Financial Modeling: A Beginners’ Guide
Finance Modeling… You must have come across this term lately.
A very popular skill buzzing around finance enthusiasts.
But what is financial modeling?
What is the scope of financial modeling?
Where do we need financial modeling?
Let’s get to understand all these here in this blog.
What is Financial Modeling?
In simple words, we can say that financial modeling is a combination of accounting, finance, and business metrics to create an abstract representation of a company in Excel, forecasted into the future.
Financial Modelling is an abstract representation of a real-world financial situation.
It is essentially a mathematical model to represent the performance of an asset or a project.
Why is Financial Modeling important?
It helps in forecasting a business’ financial performance, based on its historical performance.
Financial models are important tools for all business decisions. Whether you are looking to raise finance, buy or sell a business, assess strategic options, or just plan for the future, you are going to need a forecast. This is likely to come from a financial model.
Modeling is never about guarantee or assurance. However, it is better to be roughly right than to be precisely wrong.
What is the Scope of Financial Modeling?
Within any organization, a person looking after business development, tendering, vendor development, operations, profitability, MIS, etc. can easily acquire modeling skills and start the tradition of financial modeling there.
The modelers utility can be seen by the future success of model based decision. The model based decision is function of various inputs of various departments. But if the financial modeler has acumen of these things, modeling will be perceived as an important function.
Financial modeling skill from one industry can be easily applied to any other industry, country etc.
With the nature of businesses getting complex and uncertain.. there is going to be huge demand coming up for financial modelers.
Applications of Financial Modeling
Transactions: Used in acquisitions, divestments, dissolution
Investments: Used in capital projects such as procuring new equipment and property development
Corporate finance: Used to assist in deciding the best capital/corporate structure of a company
Project financing: Used to show if borrowers will be able to meet repayments and stay within the covenants set by the bank.
Joint venture: Used to calculate returns to various parties at various exit times
Bids and tenders: Bid models are used to assess the cost of the proposal and to derive the final market price.
Investments in technology startups, business alliances, supplier strategies, pricing strategies, stock trading, commodity trading, forex trading, personal finance etc.
Types of Financial Models
Three statement model:
- It is the most basic setup for financial modeling.
- In this model, we link the three statements (income statement, balance sheet, and cash flow) dynamically with formulas in Excel.
- The objective is to set it up so all the accounts are connected and a set of assumptions can drive changes in the entire model.
Discounted Cash Flow (DCF) Model:
- The DCF model builds on the 3 statement model to value a company based on the business’ future cash flow.
- These types of financial models are used in equity research and other areas of the capital markets.
It helps in assessing the financial viability of a project. And create a funding plan through debt and equity components.
Merger & Acquisition (M&A):
It helps the companies in access the value of the company which they want to merge or acquire by forecasting the revenues, preparing debt schedule, by doing competitor analysis.
Leveraged Buyout Transaction (LBO):
- A leveraged buyout transaction is an advanced form of financial modeling.
- It typically requires modeling complicated debt schedules.
- An LBO is often one of the most detailed and challenging of all types of financial models.
- As the many layers of financing create circular references and require cash flow waterfalls.
- The two main types of option pricing models are binomial tree and Black-Scholes.
- These models are based purely on mathematical formulas rather than subjective criteria.
- And, therefore, are more or less a straightforward calculator built into Excel.
Initial Public Offering (IPO) Model:
- Investment bankers and corporate development professionals also build IPO models in Excel to value their business in advance of going public.
- These models involve looking at comparable company analysis.
- It involves an assumption about how much investors would be willing to pay for the company in question.
Sum of the Parts Model:
- This type of model is built by taking several DCF models and adding them together.
- Any additional components of the business that might not be suitable for a DCF analysis (e.g., marketable securities) are added to that value of the business.
- This type of model includes multiple business units added into one single model.
- Typically, each business unit has its own tab, with a consolidation tab that simply sums up the other business units.
- This is similar to a Sum of the Parts exercise.
Components of a Financial Model
The components of a financial model depends upon the purpose of building the model, the final user of the model etc. So, we cannot form an exhaustive list of items to include in a financial model. However, the following items are common in all the financial models:
-Balance Sheet (Source & Application of Funds)
-Cash Flow statement
Who should learn Financial Modeling?
The financial modeling program doesn’t require anyone to have a commerce background.
Anyone can learn financial modeling who wants to understand decision making. It may be in the form of project finance, or equity research or any other field where decision making comes in handy.
If you’re a CFA student, the CFA® Program would have taught you the theoretical base on valuation, investment banking etc.
In Financial Modeling, you will learn how to use this conceptual understanding in the practical world. Here you will prepare financial models of company to estimate its valuation.
And for a CA student, who doesn’t want to get into the traditional fields of audit, account and tax and instead covets Investment Banking, Private Equity, Equity Research, should learn Financial Modeling.
Moreover, many CAs work in Project Finance as well. Financial Modeling will help you to make Project Finance reports using all the contemporary techniques.