Financial Modelling
For most working professionals, business analysts, and decision-makers, financial modelling is considered a vital finance skill.
Financial modelling, in general, is a numerical expression of the firm’s financial performance,
as embodied by the financial model used mainly in forecasting future earnings
or checking the health position of a company, including investment opportunities.
In terms of the guide, I will be taking you through some types of financial models, key components involved in the process, best practices, and then, step by step, guide you on how to build a financial model in Excel.
1. What is Financial Modelling?
It would be termed as a model; that refers to the building process of the mathematical representation which calculates any form of an entity’s financial performance.
Making use of historical data, assumptions, and projections, it is therefore developed such that future performance could be simulated.
Such models are of application in decision-making and evaluation, valuations, risk assessment, and scenario analyses.
Financial modelling is basically a projection of future income statements, balance sheets, and cash flow statements for a company for quite different scenarios.
2. Types of Financial Models
There are a lot of financial models that aim to do different things. Probably, the most common models are listed below:
a) Three-Statement Model
Three statement model is the most basic and the most commonly applied model. It integrates all three: income statement, balance sheet, and cash flow statement into one model in order to track the trend of company’s performance on financial front.
- It is generally used for
- Estimation and forecasting financial statements
- Study of historical analysis
- Companies’ valuation
b) Discounted Cash Flow (DCF) Model
The DCF model is a method of estimating an investment’s value. In this model, one predicts the cash flows of that investment. Then these cash flows are discounted to the present value by applying a given discount rate that, often, is WACC.
This kind of model can be very widely applied, especially for business valuations, investment analysis, and acquisitions.
c) Comparable Company Analysis (Comps) Model
Comps model compares the subject company with similar companies which are listed in the stock market to get its relative value.
This means the selection of a group of similar companies, calculation of financial multiples (for example, Price-to-Earnings or Enterprise Value-to-EBITDA) and their application on the subject company.
Generally, this model is used for
- Valuations
- Mergers and acquisitions
- Investment research
d) Precedent Transactions Model
This model judges the company using prices that comparable companies have received from past sales. It also resembles the comps model in nearly every respect, except this actually uses transaction data, based on the past performances can actually be good benchmarks for purchasing or a merger.
This model is used largely in the following:
- M and A deals
- Deal valuation
- Investment banking
e) LBO Model
The LBO model is utilized in the analysis of a leveraged buyout transaction. It refers to how a financial sponsor buys a company where a huge amount of debt is used.
In such a model, the debt servicing, interest payments, as well as the debt repayments schedule are part and parcel of the financial forecast.
This model is normally adopted in the following areas.
- LBO transaction analysis
- Investment in private equity
- Debt structuring
f) Mergers and Acquisitions (M&A) Model
M&A models are applied in financial analysis of the proposed merger or acquisition. Most of the time, they consist of synergy projections, financing options, and the impact it will have on the statements of the merged company. It is often applied in;
- M&A transaction analysis
- Post-merger integration
- Deal structuring
g) Budgeting and Forecasting Model
The model supports future estimations for the performance of the business based on past information and expectations of businesses upon revenues, expenses, and capital expenditures. They apply mostly in long-term finance planning, annual budget, performance management of business
h) Option Pricing Model
This is a model whose derivatives or value of options are measured. Its variables include volatility and price of the stock interest rates and time to run out.
This model can be applied in the fields listed below:
- Valuing financial derivatives
- Risk handling
- Portfolio optimization
3. Basic Components of a Financial Model
A financial model should include the following basic components:
a) Assumptions
The assumptions are the heart of the model and typically comprise of the following:
- Growth rate in revenues
- Percentage COGS to revenues
- Tax rates
- Working capital requirements
- Capital spending plan
b) Historical Data
These are the historical statements of the company, usually between 3-5 years. From the historical data, the trend can be derived so that projections for the future could be made.
c) Income Statement
Income statement, also called profit & loss statement, is the statement of revenues, costs, and profits of a business over an accounting period. The important components are:
- Revenue
- COGS
- Operating expenses (SG&A)
- Depreciation and amortization
- Interest and taxes
- Net income
d) Balance Sheet
A balance sheet is an accounting summary of the position that exists at any given time regarding the company’s finances. It shows;
- Assets-current and non-current
- Liabilities-current and non-current
- Shareholders’ equity
e) Cash Flow Statement
Cash flow statement expresses the cash generated and the cash consumed in the economy about the business over a certain period. This is further segmented into;
- -Operating cash flow
- -Investing cash flow
- -Financing cash flow
f) Annex Schedules
Annex schedules are provided for selected calculations and assumptions that might be applied in the calculation of specific line items on the statements of financial position. Example include;
- Schedule of depreciation
- Schedule of debt
- Schedule of working capital
- Schedule of tax
g) Financial Metrics and Ratios
Financial ratios are:
- EBITDA
- Return on equity (ROE)
- Return on assets (ROA)
- Debt to equity ratio
h) Outputs
It includes:
- Income statement, balance sheet, cash flow statement
- Key financial metric, ratio
- Valuation analysis- if appropriate
4. Financial Modelling Application
Financial modelling can be applied to any type of industry for different types of purposes. For example,
a) Business Valuation
Intrinsic value of the business is how much the company is worth in financial models. From DCF analysis to comparable company analysis and precedent transactions, just the right amount of light is shed by financial models regarding what the company is worth.
b) Investment Analysis
Financial models guide the investor and analysts to check out whether the investment proposed has any feasibility and returns that the investment might incur along with all the risks attached.
c) Mergers & Acquisitions
Financial models will help one to value the how acquisition or the merger would impact on the financial performance of the new entity. Synergies can be thought of, and the best funding strategy can be planned.
d) Budgeting and Forecasting
Financial models allow the firm to anticipate how it will perform given some assumptions. They support budgeting, setting financial objectives, and monitoring performance.
e) Credit and Debt Analysis
Banks and other money houses use financial models for the establishment of the debt a company can repay. It basically means providing an analysis regarding how creditworthy the company is and its soundness financial.
f) Risk Management
Financial models are applied while searching and analysing financial risk. Simulations allow changing interest rates, commodity prices, for example, considering currency fluctuations and other such factors.
5. Best Practices in Financial Modelling
The following best practices should be followed to build effective and reliable financial models:
a) Keep It Simple
Models should be kept as simple as possible without sacrificing accuracy. Overcomplication of the model can lead to errors and make it difficult for others to understand and update.
b) Ensure Consistency
Use consistent formatting and conventions throughout the model. For instance, maintain the same colour scheme, fonts, and cell references. This makes the model easier to follow and audit
c) Use Clear Assumptions
Always make your assumptions transparent. Clearly state the assumptions you’ve used for revenue growth, expenses, taxes, and other variables. This allows others to understand the logic behind your projections.
d) Include a Dashboard
Develop a summary dashboard displaying the key outputs and metrics in graphical form that is very helpful to all stakeholders who do not want to go through the entire model.
e) Test the Model
Always test the model with various scenarios before finalizing the model; this will help point out any errors or unrealistic assumptions.
f) Use Excel Shortcuts
Master Excel Short cuts. Mastering shortcuts in excel means the speed and efficiency are maintained. Knowledge of formulas including VLOOKUP, INDEX MATCH, IFERROR, SUMPRODUCT and so many more. Then financial formulas like NPV, IRR.
g) Work Documentation
Always record what is being done. Comment on what is complicated about the formulae or difficult arithmetic
6. Making Simple Financial Model in Excel Step by Step
Let us now see how one can make a simple financial model in Excel step by step.
Step 1: Historical Data
Collect the historical financial statements of the company for the last 3 to 5 years. Put it into Excel.
Step 2: Assumptions
Obtain the important assumptions such as revenue growth rate, percent sales in COGS, tax rate, capital expenditure etc.
Step 3: Building Income Statement
Income statement will project by the revenue basis to work back using the subtraction of cost items all the way down to derive the operating income or EBIT, interest, taxes, and net income.
Step 4: Building Balance Sheet
Asset, liabilities, and equity must be projected using historical trends assumptions so that at all times, balance sheets can balance with Assets = Liabilities + Equity
Step 5: Preparing Cash Flow Statement
Prepare cash flow statement using indirect method. It starts from net income, adjusts the noncash items, and changes in working and purchases capital.
Step 6: Other Schedules
Depreciation, working capital, and interest are some other schedules that bring all pieces together and tie to financial statements
Step 7: Formulating financial ratios and measures
The following key financial ratios and metrics, including EBITDA return on equity, debt equity, shall be calculated.
Step 8: Sensitivity and Scenario Analysis
This model shall be tested with a few scenarios by altering key assumptions to check the sensitivity of the model by considering the impact of changes in revenue growth or tax rate.
Step 9: Presentation and documentation of the model
This makes the formats neat; then charts and dashboard for outputs are given; finally, write down the reason behind every assumption.
Step 10: Review and Audit
Review it carefully and audit it before it goes to stakeholders; see to it that it all works correctly with formulas attached and not fuzzy at reading.
Summary
Financial modelling is the mathematical representation of a company’s past financial performance to guide the management in the prediction and valuation.
Therefore, financial modelling implies estimating the company’s future financial performance using historical data and assumptions or projections by simulating its past performance.
There are mainly four popular types of financial models: Three-Statement Model, Discounted Cash Flow (DCF) Model, Comparable Company Analysis, and the Leveraged Buyout (LBO) Model.
Assumptions and historical data comprise the inputs of a model. The chief outputs of a financial model are an income statement, balance sheet, cash flow statement, and supporting schedules.
The uses of financial models are business valuation, investment analysis, merger and acquisition analysis and support, budgeting, and risk management.
Some of the best practices for financial modelling include simplicity, consistency, clarity and transparency, and proper documentation.
For years, the most versatile and hence most widely used financial modelling package has been Excel. However, if one can apply most of the functions as well as the shortcuts possible in Excel, then quite a lot more can be done within Excel.
The typical steps applied to financial modelling include gathering history data, making assumptions in the income statement, as well as in the construction of the balance sheet,
and finally, doing some sensitivity analysis. Testing it will conclude with the accuracy of the final model. Then briefly explain how it works.
The key metrics, sum, and what is produced must also be shown. In brief words, financial modelling is in huge demand in finance since it teaches one forecasting, investing, and risk-taking competencies.
Conclusion
It forms a critical decision-making tool in finance, investment, and business management.
Therefore, understanding the types, processes, components, and best practices involved will allow you to build models that give you insights into what will happen in a company in the future.
Still one of the most popular tools for building financial models, given its versatility and vast variety of features, is Microsoft’s Excel.
In such a case, with this step-by-step approach, you will be able to produce high-class financial models, which are apt for making decisions over an acquisition need or valuation for a company and so forth.
Frequently Asked question
1. What is financial modelling?
Financial modelling is an articulated numeric form of business performance in terms of monetary aspects to forecast outcomes at later stages and decide the decisions, appraisals, and budgeting.
2. What are the 3 basic financial models?
There exist three basic models; that is
- Three-Statement Model : It includes the income statement, balance sheet, and the cash flow statement.
- Discounted Cash Flow Model or DCF Model: whereby is valued through present cash flows discounted
- Comparable or Comparable Company Analysis; hence the process is whereby company compares in relation to other similar public enterprises.
3. What are kinds of financial modelling?
Most frequent of these ones are :-
Three-Statement Model
- DCF model
- Comparable or comparable company analysis& precedent transactions
- LBO MODEL
- Budgeting & Forecasting Models
4. What are three fundamental forms of financial modelling?
Major kinds are :
- Three-Statement Model
- DCF Model
- Similar Company & Comparable Transaction Analysis
5. What is a 3-way financial model?
3-way financial model takes three models: income statement, balance sheet, and cash flow statement into a singular model that reflects changes on one statement impact the others.