Financial Modelling: Complete Guide To Learn Financial Modelling

What Is Financial Modelling?

Financial modelling is the process of estimating the financial performance of a project or business by taking into account all relevant factors, growth and risk assumptions, and interpreting their impact. It enables the user to acquire a concise knowledge of all the variables involved in financial forecasting.

Financial modelling is the task of building an abstract representation, called financial models, of a real-world financial situation. It is a mathematical model constructed to denote a simplified version of the performance of a financial asset or portfolio of a business, project, or any other investment. Financial models are activities that prepare a model representing a real-world financial situation. They are intended to be used as decision-making tools.

What Is a Financial Model Used for?

Financial models are useful for many applications. Businesses commonly use them for:

Valuations and raising capital. If you’re aiming to go public, for example, bankers will run financial models to determine how much the company is worth. You might also need to provide models in order to get venture capital funding, loans or other types of financing.
Budgeting and forecasting. Budget and forecasting models help finance understand the company’s performance based on input from its various components. As each program, department and business unit creates its own budget, they can then roll them up into a single overall financial model for the entire business to be used to allocate resources and predict financial results for the coming year.
Measuring possible outcomes of management decisions. You might use a financial model to predict changes in revenue if you were to, say, raise the price of your top-selling product next year.
Credit analysis. Investors will use financial models to determine the likelihood of your business repaying its debts, if they are to lend you funds.

Why Are Financial Models Important?

Financial models are the simplest way to compute performance and express projected outcomes for your company.
Depending on the specific model, they can advise you regarding the grade of risk associated with implementing certain decisions.
Financial models can also be used to devise an effective financial statement that reflects the finances and operations of company.
This is important for pitching investors, securing loans or calculating insurance needs.
The applications are virtually limitless, but the basic idea is that they help you understand where your company stands now, how it has performed historically and what to expect in the future.

Who Uses Financial Models?

Anyone with an interest in the financial performance and outlook of a company could use a financial model, and there are courses for developing the skill.
However, professionals in business development, accounting, financial planning and analysis ,equity research, private equity and investment banking frequently develop models in the course of their usual duties.
Each of these analysts use different types of models depending on the focus of their business.

Objectives of Financial modelling:

Financial models help in steering historical analysis of a company, projecting a company’s financial performance used in various fields.
These financial models are predominantly used by financial analysts and are constructed for many purposes.
Financial modelling supports the management in the decision-making and the preparation of financial analysis by creating financial models.

The following are the objectives of creating financial models:

Valuing a business
Raising capital
Growing the business
Making acquisitions
Selling or divesting assets and business units
Capital allocation
Budgeting and forecasting

The best financial models offer a set of basic assumptions. For example, one commonly forecasted line item is sales growth.

Sales growth is documented as the increase, or decrease, in gross in the most recent quarter compared to the previous quarter. For financial modelling, these are the only two inputs financial models need to calculate sales growth.

Financial modelling will create one cell for the prior year’s sales, cell A, and one cell for the current year’s sales, cell B. The third cell, cell C, would be used for a formula that divides the difference between cell A and B by cell A.

This will be the growth formula. Cell C, the formula, would be embedded into the model. Cells A and B are input cells that can be changed by the user. In this case, the purpose of financial modelling and creating financial models is to estimate sales growth if a certain action is taken or a possible event occurs.

What Are The Different Types Of Financial Models Used In Financial Modelling?

In practice, there are many different types of financial models. We have outlined the 10 most commonly used financial models used by financial modelling professionals.

1. Three-Statement Model

A three-statement model links the income statement, balance sheet, and cash flow statement into one dynamically connected financial model. These financial models are the basis on which more advanced financial models are built such as discounted cash flow DCF models, merger models, leveraged buyout LBO models, and various other types of financial models.
It falls under both the categories of financial models: Reporting models and Integrated financial statement models.

2. Discounted Cash Flow (DCF) Model

These types of financial models fall under the category of Valuation models and are typically, though not exclusively, used in equity research and other areas of the capital markets.
A DCF model is a specific type of financial model used to value a business. DCF model is a forecast of a company’s unlevered free cash flow discounted back to today’s value, which is called the Net Present Value (NPV).
The basic building block of a DCF model is the three-statement financial model, which links the financials together.
The DCF model takes the cash flows from the three-statement financial model, makes some adjustments where necessary, and then uses the XNPV function in Excel to discount them back to today at the company’s Weighted Average Cost of Capital (WACC).

3. Merger Model (M&A)

The M&A model also falls under the Valuation category of financial models.
As the title suggests, this type of financial modelling is towards a more advanced model applied to assess the pro forma accretion/dilution of a merger or acquisition.
It’s common to use a single tab model for each company, where the consolidation is represented as Company A + Company B = Merged Co.
The level of complexity can vary widely and is most commonly used in investment banking and/or corporate development.

4. Initial Public Offering (IPO) Model

Like the previous two type to financial models, the IPO model is also a Valuation model.
Financial professionals like investment bankers develop IPO financial models in Excel to value their business just before going public.
These financial models equate company analysis with regards to an assumption about how much investors would be willing to pay for the company in contention.
The valuation in an IPO model includes an IPO discount to ensure the stock trades well in the secondary financial market.

5. Leveraged Buyout (LBO) Model

A leveraged buyout (LBO) is a transaction where a company is acquired using debt as the main source of consideration.
These transactions typically occur when a private equity (PE) firm borrows as much as they can from a variety of lenders and funds the balance with their own equity.
An LBO transaction typically requires financial modelling with debt schedules and are an advanced form of financial models.
An LBO is often one of the most detailed and challenging of all types of financial models as they many layers of financing create circular references and require cash flow waterfalls.
These types of models are not very common outside of private equity or investment banking.
When it comes to an LBO transaction, the required financial modelling can get complex.
The added complexity comes from the following unique elements of an LBO:
High degree of leverage
Multiple tranches of debt financing
Complex bank covenants
Issuing of Preferred shares
Management equity compensation
Operational improvements targeted in the business.

6. Sum of the Parts Model

Another type of financial model that belongs to the Valuation category of financial models, this model is developed by taking in account a number of DCF financial models and adding them together.
Further, any sundry factors of the business that may not be apt for a DCF analysis are added to that value of the business.
So, for example, you would sum up, that’s why ‘Sum of the Parts’, the value of business unit A, business unit B, and investments C, minus liabilities D to arrive at the NAV for the company.

7. Consolidation Model

The Consolidation Model belongs to Reporting Model category of financial models.
It includes several business units added into one single model for financial modelling and further analysis.
Typically, each business unit is its own tab, with consolidation tab that simply sums up the other business units.
This is similar to a Sum of the Parts exercise where Division A and Division B are added together and a new, consolidated worksheet is created.

8. Budget Model

The Budget model is used to do financial modelling in financial planning & analysis to get the budget together for the next few years, typically in the range of one, three and five years.
Budget financial models are meant to be based on monthly or quarterly figures and rely strongly on the income statement.
This is one more model belonging to the Reporting model category of financial models.

9. Forecasting Model

Similar to the budget model, the forecasting model is also used in FP&A to come up with a forecast that compares to the budget model.
Since it is similar to the forecasting model, it also belongs to the Reporting model category of financial models.
The budget and the forecast models are represented one combined workbook and sometimes they are totally separate.

10. Option Pricing Model

As the name suggests, this model is part of the Pricing model category of financial models.
Binomial tree and Black-Sholes are the two main option pricing financial models and are based purely on mathematical financial modelling rather than specific standards and therefore are an upfront calculator built into Excel.

Financial Modeling Examples

To get a better picture of a financial model in use, imagine a bakery is acquiring a candy company.
The bakery could use a complex financial model for mergers and acquisitions to add the valuation of both companies together and present the new valuation of the combined entity.
When pitching to an investor, your company might prepare models that demonstrate the growth investors could expect to see based on your company’s projected sales or improvements in overhead due to economies of scale.
Or, if your print shop is seeking to build a new store with financing from a loan, the bank will use models to determine your company’s creditworthiness and the likelihood that your new location will be successful.

Why Is Financial Modeling so Important?

The possibility of a financial model’s outputs perfectly matching reality is very low.
After all, financial models are based upon a narrow set of assumptions from a range of possible inputs.
With so much uncertainty, why should business owners bother themselves with building a financial model?
And why do investors care so much about it? Improved finance skills can lead to significantly increased opportunities of success and thus founders should invest in improving these skills.
There are several reasons why founders should devote significant resources to building their model, which can be perceived as a manifestation of finance skills. Two of these reasons include:

a. A financial model gives direction on where the company is going.

In other words, it can reveal the main business drivers and, in the case of significant deviation, provides insight on where the company should focus in order to manage or hedge risks.

b. It is a strong indication to investors that the founders know what they are doing and that they understand the business.

The various assumptions and reasoning behind the financial model demonstrate whether the founders are reasonable thinkers or not, meanwhile providing a necessary tool for the company’s valuation.

Conclusion

Though financial modelling is a generic term that means different things to different users, the reference usually relates either to accounting and corporate finance applications, or to quantitative finance applications.

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