Building an Excel financial model is such a valuable skill that any financial person, investor, or entrepreneur can leverage.
Financial models let you make forecasts about how a company will perform in the financial arena; evaluate different business scenarios; and take proper decisions that will eventually repay in the long run.
This is a step-by-step guide on a very simple financial model from scratch, covering all the required components, assumptions, and techniques in Excel to help you get started.
Step 1: Define the Purpose of Your Model
Understand why you are building this financial model for, before you start in Excel. Some common uses of financial models include:
Valuation: Calculation of a company’s value.
Budgeting and Forecasting: Estimation of future revenue, expenses, and cash flow.
Scenario Analysis: Analysis of how different scenarios affect a company’s performance.
Knowing the purpose will help you decide what inputs, outputs, and calculations you need.
Step 2: Set up and organize your worksheet
• For larger models, create a separate sheet for each different section and then write down Assumptions, Income Statement, Balance Sheet, Cash Flow and Outputs. In case of a less complex model, place all sections under one sheet with adequate header definitions.
• Use a consistent format: Format cells, columns, and rows so that it is easy to read. Label rows and columns, using bold for headings of sections and the same colors for different kinds of data (e.g., inputs in blue, formulas in black).
• Make the “Gridlines” option visible if you wish to see more visual space between cells.
Step 3: Define Assumptions and Inputs
Base Your financial model on assumptions for you to create projections and calculations. You should be sure to have a special section on assumptions. It is bound to include the following;
• Revenue Growth Rate: This is the amount the revenue is growing
• COGS Percentage: Percentage COGS is of the revenue.
• Operating Expenses: Salaries, rent, marketing, etc.
• Capex: Amount to spend on assets
• Depreciation and Amortization Rates: Rate at which the assets are depreciating
• Tax Rate: Percentage applied on earnings before tax.
All assumptions should be clearly labeled so that it is easy to change later.
Step 4: Set up Income Statement
Income statement represents revenue, expenses, and profitability. This is an important building block of any financial model. Here’s how to set it up:
1. Revenue: Start with forecasted revenues using your growth rate assumption. Use a formula such as:
2. COGS: COGS % of sales on basis of assumption filled in step 3.
3. Gross Profit: Gross Profit = Revenue – COGS
4. Operating Expenses: All operating expenses, be it salary, rent or marketing will sum up to get the Total Operating Expenses.
5. EBIT (Earnings Before Interest and Taxes): EBIT = Gross Profit – Operating Expenses
6. Interest Expense and Taxes: Add net income obtained after adding interest expense, if any, and tax rate.
7. Net Income: Net Income = EBIT – Interest Expense – Taxes.
Connect all your numbers to your assumptions.
Step 5: Balance Sheet
The balance sheet provides a projection of the firm’s assets, liabilities, and equity. Remember to balance by ensuring:
1. Assets:
Cash and Cash Equivalents: This you will get from the cash flow statement, which you’ll prepare in the next step.
• Accounts Receivable and Inventory: Assume the same and project based on days outstanding-for example, average days to collect accounts receivable.
• Fixed Assets: Add initial assets minus accumulated depreciation to arrive at these.
2. Liabilities:
• Accounts Payable: You can also assume and project based on average payment days.
• Long-Term Debt: All existing debt is to be accounted for within your assumptions.
3. Equity:
• Retained earnings, for instance, should be included-they rise with net income each period.
• Total equity must therefore equal the sum of the liabilities.
Step 6: Build the Cash Flow Statement
The cash flow statement details inflows and outflows of cash. It is divided into three sections:
1. Operating Activities:
• Net income of the income statement as starting point
• Add back Non-Cash Items: add back deprecation and change in working capital. The change in working capital would include change in accounts receivables and payable.
2. Investing Activities:
• Cap Ex & Cap Receipt: Cash used in purchasing assets or received from sale of fixed assets.
3. Financing Activities:
• Debt: cash inflow and out flow from debt. This includes loan acquired new and loan repaid
• Equity: cash raised through issuing stocks and one bought back.
Calculate your net cash flow by adding cash from operating, investing, and financing. That should be coming into your cash balance in your balance sheet.
Step 7: Connect the Three Statements
Connecting the three statements will ensure that your model is well connected and accurate:
•Net Income: Compare the net income on the income statement with retained earnings on the balance sheet and with operating cash flow on the cash flow statement.
•Cash Flow Changes: Compare net cash flow on the cash flow statement with cash balance on the balance sheet.
•Depreciation: Compare the depreciation recorded on the income statement with the fixed assets section on the balance sheet.
Balance the balance sheet after all linkages.
Step 8: Sensitivity Analysis
Sensitivity analysis helps you understand how a change in an assumption influences the financial result. That is very critical to decisions. You can design the scenarios like best case, base case, and worst case by varying the following key variables:
• Growth rate of revenues
• Operating expenses
• Interest rates or tax rates.
Model the net income or cash flows under different assumptions using the Data Table or Scenario Manager in Excel.
Step 9: Review and Validate the Model
Having errors in your model destroys its reliability, and to avoid this, run these checks:
Use Error Checking: Excel has this particular tool that can track errors such as broken links or some incorrect formulas and find likely problems.
Cross check whether assumptions make their way correctly through your computations and whether everything balances if something changes in the model.
Run Tests on the Model: Update inputs to ensure the model updates correctly.
Step 10: Format and Communicate the Model
A clean model is helpful for communication and decision-making. To make your model as clean as possible:
• Color Code Inputs: Use the same colors for inputs, calculations and outputs to emphasize the variance between them. For example: blue for inputs and black for formulas.
• Summary Tables: A summary tab that shows revenue, EBITDA, and net income over the period of your forecast.
• Charts and Visuals: Put in charts for key metrics like a line chart on revenue growth or a waterfall chart on cash flow constituents.
Conclusion
A financial model created in Excel requires a systematized approach and must pay close attention to minuscule details when connecting related financial statements.
This really just is the starting point; with practice and gaining momentum, complexity can be introduced on a host of other characteristics and analysis.
With all of this, you build a foundational knowledge base and skills with financial modeling by walking through these steps.