What is financial modeling - It’s scope, uses, types, and how to build a financial model? | Explained

What is financial modeling, it’s scope, uses, types, and how to build a financial model?

What is financial modeling?

Financial modeling is a tool for decision making, let me elaborate, whenever you want to make a decision or let’s say a sensible decision, you need some data, some information, some calculation to support that. That usage of information, data to decide something is nothing but a financial model. Let’s narrow it down a bit more and most importantly will also learn how to build a financial model.

Financial modeling is an activity of preparing any entity’s future financial statement, this future financial statement is known as financial models.

Let me explain, based on the information I have right now about the business entity, maybe I could use its past three years of financial information, the current information about the industry and my thoughts, my conclusions about How the future will unfold? How sales of an entity would increase? Will the demand for the product that the entity is offering will increase or go down? How the capital structure would change? How will the profits increase? What are the assets required to maintain/increase the level of sales?

Based on all these things I would try to estimate how the future financial statements of any particular business would look like. Though financial modeling is not only concerned about financial statements, it goes far beyond but on the very ground level, this exactly is the definition of a financial model. We are trying to prepare an entity's future financial statements using the information and the conclusion that we are going to make about the business and industry information that we have right now.

Tools used to prepare financial models

To build any financial model we need to process a lot of information data and the best tool we have right now is Microsoft Excel. Although financial models can be prepared on any spreadsheet software but there is no other software that is as comprehensive and easy to use as Microsoft Excel. It is widely used in the industry to prepare financial models. So, it’s always beneficial to have a good grip on Microsoft Excel.

(For more information on the usage of Excel, do check out our other articles below)

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So, I hope, now you have a broad understanding of what financial modeling is, now let’s move to the next section.

 

Types of financial models.

1. Three statement model:

In this model, we are going to prepare the entity’s future profit and loss account, balance sheet, and cash flow statement. This is the most common and most popular financial model that is being used in the industry.


2. Merger model:

When there’s a merger or acquisitions of entities, it is required to anticipate the earnings, synergies, profit margin, cash flow, the capital structure of new entities post-merger or acquisitions. Some questions that are required to be answered before M&A are such as what will be the revenue of the new entity, what would be the capital structure of the new entity, etc. Hence, we need to predict all this information through merger models.

 

3. Discounted cash flow model, also known as the DCF model:

In this, we try to predict the future free cash flow of the business and discount it using the appropriate rate and then try to calculate the value of the business and ultimately value per share. This is used for valuation purposes.

 

4. Sum of parts model:

When any business is deriving revenue from multiple segments, for example, Reliance Industries is deriving revenue from petrochemicals, telecoms, retail, and other sectors as well. So, it is very difficult for us to calculate the value of entire reliance industries in one go, as the assumptions and industry situation would change based on the particular business. Considering similar assumptions for all businesses would not give us fair results and thus what we will do is, We would calculate the value of businesses one by one, for example, will value the petrochemical business, then telecom business, then retail business and similarly the value of other businesses and ultimately summing up all the different business values to come up as a single value of the entire Reliance Industries.

 

5. Leveraged buyout model, also known as LBO model:

This model is used by PE firms to make a decision while buying entities by using heavy debts, so whenever any private equity firm purchases any business using lots of debt and uses the cash generated from this business to pay out the debts, ultimately reducing the level of debts and increasing the level of equity, it is called as LBO model.

 

6. Comparable company analysis:

It is another kind of financial model that is used to calculate the value of a business based on how the market is valuing similar businesses or the businesses operating in the same industry. It is also used for valuation purposes.

 

7. Initial public offering model (IPO):

It is very similar to the DCF model or comparable company analysis. Although you have one extra element that is IPO discount.

 

8. Option pricing model:

Under this, we use the BMM model or binomial model which uses complex formulas to calculate so it is more or less statistical in nature while other models were revolving around your accounting principles, mathematical principle, and financial knowledge.

 

Uses of financial model

We saw multiple kinds of financial models; they are prepared for the purpose of decision making. So, what are the decisions you can take or what are the uses of the financial models, we will have a look at those under this section.

 

1. To assess the future operating performance of the business:

In order to increase sales we need to increase the number of employees, so this kind of application can be done in order to calculate breakeven units i.e. how much units are required to be sold to reach a point of no profit or no loss, in simple words minimum units that need to be sold to avoid losses.

 

2. To assess future financial performance:

That is how your profits will be in the future i.e. in two years or three years or five years down the line, what will be the profit margin? what are the sales that we need to achieve those profits?

 

3. To estimate the capital expenditure that a particular project required:

How much money needs to be funded and how that funded money will be used? what all will be invested in the fixed assets and current assets? Etc.

 

4. To understand the requirement of funds in the future:

It includes short-term fund requirement that is your working capital requirement as well as your long-term fund requirement that is equity financing or debt financing, getting funds from PE funds.

 

5. To understand what all the cash flows/free cash flows my business is generating:

You can estimate the free cash flow that your business will be generating. We all know the value of any asset is nothing but the present value of whatever earnings are going to be generated from that asset in the future, discounted at an appropriate rate.

 

6. To calculate the value of the business or calculate the value of equity i.e. nothing but enterprise value. 

 

7. To perform ratio analysis:

We can calculate ratios such as profitability ratios, liquidity ratios, solvency ratios, capital structure ratios, and many more. We can use the financial model to compute these ratios and analyze the business performance

 

8. To understand how my sales are growing, how my profits are growing:

That is nothing but the trend of business it includes upward growth, static growth, downward growth, no growth, negative growth.


9. To perform stress testing, sensitivity analysis, scenario analysis:

Although these terms are used interchangeably but there is a difference. Basically, three scenarios are built in a financial model such as the worst-case scenario, the best-case scenario, and the base-case scenario.

 

These are the multiple uses of financial models and there could be n numbers of uses. Now let us move ahead to our next section and also one of the very interesting section

 

How to build a financial model?

So these are theoretical steps which are going to be discussed here, there is no way you could learn financial modeling just by reading this article or watching online videos, it’s always about how much you practice, still, this will definitely help you to understand the basics and clear some important confusions or doubts you might have and help you to create the financial models.

So, by this point, we know there are n number of financial models that are possible, here I will be talking about the basic financial model that is the “three statement model”. Now how do I make my three-statement model?

So below are the steps we need to follow:

1. Input historical financial information into Excel, that means we have entered what we have, the facts, the data which the company have already mentioned in their annual reports (In order to learn how to read and analyze annual reports, Click here)  

 

2. Determine the assumptions that will drive the forecast, how much revenues will increase, how much cost will increase, how much assets do I need, these all need to be included in the financial model as an assumption.

For example, I am assuming my revenue will increase by 10% every year based on facts and past performance of the company, there can be n numbers of combinations and permutations. Basically, we have our past data and industry information based on which I will be putting my assumptions about how the future will unfold and what are the factor that will drive those assumptions.

 

3. Forecast the income statement, once I have noted down my assumptions regarding future revenue, cost, etc. I can calculate my profit and loss, right? Once I have my income statement ready, we will move to the next point.

 

4. Forecast capital assets, in order to achieve that particular sale how much money I need to invest in the machinery. For example, investing in any particular kind of technology that will help me to boost my sales in the future. 

 

5. Forecast capital structure, in order to buy these capital assets I need funds, and funds can be sourced in two ways, one is debt and another is equity, so I need to find out where I will be getting this debt, what will be the interest rate, what will be the contribution of equity holders from where I will be getting this equity. I need to put in all the assumptions related to that.

 

6. Forecast the balance sheet, once I have my capital structure ready, I need to forecast my balance sheet, I have my assets, I have my sources of funds than I can forecast my balance sheet. Once I’m done with the balance sheet, we will move to the next point

 

7. Forecasting the cash flow statement, we already have the required information so it won’t be a problem to forecast the cash flow statement, technically it would be already done, just we have to complete it. (Very easy task)

 

8. Prepare output sheet, there will be some reason why you are preparing the financial model it could be assessing the profitability of the project or it could be to calculate the net present value of the project or it could be calculating the rate of return of the project, whatever it would be we are concerned with the reason why we are preparing the financial model and that is something that would be included in the output sheet i.e. the sole motive of preparing the financial model.

 

Final Verdict - Decision

Post this we are going to make a decision and mention it separately, so let me explain the final part, if you want to undertake a project only if the rate of return is say 20%, so after preparing the financial model we will get the rate of return that would be derived from that business and if it meets our requirement say it’s 20% or more than it, then we will proceed with the project or else we will reject it.

I hope you enjoyed this brief overview on what is financial modeling, it’s scope, uses, types, and how to build a financial model. If you have any doubt, do let us know in the comment box below.

 

Thanks for reading

The Finance Magic 


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