Financial Modeling in Excel is one of the most sought-after professional certification today.
And why not?
Every other hard working individual aspires to be a part of the lucrative financial industry.
World over there are notable financial capitals starting from New York, London, Hong Kong, Tokyo & Mumbai.
These global financial hubs offer the most-in-demand financial jobs. But finance-related jobs are aplenty at most of the cities offering decent employment prospects.
Irrespective of where a finance job is, it continues to be one of the most demanding ones. To succeed in your financial career, you need to have thorough knowledge, steely grit and willingness to put in a lot of long hours.
Having the right skill-set in such an environment can go a long way in ensuring success. Financial modeling in Excel is one such must-have skill-set for all finance professionals.
What is an Excel Model in Finance?
There are two key components of “Excel Model in Finance” namely, Excel Model and Finance.
#1. Excel Model
Very simply put, a model is a framework that emulates a business process. It takes certain input and produces one or more output depending on the rules associated with the business process.The inputs in the model then interact with each other (through calculations) under the specific rules and assumptions and finally produce an output. When we use a spreadsheet software, and more particularly, when we use Microsoft Excel software to build this program, it becomes an Excel Model.
Finance is a discipline that deals with investment and money. It is a field where professionals find the most optimum application and allocation of money. Finance professionals invest money for their clients (or their company) in such a way as to maximize returns for the stakeholders.
Putting them Both Together
Therefore, an Excel model in finance is nothing but a dynamic tool written using Microsoft Excel software that evaluates and predicts an outcome of a financial business process. For example, you can write an excel model to evaluate why an investment opportunity ‘A’ is better than investment opportunity ‘B’, or to evaluate the performance of an investment portfolio for a client or to forecast the financial performance of a manufacturing plant or to arrive at a DCF valuation for a security.
What Makes Excel Model in Finance So Important?
Financial Modeling Example
Businesses have limited resources and they need to put these to best use. For every decision, there is an alternative or an opportunity cost.
Would you make more return by investing the same money in stock A or stock B? If your company is about to acquire a new business, will the deal prove to be profitable for the price being paid? How many sales is a chocolate manufacturing company likely to have in the following year to plan raw material purchase accordingly?
An Excel model can help you answer such business problems and more. Let us look at few key application of an excel model in finance, which will explain why they are so important.
#1. Company Financial Model for Buy-Side & Sell-Side Analysts
Company financial models are used to predict the future financial performance of a company. They take various operational line-items such as Sales, Cost of Goods Sold, Marketing & Distribution costs etc. as inputs and then build a company’s balance sheet.
Profit & loss statement and cash flow statement from there. Depending on the company and the analyst these models can be much complex or very simple.
Predicting a company’s future financials and carrying-out scenario analysis is one of the routine responsibilities of buy-side and sell-side analysts. Depending on the outcome of their models the analysts can give any company a “Buy” or “Sell” rating, which is then used by investors.
#2. Cashflow Valuation Model
Investors use different methods to arrive at a company’s valuation.
One of the ways is to build a cash-flow model assess a company’s valuation. Discounted Cash Flow (DCF) modeling is widely accepted valuation model. The free cash flow (equal to operating cash flow minus the capital expenditure) estimate gives a good measure of company’s future performance.
This model is useful since it discounts the future cash-flows with WACC (Weighted Average Cost of Capital) to arrive at the Net Present Value (NPV) of a company.
The model also includes the terminal value of an enterprise based upon a future steady growth rate. The investors use this model to arrive at the total absolute value of the company.
#3. Comparative Company Analysis Model
Used widely in the investment banking industry, here analysts carry out a peer-group analysis. They select similar companies from the same sector and compare their financial metric. It involves calculation of valuation multiples such as EV / EBITDA or any other relevant valuation metric. A company’s valuation is then ascertained in relation to all its’ peers.
#4. Sum of the Part (SOTP) Valuation Model
This model is also used to arrive at a company’s absolute value. Usually used for the conglomerate, in this case, various divisions of a company are treated and valued separately.
For example, Grasim Industries has various business units, including Ultratech Cements, textile, chemicals, telecom (under Idea Cellular) etc. To arrive at the correct valuation for Grasim Industries, an analyst will treat each of these business units separately, arrive at their value and then carry out a Sum-of-the-Part.
Underlying philosophy here is that if a company is broken down or a particular business unit is being spun-off and getting acquired then what would be the estimated value of the company.
#5. Leveraged Buy Out Model
When a company acquires another company through a considerable amount of debt or leverage it is called Leveraged Buy Out (LBO). A model used to value such deals is known as LBO model.
Typically, this model is used by private equity firms. Private equity firms usually sponsor a company’s buy-out and later want to sell-it-off at profit.
This model helps them in ascertaining whether acquiring a company even at huge debt levels will result in decent returns on deal or not. You can learn more in-depth about an LBO model here.
#6. Mergers & Acquisition (M&A) Model
Whenever two firms are merged together with the resulting entity’s value either increases or decreases. The impact of the merger on a firm’s value can be analyzed through comparison between original EPS of the entity and EPS of the merged entity.
An M&A model can predict the scenarios in which the deal would be value-accretive and the scenarios in which the deal would value-dilutive. Depending on the likely scenario the firms can go ahead with the M&A deal.
#7. Option Pricing Model
Options are contracts which give its holder the right but not obligation to sell or buy the underlying instrument at a specific price (strike price) before a specified future date.
Option traders calculate the theoretical value of the option based on certain assumptions such as volatility and the few known factors such as underlying price, strike and days till expiry. Since these variables fluctuate over time, an option-pricing model helps the trader to analyze the value of option over its life.
While a model may be elaborate or simple, it is only as good as the estimates of its modeler. A good model requires its’ analyst to know the business in-depth and be thorough in approach. To become a successful modeler, you need to be trained in specific knowledge areas.
Suggested: Read more about Financial Modeling Examples
What does it Take to become a Pro at Financial Modeling in Excel?
To become an expert in Financial modeling in excel you need to get trained in three essential modules:
1. Finance & Accounting
Since you will be dealing with problems in the finance subject, you must have strong foundation knowledge in accounts as well as finance. You must know how to construct the three fundamental financial statements i.e. Balance Sheet, Profit & Loss Statement and Cash Flow Statement. You must also know the basic accounting concepts such as accrual, matching principle, revenue recognition etc.
2. Excel Skills
Mastering Excel skill requires you to be adept at both arts and science. While you must know the important excel functions, referencing between different excel files and different excel sheets – it is equally important how you approach to build the model. The layout of input data and output cells is equally important and this is more of an art than a set of rigid rules.
3. Problem Solving and Logic
Suppose you have acquired the subject matter expertise by knowing finance & account and you have also mastered the excel functions. But until you have trained yourself to have an aptitude for problem-solving you cannot be a successful modeler.
You must learn how to approach and solve a problem step-by-step, thinking in a very organized manner. This is important so you can follow a logical flow of complex information.
Besides the above-mentioned 3 skills, you must also have:
- An attention to detail
- Ability to handle complex information and data
- A flair for design and aesthetics
6-Point Checklist Before You Start your Financial Modeling in Excel
Once you have mastered financial modeling in excel you must put-to-use few practices which will make the financial model stand-out. Here is a 6-point checklist which will come in handy whenever you will make a financial model in excel.
1. Work in a Tab Structure
It is very important that you work in tab structure in the while doing financial modeling in Excel. This helps you organize the model flow. Every tab denotes a purpose. An input tab, for example, will help you keep all your inputs in one place. So, if some input value changes process workflow, just changing the value in one cell will suffice. And you would not need to make changes in multiple places. Likewise, you must have separate tabs for calculations, output, and documentation.
2. Know the Output You Want
Before you start building the model, know the outputs expected from the model. So, if eventually, you want to carry out a scenario analysis or build a sensitivity table then you plan for the same in the output tab.
3. Data Collection
Once you know the result you want, you can then work backward, step-by-step towards gathering the input data. For example, if you want to predict the Net Profit for a company, then you can do something like this:
Step-1: Net Profit = Total Revenue – Total Cost
Step-2: Total Revenue = Sum of Revenue of (Product-1, Product-2, Product-3) + Other Income
Step-3: Total Cost = Operational Cost + Marketing Cost + Financing Cost
Just go on breaking each individual data-point till the last possible information.
Once you have the last piece of input required, then you can build your Inputs tab. Any derived value of variables must go into the calculations tab only and should not be on the inputs tab.
4. Never hard-code values
If your model involves assumptions such as using inflation rate or an estimated industry growth rate, then build a separate “Assumptions” tab and keep all such values there.
For example, if sales growth is expected to grow at 5%, next year sales formula should not be = S1*(1+5%). Instead, you must input the growth-rate separately in an input cell and then use it.
5. Build index tab
For a complicated model, always include an index tab which is only used to describe the purpose of all other tabs. The index tab should provide full information on the functionality of the model.
The documentation in the index tab will increase the transparency of the model.
6. Keep the formats consistent
You must maintain a consistent format. For example, you may choose to always keep the color of your input cells as blue. And then do not use the same color anywhere else. Likewise, you can choose one color for output labels.
Whether you aspire to be an investment banker or want to work in commercial bank or you want to be a financial controller in a manufacturing plant or you want to be a part of the new cool fintech start-up the job function financial modelling in excel will be a skill-set which will be much useful throughout the course of your job.
A Quick Video on How to Build Financial Modeling in Excel
I hope this guide on Financial modeling helped you in learning everything across the topics. Let me know in the comments section if I missed out on any point. I'd be more than happy to hear from you.