in finance is the creation of a financial model in Excel. It helps you project the future performance and estimate the potential of a project or investment.
Here is how you can build your first financial model step by step:
Step1: Define the objective of the model
Start by defining your purpose: Are you modelling revenues, evaluating an investment, or doing scenario analysis? This will help determine how your model should be structured and what data you might want to input. Thus, it will ensure the focus and relevance of your model.
Step2: Set up a model structure
Divide your model into easily readable sections. Most common sections include:
Inputs/Assumptions: This section includes all assumptions, which might be growth rates, expenses, or discount rates. All of these should go into a separate, color-coded section to distinguish the assumption from the calculation.
Calculations: This section performs the inputs for usually formulas to compute revenues, costs, and other key metrics.
Outputs: The last section is to present results in the form of income statements, cash flows, or key performance indicators. The model would remain clean and easier to update by keeping it with a structured organization.
Step3: Input Assumptions
Collect and input relevant assumptions driving the model. For example, if you devise a revenue model, inputs may include average price per unit, growth rate, and units sold. Fixed and variable cost can be included in expense prediction. To maintain proper formatting, assume consistent to denote in blue text wherever the variables are supposed to change but should not affect calculation.
Step4:Build the revenue and cost projections
Calculate revenues by multiplying price per unit by the number of units sold. Then project costs, separating them into fixed and variable costs, if applicable. Subtract the costs from revenue to get the gross profit, which is a good indicator of how profitable the business is. Now build the Income Statement using your revenue and cost projections. The main items usually are:
Revenue: Total revenues based on the projection
COGS: Cost of Goods Sold: Direct costs related to direct production.
Gross Profit: Revenues minus COGS
Operating Expenses: All the fixed and variable costs which are not direct and directly not tied to a product
Operating Income: Gross profit minus operating expense
Net Income: It is subtracted with tax and other expenses which will show the profit.
Step 5: Add cash flow and balance sheet projections
For a full model, include a cash flow statement and balance sheet:
Cash Flow Statement begins with net income, adjusting for non-cash items such as depreciation, working capital and capital expenditures showing cash generated from operations, investing and financing.
Balance sheet summarizes the projected cash flows and profit along with assets, liabilities, and equity of a company.
Step 6:Incorporate ratios and metrics
Performance is analyzed through the help of key performance indicators such as return on assets, debt-to-equity ratio, and profit margins. Inclusion of such metrics will immediately give an overview of the financial health of the organization and thus be useful for decision-making purposes.
Step7:Scenario Analysis and Sensitivity Analysis of the Model
Use scenario analysis to test the sensitivity of outcomes to changes in assumptions. For instance, change revenue growth rates or expense ratios to see the effects on net income. Sensitivity analysis helps you understand the most critical assumptions, to fine-tune your model.
Conclusion
Building a financial model in Excel involves assumptions, projecting financial statements, and analyzing metrics. So, with these steps in place, you ensure your model is structured, accurate, and adaptable to the realities of real-life decisions. Practice will enable your skills to improve further to deliver more robust models and insights for any business or investment decision.