What is Financial Modeling?

Key Components of a Financial Model

• Cash flow:-  A cash flow statement is a forecast of cash inflows and outflows from the operations, financing, and investment activities that may be used to estimate the company’s ability to maintain its liquidity.

• Supporting schedules:-  There could be some other supporting schedules such as debt, working capital, depreciation, and capital expenditures which the model will consider to ensure accuracy in the forecasts.

• Assumptions and Drivers:- Assumptions on market trends, growth rates, cost structures, and all the economic factors will serve as a basis for making projections. Such assumptions power the final output of the model.

• Valuation Methods:- The valuation methods that financial models use may include DCF analysis, comparable company analysis, and precedent transactions, which depend upon the specific investment banking context.

Importance of Financial Modeling in Investment Banking

• Decision Making: A structured financial model can be used for important decisions regarding investments. Investment bankers could run through multiple financial scenarios, and then, they would identify all possible risks that might arise while returning the money and recommend to clients.

• Mergers & Acquisitions (M&A): While building a model to forecast the performance of the merged entity and its potential synergies, bankers may cross-check whether the deal will add or dilute the earnings of the acquirer.

• Valuations: Investment bankers have to value a company while advising clients about it for sale or raising business capital. Whatever is the requirement, financial models are used to forecast cash flow in the future and will determine valuation metric approximations in order to understand better market value.

• Capital Raising: Financial modeling may become a critical input into funding companies through debt or equity. It allows bankers to know at what level of capital is required and the implications that incremental funds will bring to the bottom line of the company.

• Risk Assessment: Using financial models, bankers are able to identify various risk assessments and downside scenarios. Stress testing different variables allows analysts to see the level at which the company’s financials change with changes in market conditions.

Types of Financial Models Used in Investment Banking

• Three-Statement Model: The most straightforward and essential model that connects the income statement, balance sheet, and cash flow statement. It eventually serves as the foundation model for most of the much more complex modeling exercises.

• Discounted Cash Flow Model: A valuation method that computes and projects a firm’s free cash flows and then discounts them back to their present value using some form of discount rate, often calculated as the weighted average cost of capital, or WACC.

• M&A Model: An advanced model that calculates the financial impact that a merger or acquisition would have on a company. The synergistic benefit of a deal is calculated in terms of the effects on earnings per share.

• Leveraged Buyout (LBO) Model : This model is used for the purpose of determining the viability of a buyout that is highly debt-financed. It assesses schedules of payback of the debt, interest expenditure, and potential returns for private equity investors.

• Sensitivity Analysis and Scenario Modeling: Creates multiple scenarios (best-case and worst-case scenarios, for example) and adjusts key drivers: growth rates, margins or cost of capital to understand sensitivity of financial results to changes in assumptions.

Steps to Building a Financial Model

Understanding the steps involved in building a basic financial model is important,  for beginners:

• Data gathering for Historical Period: Gather historical financial statements, market data, and report of the company. These form the basis of your assumption.

• Assumptions : Establish the critical drivers such as revenue growth, cost structure, interest rates based on historical outcomes and industry studies.

• Earnings Projections :Using these assumptions, the future streams of revenue can be projected. This can be done through a number of different methods including percentage growth and specific unit sales estimates.

• Expense Forecasting: Project future operating expenses including COGS and SG&A (Selling, General, and Administrative) using historical margins or industry standards.

• Tie the Statements: Use linkages between separate sections to create the three financial statements (income statement, balance sheet, and cash flow). For example, depreciation and amortization on the cash flow statement ties back through the income statement and balance sheet.

• Validate and Analyze: Having created your model, validate your results by running them against historical data or industry averages. Use scenario analysis to determine what different financial outcomes would be.

Conclusion