"What is financial modeling?"
“Do you teach financial modeling?”
“Can you give me a sample financial model that I can fill with numbers and present in the interview?”
"How to build a financial model?"
“Do you cover macros while building financial models?”
I’m constantly bombarded with such questions on financial modeling. And, the funny thing is—when I ask the person, "what is financial modeling?", that person doesn't have any clue.
So, I thought it’s apt to write on this subject today.
What Is Financial Modeling?
As per Investopedia,
The process by which a firm constructs a financial representation of some, or all, aspects of the firm or given security. The model is usually characterized by performing calculations, and makes recommendations based on that information. The model may also summarize particular events for the end user and provide direction regarding possible actions or alternatives.
As per my experience," financial modeling" involves building financial models, sometimes from scratch or sometimes maintaining and updating the existing financial models.
Financial modeling is a skill, and you can learn it through lessons and practice.
What Is a Financial Model?
According to Moneyterms,
A financial model is anything that is used to calculate, forecast or estimate financial numbers. Models can therefore range from simple formulae to complex computer programs that may take hours to run.
In short, financial models are mathematical models in which variables are linked together to represent a simplified version of the performance of a financial asset or portfolio of business, project, or any other investments.
For sophisticated models such as Discounted Cash Flow (DCF) model, you need to use a computer.
Microsoft Excel skills are must to build or update financial models.
There are computer programs built for high-end and complex financial models such as—Value-at-Risk(VAR) models used in risk management.
Financial modeling is the task of building a model of abstract representation of a real-world financial situation.
Financial modeling is a term defined and means different things to different people, and it usually relates to either corporate finance or accounting or quantitative applications.
The work of financial modeling has been gaining significance and acceptance all over the world over the past few years.
Commonly, financial modeling is understood to mean practice in either asset pricing or corporate finance, of a quantitative nature. In other words, financial modeling is about translating a set of hypotheses about the behavior of markets or investment decisions into numerical predictions.
A financial model helps in the future operating, investing and financial activities to determine future profitability, financial position, and possible risks that can be mitigated. Financial models should be exhaustive, internally dependable, and externally acceptable and analytical.
In Financial Modeling, it is desirable that the entire task should be free from error and should be easier to read and understand. By following these fundamental principles, the model will be easier to handle, direct, check and become more reliable.
Define the Need:
- What is the desired goal of the financial model?
- Launching a new product?
- Integrating a potential acquisition?
- Refinancing debt?
- Who is the expected user? Management/ Investors/ Bankers?
- What is the expected use? Internal or External?
Presentation or engagement of financial models will depend on purpose and target audience.
Financial Modeling may require preparation of complete financial statements over a defined period, or it may require limited information over a defined period.
Complete Financial Statements are challenging and time-consuming to prepare, but at the same time also most instructive to users. For example, Balance Sheet measures future liquidity and Leverage. Income Statement estimates future operating results. Statement of Cash Flows outlines future cash need for growth (investments and borrowings) and Return to Investors collectively completes financial statements and can help in measuring return on investments and potential risks related to it.
Most of us overlook Cash Flows in financial modeling, but it is a very significant element. Statement of Cash Flows shows the timing of capital expenditures for growth, additional borrowing needs, the ability to provide a return on investments.
Cash flows are available to investors (free cash flows) and are a core element in financial decision making, and are essential to arrive at net present value analysis or an internal rate of return analysis.
For the most accurate results we need to follow the Firms standard format:
- Maintaining an appropriate number of spreadsheets.
- Using page breaks wherever required.
- Writing an executive summary on top if required.
- Maintain proper versions of documents if future upgradations are expected.
- Using modular spreadsheet blocks will make changing each sheet easier without affecting others.
- Proper protection should be made to the sheets and workbooks from unauthorized usage.
- Labeling sheets, columns, and rows with their appropriate headings so that files become easily searchable and can be followed.
Document your assumption in an organized and better way:
- Assumptions documentation helps in validating & avoids misinterpretation.
- Listing assumptions will be helpful for easier and quicker understanding.
- Adding source data as well as calculations will provide a sound projection of the map.
- Linking wherever required will be a good practice such that when the inputs change, the outputs will be changed automatically.
- It will save a lot of confusions and hassles at the final stage and even at working stage.
Facilitate Data entry at one place only:
- Avoid retyping and repetition of data, entering it once as a source and referencing it will make it simpler.
- Using Consistent Formulas is good practice.
- Using formulas and functions will make data accurate and will save time.
- You should not copy a formula from one sheet to another as it will create links to files.
- Avoid unnecessary blank columns and rows as this can be tedious at the time of making tables or other charts.
- Creating Templates will be beneficial.
Who Should be Studying Financial Modeling?
Financial Modeling could be beneficial and may be explored by a vast majority of people.
- The Financial Modeling study can be done by anybody who wants to study the world of finance and who wishes to get involved in money related decision making. These people can be Executives, Business planners, Strategy Decision Makers, Managers working with Banks, Equity Researchers, Project Managers, Research Analysts, Investment Banking people, Portfolio Managers, Commercial Bankers, Risk Managers, Accountants, and all those who are part of the finance department in all types of the different firms.
- It’s an added advantage for those people who are pursuing CA (Chartered Accountant), MBA (Masters of Business Administration), CFA (Chartered Financial Analyst), FRM (Financial Risk Manager) and Commerce Graduates.
- Also, the candidates having Degree, Diploma, in technical fields like B.TECH or Engineering, who wants to make a career in finance.
- Any individual who just wants to gain knowledge out of passion or curiosity.
Also Read: Financial Modeling Examples Using Excel
Where Can You Use Financial Models
Financial models are used in:
- Historical analysis of a company
- Projecting a company’s financial performance
- Project finance
- Real estate investments
- Oil & Gas projects
- Banks & Financial Institutions
- Personal finances
- Non-profit organizations
- Investment banking
- Equity research
Users of Financial Models
There are four main groups of users that use financial models.
- Business owners and entrepreneurs
- Finance and Accounting professionals
- Financial Modelers and Consultants
- Individuals for personal finance
Let’s see the areas where you, as a financial analyst, can use financial modeling skills.
- Forecasting future raw material needs
- Valuation of a security
- Benefits of a merger
- Check the size of the market opportunity
- See the roadmap to profitability
- Check investment requirement
- Quantify and predict risk
- Portfolio performance
- Identify undervalued securities
The question comes to mind that only one financial model is useful, or we need to use different types of financial models.
Types of Financial Models
There are different financial models that you can use as per the need.
- Discounted Cash Flow model
- Comparative Company Analysis model
- Sum-of-the-parts model
- Leveraged Buy Out (LBO) model
- Merger & Acquisition (M&A) model
- Industry-specific financial model
- Option pricing model
- Corporate finance models
These financial models are used to solve different problems.
As a financial analyst, you should know the time and type to use a financial model.
To gain expertise in financial modeling, you should know the financial modeling basics.
Suggested: Read more about Financial Modeling Examples
Financial Modeling Basics
How to learn financial modeling? Are you preparing for financial modeling jobs? Then only downloading financial modeling templates won't help. This will help:
- You should be good in Accounting, Finance and Valuation and financial modeling Excel skills.
- Ask yourself, “What problem I’m going to solve by creating this financial model?”
- You should know the scope, benefits, and limitations of financial modeling.
- Remember: Garbage in garbage out principle. So, check your inputs.
- Your model should be simple, easy to understand and flexible enough to accommodate future revisions.
- Time management is an essential aspect of financial modeling. Don’t get overwhelmed by numbers and calculation part in spreadsheets.
- Lastly, you should be able to take a decision based on your financial model.
In short, financial modeling is a skill, and you can develop this skill by learning Excel Financial Modeling Training, (classroom or online) applying and practicing it well.
Have queries? Write them below.