Difference between Financial Analysis & Financial Modeling

Financial analysis and financial modeling are the most vital skills in the finance world. Though they both originate from data analysis, each has a particular purpose, approach, and applications.

Knowing the differences between financial analysis and financial modeling can help professionals and investors make better financial decisions on assessing a company’s health to forecasting its future. 

This article presents a comprehensive understanding of both disciplines, touching on definitions, objectives, methodologies, and a clear pragmatic application thereof. 

1. What is Financial Analysis?

 Financial analysis is defined as the process of systematic evaluation of a company’s financial data based on performance, stability, and future prospects for growth. It includes assessments of financial statements, metrics, and ratios in order to obtain interpretations regarding profitability, liquidity, efficiency, and solvency. Financial analysis helps the investors, analysts, or managers of business make informed decisions in making investments, operating improvements, or strategic planning. 

Objectives of Financial Analysis: 

The three primary goals of financial analysis include: 

Analyzing past and present performance: Financial analysis is a retro look to see in what way a company has performed in the past and is performing currently. This tells one about the trend prevalent and past results. 

Health assessment: With the aid of some essential ratios and metrics, financial analysis helps determine whether a company is stable, liquid, or solvent. 

Helping in investment decisions: Investors look at the financial analysis in order to determine if a company is a good investment for profitability and risky in nature. 

Identify operational efficiencies: Management may refer to financial analysis to determine the areas where operations must be improved either by cutting costs or by improving revenue. 

Types of Financial Analysis 

1. Horizontal and Vertical Analysis: Horizontal Analysis compares financial data for periods to determine growth trends or declines. Vertical Analysis reports each line item as a percentage of a base figure (such as revenue) to find out the composition of costs or assets. 

2. Ratio Analysis: Ratio analysis determines financial ratios such as profitability, liquidity, efficiency, and solvency ratios. Major include: 

• Profitability Ratios (such as return on equity, profit margin) 

• Liquidity Ratios (such as the current ratio, quick ratio) 

• Efficiency Ratios (such as inventory turnover, asset turnover) 

• Solvency Ratios (such as debt-to-equity ratio) 

3. Trend Analysis: It involves the tracking of a series of key indicators about a firm over time to identify trends. Revenue growth trends indicate whether a company is growing or shrinking.

4. Variance Analysis: Actual results are compared with budgeted or forecasted figures to identify areas where performance differs from the expected value. 

5. Fundamentals Analysis: Often employed in equity research, this technique examines a company’s financial statements and industry as well as economy factors in order to determine intrinsic value. 

Financial Statements Used in Financial Analysis 

There are three major fundamental financial statements that are used within financial analysis, Income Statement: It provides information related to revenues, expenses, and profits of the business for a given period. This statement refers to the profitability of the company.

Balance Sheet: It is a snapshot of what a company owns, owes, and the equity at any given point. Using it helps evaluate its solvency. 

Cash Flow Statement: This statement tracks cash inflows and outflows from operations, investing, and financing, giving more insights into liquidity and cash management. 

Applications of Financial Analysis 

Financial analysis can be used in lots of ways: 

Investment Evaluation: Investors evaluate profitability and growth potential in a company before buying shares. 

Credit Analysis: A lender checks a firm’s liquidity and solvency to decide whether to advance or not. 

Performance Benchmarking: Management uses the model to compare its company’s financial performance against others in the same industry. 

Strategic Decisions: Financial analysis decides to expand into new markets, increase scale of operations, or reduce costs. 

2. What is Financial Modeling? 

Financial modeling is the creation of an organized mathematical expression of a firm’s financial position. Models developed are primarily through spreadsheets and represent projections of future financial performance, based on certain assumptions as well as historical data. A fundamental role of financial modeling can be seen in valuation, budgeting, investment analysis, and strategic planning. 

Aims of Financial Modeling 

Financial modeling primarily focuses on: 

Projections: A model forecasts a company’s revenues, expenses, and profitability for periods in the future. 

Business Valuation or Asset Valuation: Financial modeling may be used to estimate the intrinsic value of a firm or an investment. 

Aid in Strategic decisions: Management uses financial models to assess the impact of strategic choices, like acquiring other firms or introducing new products. 

Scenario Analysis: With a model, one can run different scenarios to understand what could happen if specific assumptions were considered. 

Types of Financial Models 

1. Three-Statement Model: It is a model that puts the income statement, balance sheet, and cash flow statement into one, so you get just one composite model that combines all the financials, but it’s simple and used as the basis of more complex models. 

2. Discounted Cash Flow Model: It’s a DCF model, wherein for instance, a company’s valuation would depend on the present value of projected cash flows with risk-adjusted discounting. Most widely used model in equity research and corporate finance. 

3. Merger and Acquisition Model: Investment banking and corporate finance use this model to calculate the acquisition or the merger’s financial impact on the acquiring company’s financials, generally on the earnings per share. 

4. Leverage Buyout (LBO) Model: Applied if the company is primarily bought with debt. Then it becomes more aligned with cash flows and debt repayment schedules as well as expected returns. 

5. Budget Model:  Commonly used for intra-firm planning, a budget model provides a projection of revenues, expenses, and cash flows for a given period, commonly a fiscal year. 

6. Sensitivity and Scenario Analysis Models:  These models examine how a specific variable might shift – such as interest rate or growth rate – in order to understand the potential outcomes and risks. 

Components of a Financial Model 

Main components of financial models are: 

Assumptions and Drivers: Forecasts are based on assumptions such as growth rates, profit margins, interest rates, etc. These drivers affect the projected financials and also influence the model outputs.  

Projected Financial Statements: Depending on the model, these generally include income statement and balance sheet projections with a cash flow projection, usually done for 3-10 years. 

Valuation Metrics: Typical measures in valuation models are NPV, IRR, and WACC. 

Sensitivity and Scenario Analysis: Users can model different results by changing pivotal assumptions and therefore track what happens to the financial projections of such changes. 

Applications of Financial Modeling 

Financial modeling has numerous applications, such as: 

Valuation: To determine intrinsic value for a company or an investment. 

Strategic Planning: To compute potential initiatives’, expansions’, or mergers’ financial impact. 

Budgeting and Forecasting: In the production of forecasting and budget realization.  

Risk Analysis: Sensitivity analysis enables a business to measure the risk associated with a decision, which it may do by any change in relation to significant variables as well as their respective influences on results.

3. Financial Analysis v/s Financial Modeling 

Financial analysis and financial modeling are two interconnected activities, but they have different purposes, scopes, and methodology. 

4. When to Apply Financial Analysis versus Financial Modeling 

Both financial analysis and financial modeling are unavoidable, and realization of when to use either one might make it possible to gain more accurate insights and better decision-making. 

When to Use Financial Analysis 

Investment Decisions: Investors base their investment decisions on current financial health of the firm and profitability through financial analysis. 

Credit Evaluation: The lenders check the ability of a company to repay the debt through the use of financial ratios and metrics. 

Internal Performance Review: Here, managers review performance that helps trace the flaws. 

Benchmarking: Here, it is the process where a company compares its performance with the peer group using financial analysis. 

Use of Financial Modeling 

Valuation: The real worth of a company can be determined, primarily in M&A and capital raising, by financial models. 

Strategic Decisions: Modeling lets you decide whether there is a financial implication of a business decision like expansion or introduction of new products. 

Budgeting and Forecasting: Financial modeling for future financial goals 

• Risk analysis through model-based sensitivity and scenario analyses unveil risks as several scenarios are run. 

5. How Financial Analysis and Financial Modeling Interrelate 

Financial analysis and financial modeling are two different processes that actually complement each other to make fantastic financial decisions. 

Financial analysis gives the general outlook of a firm’s past performance and its financial standing at present. This presents a base from which assumptions or projections are derived in financial modeling. 

In the context of assessing a company’s financial health in order to render appropriate judgements, financial analysis and financial modeling are very similar but not the same.

Historical financial data is exploited in financial analysis, which looks at performance, trends and a host of other attributes that encompass profitability, liquidity and solvency, among others. 

Whereas in financial modeling, lessons from the past are used to envision what the future will be like and come up with numbers based on certain parameters. This would further aid in performance prediction, ideal for investment appraisal and strategic planning. 

While financial analysis enables a viewer to see how well or poorly things have been done in the past and present, financial modeling uses the very same past and present data to create various scenarios and forecasts of what the future holds for decision makers. 

A comprehensive paradigm for financial decision making and strategy formulation is indeed completed by these elements. 

6. Working Example: 

Financial Analysis and Financial Modeling in Practice: To explain the better interaction between financial analysis and financial modeling, let’s take an example where a firm wants to take expansion decisions. The step-by-step explanation of the decision-making process is as follows:

 Step 1: Financial Analysis 

At this step, the company’s historical data in terms of its performances and health are reviewed. This is done through the following steps: 

Updates on past income statements, balance sheets, and cash flow statements.

Profit margins, debt-to-equity ratio, return on assets: to see what state the company’s finances are in. 

Revenue and net income growth trends study to establish if the company has a sound financial base to stand on in case of expansion. 

Step 2: Formulation of Assumptions Using Financial Analysis 

From the insight of the analysis of the company’s finances, the finance team of the company will formulate assumptions for the financial model based on the following: 

• Growth rate in revenue extracted from the past rate of growth. 

• Estimated operating costs based on an assessment of the past costs.  

• Assumptions regarding financing-inclusive of the interest cost, which is usually pegged on the past capital structure of the company, together with prevailing interest rates. 

Step 3: Creating the Financial Model 

After setting the assumptions, the finance function develops a financial model that captures the financial implications of expansion. This may include; Project income statements, balance sheets, and cash flow statements for the next 5-10 years. 

• Other revenue growth rates and cost structures to test in case of no desired expansion for this. 

• Sensitivity analysis: how changes to assumptions like the growth rate or financing costs influence the profitability and cash flow of the company. 

Step 4: Use financial analysis to validate the model

Once that model is built, the finance team will apply those projections against history to make sure that they have come up with the most realistic estimate possible. 

They fine-tune the model every time they encounter assumptions that are too optimistic or not in tune with historical trends.

Step 5: Make Expansion Decision

The last is to leverage both financial analysis and financial modeling input in deciding whether or not it would be feasible to move ahead with the expansion. 

Where the cash flow model suggested by the expansion model indicates a cash flow model that reflects the expansion as a positive cash generator and consistent with past growth of the company, the management team may move ahead with greater safety.

7. Differences and Overlaps in Skill Sets

Financial analysis and financial modeling are somewhat different in many aspects, yet share their skills in various areas; with distinct skill sets for each:

Skills in Financial Analysis

• Reading of Financial Statements: A prudent analyst needs to be smart in reading and extracting information from income statements, balance sheets, and cash flow statements.

• Ratios: Knowledge of different types of ratios and the ability to analyze trends and make comparisons is necessary.

• Crediting minor details: Analysts are made to capture even minute deviations or unusual patterns of financial data.

• effective communication skills: Analysts often have to present technical financial information convincingly and in simple words to the stakeholders concerned.

Financial Modeling Skills

•Spreadsheets: For financial modeling, one needs to know what all can be done with an Excel sheet-including using formulae and functions and using all the advanced features of data tables and scenario analysis.

•Financial Projections and Valuation: The modelers should understand that there is a prime necessity for drafting projections by using forward-looking metrics and that they need to do NPV and IRR computation.

•Analytical Skills: Models have to employ critical and analytical thinking in developing pragmatic and realistic models.

•Scenario and Sensitivity Analysis: Modelers should be able to analyze different scenarios and parameters that could cause modifications in financial projections.

Overlapping Skills

Financial Literacy: Primarily, financial analysts as well as financial modelers need to be adequately armed with finance and accounting knowledge.

Data Analysis: Both require data analysis so that trends, patterns, and insight can be identified.

Problem-Solving: Both financial analysis and financial modeling require complex financial problem solving and recommendations based on the quantitative data.

8. Career Pathways and Job Roles

Financial Analysis and Financial Modeling jobs show many overlap profiles in the skill set; yet, both types of skill sets may further orient in different careers and specializations.

Career Paths for Financial Analysis

• Financial Analyst: Financial analysts work in corporations, investment firms, or banks. Essentially, they basically use financial data to advise on investments.

• Credit Analyst: Credit analysts use financial analysis to ascertain a person’s or company’s credit worthiness.

•Equity Research Analyst: Equity analysts study the activities of public companies to conceptualize investment ideas. Equity analysts rely heavily on financial analysis.

Careers in Financial Modeling

• Investment Banking Analyst: The investment banker works on mergers, acquisitions, and initial public offerings. They apply financial models to determine if a deal can be done.

• Private Equity Analyst: Private equity professionals use the forecasted information created from financial models to determine which investments to pursue and determine their expected returns.

• Corporate Development Analyst: Corporate development analysts make use of financial models in order to figure out if a particular acquisition pays off or not, and also for other strategic investments like divestitures.

9. Conclusion

Financial analysis and financial modeling are two distinct but complementary disciplines in finance. 

Financial analysis therefore entails seeking the nature of history and the present for the purpose of determining how bad or good the financial health of the company is, and hence, it is indispensable for every past performance study and risk assessment and helps the short-term decisions. 

As a result, financial modeling is therefore an aspired forward-looking framework built on assumptions and projections that allow decision-makers to predict the likely future financial outcomes and hence make strategic choices.

Financial analysis and financial modeling are two firms that very much walk hand in hand within finance. 

They complement one another with the application of a holistic approach toward the analysis of the possible health of a company relative to its financial capabilities, yielding critical information that would enable deep thinking for sound decision-making-from short to long-term strategic business plans. 

Whether it is an attempt at financial statement analysis with the objective of investment or a financial model based on contemplated acquisition, success in finance is achieved by the power to effectively conduct financial analysis and financial modeling.