What is Financial Modeling?

Financial Modeling is a tool that can be used to forecast a picture of a security or a financial instrument or a company’s future financial performance based on the historical performance of the entity. Financial Modeling includes preparing of detailed company specific models which are then used for the purpose of decision making and performing financial analysis. It is nothing but constructing a financial representation of some, or all, aspects of the firm or given security. OR  it is mathematical model of different aspects of financial health of a given company and this model can be made on a simple not book paper or in excel, with later it is easily possible to analyse  the impact of different assumptions or change in value of various variables hence gives the more flexibility. Financial modeling is a mirror which shows whether

• An Organization is in need of additional funds (debt or equity) or not
• how a business will react to different financial situations or market conditions
• In which company we should make investment for better returns i.e. comparative analysis
• Analyzing and defining  the risk level
• Has the company had a change in direction that is loss of customers, expansion etc.
• Identifying of Strategic and Business Plans through finding strengths and weaknesses.
• It’s a technique to value and analyze Firms, IPOs and FPOs

A good financial model should

• Be relatively simple
• Focus on key cash flow drivers
• Clearly convey assumptions and conclusions
• Evaluate Risks

Financial Modeling forms a core of various other Finance areas like Equity Research ,Investment Banking. Credit Research etc.  If you are searching for a Financial Modeling Online Course/Training then you may consider one of our Financial Modeling courses  here.

Applications of Financial Modeling

The  purpose of Financial Modeling is to build a Financial Model which can enable a person to take better financial  decision.The decision could be affected by future cash flow projections. debt structure for the company etc. All these factors may affect the viability for a project or investment in a company.The Applications of Financial  Modeling mainly includes the followings :

• One applications of Financial Modeling may be Business Valuation that is deciding the fair value for a business. Financial Modeling will help participants to reach to a price they are willing to pay or accept for the selling  business.
• Second applications of financial modeling is Organization’s decision making and scenario preparation .Financial Modeling is used by organizations for future planning  their long term goals according to different situations that may arise.
• To decide the Cost of Capital – if a company is going to invest in a new project then Financial Modeling for it will give analysis for debt/equity structure and expectation in return by investors ,thus setting benchmarks for project to meet .
• Capital Budgeting -Financial Modeling helps companies determine alloting  resources for major expenditure or investment etc.Purpose – increasing the value for the firm.
• Project Finance
• Financial Statement Analysis

Basic Financial Analysis tools include

• Common size financial statements
• Analysis of Various Ratios
• Trend or Pattern analysis
• Industrial comparatives

Best Practices in Financial Modeling

In Financial Modeling it is desired that the working should be error less and should be easier to read and understand for audit purposes. By following these key principles, model will be easier to navigate and check, and reliable.

• For most obvious results we need to follow the Firms standard format
• Maintaining appropriate number of sheets
• Using page breaks wherever required
• Writing Executive Summary on top if desirable
• Maintain versions of documents if future up gradations are expected

The following points should be kept in mind:

Spreadsheet Design

• Using modular spreadsheet blocks will make changing each sheet easier without affecting others.
• Proper protection should be given to the sheets and workbooks from unauthorized usage.
• Labeling sheets, columns and rows with their applicable headings so that files will become easy to follow.

Better Document your assumptions

• Assumptions documentation helps with validation & avoids misinterpretation.
• Listing assumptions will be helpful for easier and quicker understanding.
• Adding source data as well as calculations will provide a good map.

Use Linking and not hard-coding

• Linking wherever required will be a good practice such that when the inputs change, the outputs will be changed automatically
• It will save lots of hassles at final stage or at working stage

Facilitate Data entry at one place only

• Avoid retyping of data, entering it once as a source and referencing it will make good sense.
• It’s always better to link cell value rather than writing numeric value for calculations.

Good Practice is using Consistent Formulas

• Using formulas and functions will be accurate and will save time.
• Do not copy formula from one sheet to another as it will create links in 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

Formatting Charts

• Be precise with chart axes scale
• Creating a VBA Style Guide containing rules and details about coding standards is good

Format and Label Clearly

• It’s very important to format cells appropriately i.e. we should follow standard practices eg. we should use symbols for currency. percentages values etc. which will make model  easier for reading.
• In Financial Modeling clear labeling is very important to improve readability
• Try using different background colors for distinguishing input areas and calculation parts

Common Financial Modeling Approaches

Financial Modeling – Income Statement: Line Item Drivers

a) Financial Modeling –Revenues Projections For most companies revenues are a fundamental driver of economic performance. A well designed and logical revenue model reflecting accurately the type and amounts of revenue flows is extremely important. There are as many ways to design a revenue schedule as there are businesses. Some common types include:

1. Sales Growth: Sales growth assumption in each period defines the change from the previous period. This is simple and commonly used method, but offers no insights into the components or dynamics of growth.
2. Inflationary and Volume/ Mix effects: Instead of a simple growth assumption, a price inflation factor and a volume factor are used. This useful approach allows modeling of fixed and variable costs in multi product companies and takes into account price vs volume movements.
3. Unit Volume, Change in Volume, Average Price and Change in Price: This method is appropriate for businesses which have simple product mix; it permits analysis of the impact of several key variables.
4. Dollar Market Size and Growth: Market Share and Change in Share – Useful for cases where information is available on market dynamics and where these assumptions are likely to be fundamental to a decision. For Example: Telecom industry
5. Unit Market Size and Growth: This is more detailed than the preceding case and is useful when pricing in the market is a key variable. (For a company with a price-discounting strategy, for example, or a best of breed premium priced niche player) e.g. Luxury car market
6. Volume Capacity, Capacity Utilization and Average Price: These assumptions can be important for businesses where production capacity is important to the decision. (In the purchase of additional capacity, for example, or to determine whether expansion would require new investments.)
7. Product Availability and Pricing
8. Revenue driven by investment in capital, marketing or R&D
9. Revenue based on installed base (continuing sales of parts, disposables, service and add-ons etc). Examples include classic razor-blade businesses and businesses like computers where sales of service, software and upgrades are important. Modeling the installed base is key (new additions to the base, attrition in the base, continuing revenues per customer etc).
10. Employee based: For example, revenues of professional services firms or sales-based firms such as brokers. Modeling should focus on net staffing, revenue per employee (often based on billable hours). More detailed models will include seniority and other factors affecting pricing.
11. Store, facility or Square footage based: Retail companies are often modeled based on the basis of stores (old stores plus new stores in each year) and revenue per store.
12. Occupancy-factor based: This approach is applicable to airlines, hotels, movie theatres and other businesses with low marginal costs.

b) Financial Modeling – Costs projections Drivers include:

1. Percentage of Revenues: Simple but offers no insight into any leverage (economy of scale or fixed cost burden
2. Costs other than depreciation as a percent of revenues and depreciation from a separate schedule: This approach is really the minimum acceptable in most cases, and permits only partial analysis of operating leverage.
3. Variable costs based on revenue or volume, fixed costs based on historical trends and depreciation from a separate schedule: This approach is the minimum necessary for sensitivity analysis of profitability based on multiple revenue scenarios

c) Financial Modeling – Operating expenses

1. General and Administrative: Generally treated as % of Revenues
2. Sales and Marketing: Generally modeled as % of Revenues. In some cases, it is actually a revenue driver and not driven by revenues. For example, brokerage business or pure plays trading and marketing firms.
3. R&D: Generally R&D costs are treated as % of revenues.

d) Financial Modeling – Interest expense (or Net interest expense):

1. This is one of the few income statement items that is driven by balance sheet information. A interest schedule is generally developed to i) calculate interest received on cash and short term investments and ii) calculate interest expenses arising from all types of debt. Interest rate assumptions are needed.
2. Ending balance of previous year can be used to calculate interest expenses to avoid circular reference in excel
3. Average balance can be used as well (it will give circular reference though)

e) Financial Modeling – Income taxes :

1. Effective tax rate is generally used. Effective rate is calculated as Taxes paid / Pre-Tax income.
2. For future years, either the marginal tax rate equivalent to the country of incorporation is taken or if the effective rate is much lesser than the marginal tax rate then during the initial years, tax rate can be low but gradually would have to be moved to marginal tax rate. For example, In India, marginal corporate tax rate is 33%.

Balance Sheet: Line Item Drivers (Assets)

•  Cash and Cash Equivalents:

• Linked to cash from Cash Flow Statement

Balance Sheet: Line Item Drivers (Liabilities)

• Financial Modeling – Current Liabilities Projections

• Accounts Payables (Part of Working Capital Schedule):
• Payables turnover = Payables/COGS * 365; For Historical
• Assume Payables turnover days for future years based on historical trend or management guidance and then compute the Accounts Payables using the formula given below
• Accounts Payables = Payables turnover days/365*COGS
• Short Term Debt: Usually modeled as part of debt schedule
• Accrued Liabilities: Kept constant most often; Can be modeled as % of sales
• Deferred taxes: Kept constant most often; Can be modeled as % of sales
• Other Current Liabilities: Can be modeled as % of COGS or as % of Sales

Who should study Financial Modeling?

The Financial Modeling could be beneficial to a vast majority of peoples,Some of the cases are summarized below

• The aspirants of Financial Modeling Course can be everybody who wants to explore the world of finance and get involved in money related decision making. These people can be Executives, Business planning and strategy deciders, 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 firms
• It’s an added advantage for those people who are  pursuing  CA, MBA, CFA, FRM 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 want to  gain knowledge out of passion or curiosity

Now after knowing Who can do Financial Modeling Course now let us look at what all it need. to go for a financial modeling training  .

Who can do Financial Modeling OR Financial Modeling Pre-requisites:

The following points could be advantageous :

• Basics of Finance and accounting concepts (e.g. fundamental, valuation concepts etc.)
• Thirst to learn financial conceptual terminology, general business procedures and self confidence.
• Usage of Excel

Though even if you know nothing about above mentioned knowledge then do not get dishearten it simply means that you are supposed to take a course which starts from basics and covers MS Excel in detail as Excel is very essential for Financial Modeling so there is no escape and this part should be strong If you want to check out one such Online Course offered by us which covers everything exhaustively then you can click here