What is Financial Modeling?
Financial modeling is the process of predicting and analyzing the company’s future performance, generally through spreadsheet software likeMicrosoft Excel. This includes:
- Calculating future cash flows
- Determining funds and their future needs
- Evaluating company performance, and more
Financial models often help decision-makers, such as business managers or parties, in an M&A transaction. As a result, they are probably one of the most common tools used across the financial modeling industry.
Financial modeling is a fundamental skill that is important for performing financial analysis. Industry professionals use it to derive a company's current value based on an analysis of its future performance.
Financial modeling is used in banking, private equity, and other related finance and investment industries to value businesses, structure deals, and advise on transactions.
On the other hand, corporate analysts use financial models to analyze trends in their company’s performance and help managers make critical decisions on future business operations. Hence, financial modeling skills are a must-have for those looking to get started in the world of finance.
Building a Financial Model
The first step to building a financial model is understanding the model’s objectives and deciding what type of model meets those objectives. Your model exercise will almost always begin with building the three-statement model.
Next, make a list of inputs that are needed for your model. Some examples of inputs include:
- The costs of goods sold
- Wages and salaries
- Sales revenue
- Operating expenses
- Capital expenditures (CAPEX)
- Depreciation expense
- Interest expense, or income
The next step is to figure out the sources from which to obtain these inputs. They can often be located on the historical financial statements and equity research reports. Other places include 10-K and 10-Q filings, as well as merger proxies.
Lastly, fill out and connect the formulas or equations used in the model. Many different formulas or equations can be used depending on the type of model you’re building.For example, if you’re building a three-statement model on the income statement, one equation might be sales revenue minus the cost of goods sold equals gross margin. Wages and salaries can be reduced from it to arrive at operating profit.
Who Builds Financial Models?
Financial models are built by professionals who work in the finance industry. Examples of such industries include:
- Investment banking
- Private Equity
- Valuation
- Accounting
Financial modeling is usually performed by those working in junior roles. They build these models to help their seniors make the right decisions and provide essential input to the overall decision-making process. At the senior levels, the skill lies not in financial modeling itself but in interpreting the model’s output. However, someone who has never built a financial model will have a hard time figuring out what the output means and how they are related to the model’s inputs.
Requirement of Accounting Knowledge
To understand financial modeling, you must have good familiarity with accounting. Accounting includes the study of transactions and analyzing and presenting historical financial data. It is a subset of business administration and finance.
A strong background in accounting allows you to understand financial models and comprehend how their various components interact with each other.
Excel for Financial Modeling
Financial modeling is usually performed on tools that make number crunching and data analysis easier and faster. Excel is the most commonly used tool for financial modeling. It is a versatile software that meets all the requirements required to build models, such as:
- Versatility
- Flexibility
- Built-in formulas
An often underrated and underutilized functionality is the possibility of creating informative dashboards. This feature is mainly used in corporations, where data is presented periodically in reports.
An example of this is the treasury department. This organization is required to manage the cash flow in the business and hence has to generate reports for follow-up on receiving payments from debtors, or structure payments to creditors, to ensure that there is no shortage of funds at any point.
Excel Skills Required for Financial Modeling
Understanding how to build and interpret a financial model is only one part of the equation. Having a strong background in Excel is one of the essential prerequisites to land a role in finance.
Since finance is a fast-paced industry, it is of utmost importance that anyone looking to break in matches the pace. This means cranking out a financial model every day instead of taking a fortnight.
Being efficient with Excel can mean the difference between going home at 10 PM instead of way past midnight. Unfortunately, it is one of the reasons why new analysts tend to suffer a lot after landing a role in finance.
