In one of my previous articles, I explained what is financial modeling, types of financial models, users of financial models and the basics of financial modeling. Then, I also covered some financial modeling examples using Excel.
In this article, Building Financial Models: How to Build a Financial Model, my main focus is to cover the strategies of financial modeling.
Suggested: Read more about Financial Modeling Examples
Building Financial Models: 5 Strategies to Help You
No matter where you work, be it private equity, mergers and acquisitions or even equity research, when it comes to the key to enter into a financial position, then it solely depends upon a financial model.
In fact, if you own your business, then the importance of a financial model remains indispensable.
Financial models acts as a doorway into the inner functioning of any company. Building financial models fulfills certain important aspects of a business organisation. These are:
- to explain the nature of the business. The financial model is a great indicator of how a business is shaping up and its long-term prospects.
- to illustrate the market. The financial models are used by potential investors to adjudge the business and its potential, which means adjudging the size of the market and its opportunities.
- to understand business profitability. Every shareholder or investor willing to participate needs profit ultimately. The financial model gives a glimpse of estimated profits.
- to evaluate the business value. The financial model indicates the value of a business and helps to reach a certain valuation.
- to ascertain investment requirement. The financial model helps interested investors to understand the level of investment necessary.
This generally seems like a difficult task, especially for beginners. However, the fact is that if you manage to break things down, then you’ll realize that you should very well be able to build a great model on your own or for your financial clients.
5 Strategies on How To Build A Financial Model:
Check out the following strategies that would help you in building a financial model easily -
1. Adjudge the purpose and audience:
The very first thing that you’re required to do is adjudge the purpose and audience of your financial model.
Most financial models would, of course, come across as similar, but the presentation of various metrics would be different because the targeted audience is different.
Depending on the kind of audience you have got, illustrate the variables as deemed necessary by the main audience base.
Targeting the financial model to the correct audience improves business in many aspects.
2. Set up an assumptions page:
The next thing that you’re required to do is set up an assumptions page in which the first one should lay out the complete set of assumptions that you’ve used for your model.
A financial model is created on the basis of certain realistic and premeditated assumptions. These assumptions are complicit with the business requirements and the market demand.
In building financial models, you are essentially offering the targeted audience a proposal, stating business prospects and profitability. To a large extent, this business proposal is based on realistic assumptions.
3. Set up profit and loss statements:
The next thing you have got to do is set up a profit and loss statement. Remember, whether you own your business or work for one, it’s extremely important that your audience determine how detailed your profit and loss statements are going to be.
The profit and loss statements are an indicator of the financial health of the business. A poor profit and loss statement doesn’t attract good investments. Ultimately, what investors are looking for is a profitable company; the length of time doesn’t matter.
The financial profit and loss statements should contain the major line items like say net income, revenue, liabilities and more.
Now, the essential bit is that the forecasted numbers should be pulled from your assumptions page, and again, the assumptions should be realistic.
In this manner, you’ll be able to show your audience the change in different metrics on the basis of the realistic assumptions or projections.
4. Build up cash flow statements:
After the creation of detailed profit and loss statements, you need to handle the building up of cash flow statements.
You should show specific details here like Beginning Cash Balance, Cash Flow from Financing, Cash Flow from Operations, Cash Flow from Investing, Ending Cash Balance and other factors. The purpose of cash flow statements is to reveal the operating expenses of the company, and it usually includes factors like gross payments and gross receipts over a specific period of time.
Now, you should make sure of the fact that the Ending Cash Balance is linked to your balance sheet and that they should match.
5. Put together your balance sheet:
The balance sheet is a rather important thing to do and it should be pulled from your assumptions page, obviously. Investors peruse the balance sheet of the business as it gives an overall idea of how the business is functioning.
You should make it a point to link your balance sheet with the Profit and Loss statement, wherever it’s applicable.
Once all the factors are assessed and analyzed, present them in the form of a report. The report is sent to interested investors.
Now You Try It
Follow the 5 strategies discussed above and also make sure of the fact that everything ties and falls into place. Remember, you’re going to lose your credibility if your numbers don’t tie. It’d be good if you build checks in your model, as a kind of benchmark.
I hope you can see the potential of Building Financial Models for your career.
Yes, it takes hard work to create something great. But, with this skill, you will be ahead of your competition.
Your hard work is going to pay off.
I want you to start building financial models. Give it a try and let me know how it works for you.
If you have a question or thought, leave a comment below and I’ll get right to it.