Financial Modelling: What is it and how can you use it

The ability to forecast financial outcomes is more crucial than ever.
It allows investors to navigate uncertainty, make informed decisions, and strategize for the future.

But what exactly is financial modelling? How does it work? And more importantly, how can you harness its power to drive your business forward?

In this comprehensive guide, we’ll delve into the intricacies of financial modelling, exploring its various types, best practices, and real-world applications.

Let’s get started.

What is financial modeling?

Financial modeling is the art and science of creating a mathematical representation of a company’s financial performance. This representation, typically built in a spreadsheet, aims to forecast the company’s financial future based on historical data, assumptions, and expectations.

The primary purpose of financial modeling is to provide a tool for informed decision-making. By creating a detailed and dynamic model, executives, analysts, and investors can:

• Predict outcomes: Financial models allow users to project a company’s financial performance under various scenarios, helping them anticipate potential results and plan accordingly.
• Assess risks: By stress-testing the model with different assumptions, users can identify potential risks and evaluate the company’s resilience in the face of uncertainty.
• Strategize on future actions: Financial models provide a platform for testing strategic initiatives, such as expansions, acquisitions, or new product launches, allowing decision-makers to evaluate the potential impact on the company’s financial performance.

Financial modeling is an essential skill for professionals in various roles, including:

• Corporate finance
• Investment banking
• Private equity
• Equity research
• Business development

A well-constructed financial model is a powerful tool that enables stakeholders to make data-driven decisions, communicate effectively with others, and navigate the complexities of the business world with greater confidence and clarity.

Types of Financial Models

Financial modeling encompasses a wide range of techniques and approaches, each designed to address specific business needs and objectives. In this section, we will explore three common types of financial models: three-statement operating models, discounted cash flow (DCF) models, and merger models (M&A).

Three-Statement Operating Models

Three-statement operating models provide a comprehensive view of a company’s financial health by integrating the income statement, balance sheet, and cash flow statement. This type of model is particularly useful for assessing the impact of strategic decisions on a company’s financials.

Key Components:

1. Income Statement: The model begins with revenue projections and then forecasts expenses to arrive at the net income.
2. Balance Sheet: The net income from the income statement ties into the balance sheet.
3. Cash Flow Statement: The balance sheet and income statement feed into the cash flow statement.

Example Scenario:
Consider a company looking to evaluate the potential impact of a price reduction strategy. A three-statement operating model would be the ideal tool for this analysis.

The model would:

1. Forecast how the price change affects sales volume and revenue.
   • For instance, a 10% price reduction could lead to a 15% increase in sales volume.
2. Calculate the overall revenue impact, considering the cost of goods sold remains constant.
   • In this example, the net effect would be a 5% revenue increase.
3. Flow the revenue impact through to the income statement, balance sheet, and cash flow statement to provide a holistic view of the strategy’s impact on the company’s financials.

Color-Coding Best Practices:
To ensure clarity and ease of auditing, it’s essential to follow a consistent color-coding scheme when building a three-statement operating model:

• Blue: Inputs
• Black: Formulas
• Green: Links to other worksheets
• Red: Links to other files

By adhering to these color-coding best practices, you can quickly identify the different components of the model and trace the flow of information.

Discounted Cash Flows (DCFs)

Discounted Cash Flow (DCF) is a valuation method used to estimate the attractiveness of an investment opportunity. DCF analysis uses future free cash flow projections and discounts them to arrive at a present value estimate, which is used to evaluate the potential for investment.

The basic principle behind the DCF model is the concept of time value of money, which states that a dollar today is worth more than a dollar in the future due to its potential earning capacity. In other words, the DCF model adjusts the value of future cash flows to account for the fact that money received in the future is less valuable than money received today.

Here’s an example to illustrate how DCF works in practice:

Let’s say an investor is evaluating a potential investment in a startup. The startup expects to generate the following cash flows over the next three years:

• Year 1: $50,000
• Year 2: $70,000
• Year 3: $100,000

If the investor’s required rate of return is 12%, the present value of these cash flows can be calculated using the following formula:

Where:

• PV = Present Value
• CF = Cash Flow
• r = Discount Rate

Plugging in the numbers, we get:

PV = 50,000 / (1+0.12)^1 + 70,000 / (1+0.12)^2 + 100,000 / (1+0.12)^3

= 44,643 + 55,816 + 71,181

= $171,640

So, based on the DCF analysis, the present value of the startup’s expected future cash flows is approximately $171,640.

The discount rate used in the DCF model is a critical component, as it represents the required rate of return for the investor. Often, the weighted average cost of capital (WACC) is used as the discount rate, which takes into account the expected returns of both debt and equity holders in the company.

DCF models are powerful tools for evaluating investment opportunities, but they are highly sensitive to the assumptions used, particularly the discount rate and the projected cash flows. As such, it’s important to carefully consider these assumptions and to perform sensitivity analysis to understand how changes in these assumptions can impact the valuation.

Merger Models (M&A)

Merger models, also known as M&A models, are essential tools used to assess the financial viability and potential benefits of a merger or acquisition. These models focus on forecasting the combined company’s financials post-merger and identifying potential synergies that could result from the deal.

Key aspects of merger models include:

• Combining financial statements of the acquirer and target companies
• Estimating the impact of the merger on key financial metrics, such as earnings per share (EPS)
• Analyzing potential synergies, cost savings, and revenue enhancements
• Determining the appropriate offer price and method of payment (cash, stock, or a combination)

One of the most important outputs of a merger model is the accretion/dilution analysis. This analysis determines whether the merger will be accretive (increasing EPS) or dilutive (decreasing EPS) to the acquirer’s shareholders.

For example, consider Company A (acquirer) with an EPS of $2.00 that is planning to acquire Company B (target) with an EPS of $1.50. The merger model would calculate the new combined company’s EPS based on factors such as:

• Offer price for the target company
• Method of payment (cash, stock, or a mix)
• Expected synergies and cost savings

If the resulting EPS is higher than the acquirer’s pre-merger EPS, the merger is considered accretive. Conversely, if the new EPS is lower, the merger is considered dilutive.

As we have seen, each type of financial model serves a specific purpose and provides valuable insights for decision-makers. Whether it’s assessing the impact of strategic decisions, evaluating investment opportunities, or analyzing potential mergers and acquisitions, financial models are indispensable tools in corporate finance.

Building a financial model

Building a financial model involves several key steps to ensure the model is accurate, reliable, and useful for decision-making. Here’s a closer look at the process:

1. Historical Data Analysis

• Gather relevant historical financial data, such as income statements, balance sheets, and cash flow statements.
• Analyze the data to identify trends, patterns, and key performance indicators (KPIs).
• Use this information to establish a baseline for the model and inform future projections.

2. Forecasting

• Develop assumptions about future growth rates, market conditions, and operational changes based on historical data and industry research.
• Project future financial performance using these assumptions, typically over a 3-5 year period.
• Create detailed schedules for revenue, expenses, capital expenditures, and working capital requirements.
• Link the schedules together to create a dynamic, integrated financial model.

3. Risk Assessment

• Incorporate sensitivity analysis into the model to understand how changes in key assumptions impact the outcomes.
• Identify the most critical variables and create scenarios to test the model’s resilience under different conditions.
• Use this information to assess the potential risks and opportunities associated with the modeled entity or project.

Throughout the process, it’s important to maintain a clear and logical structure, with well-documented assumptions and formulas. This ensures that the model is transparent, easy to navigate, and can be updated or modified as needed.

Best practices in financial modeling

When creating a financial model, it is crucial to adhere to certain best practices to ensure the model’s effectiveness, reliability, and usability. Here are some key best practices to keep in mind:

Accuracy and Simplicity:

• Strive for the highest level of accuracy in your financial model.
• Double-check formulas, links, and references to ensure they are correct.
• Keep the model as simple as possible, avoiding unnecessary complexity.
• Use clear and concise formatting to enhance readability.

Assumptions Documentation:

• Clearly document all assumptions made in the model.
• Provide detailed explanations for each assumption.
• Use comments or a separate worksheet to record assumptions.
• Ensure that assumptions are easily accessible and understandable to users.

Regular Updates:

• Keep the model up to date with the latest financial data and market conditions.
• Establish a regular update schedule to maintain the model’s relevance.
• Incorporate new information, such as changes in assumptions or actual financial results.
• Communicate updates to stakeholders and users of the model.

Other best practices include:

• Using consistent formatting and naming conventions throughout the model.
• Building in error checks and data validation to prevent incorrect inputs.
• Creating a user-friendly interface with clear instructions and navigation.
• Testing the model thoroughly to identify and fix any errors or inconsistencies.
• Collaborating with stakeholders to ensure the model meets their needs and expectations.

Software to use

When it comes to financial modeling, having the right software is crucial for creating accurate and efficient models. While there are various options available, two main categories stand out: spreadsheet software and specialized financial modeling software.

Microsoft Excel

Microsoft Excel is by far the most widely used tool for financial modeling. Its popularity can be attributed to several factors:

• Flexibility: Excel allows users to customize their models according to their specific needs and requirements.
• Familiarity: Many professionals are already proficient in using Excel, making it an accessible tool for financial modeling.
• Functionality: Excel offers a wide range of functions and features that are useful for financial modeling, such as formulas, charts, and pivot tables.

Despite its advantages, Excel may not always be the best choice for complex financial modeling scenarios. In such cases, specialized software can provide more targeted solutions.

Specialized Financial Modeling Software

For more advanced and complex financial modeling, consider using specialized software designed specifically for this purpose. Some popular options include:

1. Cube
2. Finmark
3. Mosaic
4. Planful
5. Jedox
6. Sage Intacct
7. Anaplan
8. Oracle BI
9. Jirav
10. Quantrix
11. Synario

These specialized tools offer features and functionalities tailored to the needs of financial modeling, such as:

• Built-in templates and frameworks for common financial models
• Collaboration and version control features for team-based modeling
• Integration with other financial data sources and APIs
• Enhanced data visualization and reporting capabilities

While specialized software can provide more powerful and efficient solutions for complex financial modeling, it’s important to note that they may require additional training and come with higher costs compared to using Excel.

Ultimately, the choice of software for financial modeling depends on the specific requirements of the project, the complexity of the model, and the resources available. Many professionals find that a combination of Excel and specialized software works best for their needs.

Typical users of financial modeling

Financial modeling is a powerful tool used by various professionals to make informed decisions and analyze complex financial scenarios. Two of the most common users of financial modeling are:

1. Corporate Executives:
   • Executives rely on financial models for strategic planning purposes.
   • Models help them create and manage budgets effectively.
   • Financial models assist in making crucial capital allocation decisions, ensuring optimal use of company resources.
2. Financial Analysts:
   • Analysts use financial models to determine the intrinsic value of businesses.
   • Models enable them to analyze potential investments and assess their viability.
   • By using financial models, analysts can provide well-informed advice on financial strategies to their clients or employers.

Whether it’s a corporate executive planning for the future or a financial analyst assessing investment options, financial modeling serves as an indispensable tool in their arsenal.

Real-World applications

Financial modeling has a wide range of practical applications in the business world. While there are numerous use cases, two of the most common applications are:

1. Investment Valuation
   • Discounted Cash Flow (DCF) models are frequently used to determine the fair value of stocks or other investments.
   • By projecting future cash flows and discounting them back to the present, investors can estimate the intrinsic value of an asset.
   • This helps in making informed investment decisions by comparing the fair value with the current market price.
2. Strategic Planning
   • Financial models are powerful tools for strategic planning and decision-making.
   • Scenario analysis allows companies to test the financial impact of different strategic choices.
   • By modeling various scenarios, such as best-case, worst-case, and base-case, managers can assess the potential outcomes of their decisions.
   • This helps in identifying risks, opportunities, and the most viable strategies for the organization.

Other notable applications of financial modeling include:

• Budgeting and forecasting
• Capital allocation and project evaluation
• Merger and acquisition analysis
• Debt and equity financing
• Risk management and sensitivity analysis

Conclusion

Financial modelling is an indispensable tool in today’s business landscape, offering invaluable insights for decision-making across various sectors. From investment valuation to strategic planning, its applications are vast and varied.

As we’ve explored, building an effective financial model requires a blend of technical skill, industry knowledge, and adherence to best practices. While tools like Excel remain popular, specialized software is increasingly being adopted for more complex modelling tasks.

Whether you’re a corporate executive, financial analyst, or aspiring entrepreneur, understanding and utilizing financial modelling can give you a significant edge in navigating the complexities of modern business. As the business world continues to evolve, so too will the techniques and applications of financial modelling, making it an exciting and dynamic field to watch and participate in.