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

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