Financial modelling is a crucial step in the process of financial statement preparation. Financial models refer to spreadsheets built in MS Excel, used by companies to forecast the financial performance of a business. It is based on the historical performance of the company as well as future expectations and assumptions. To efficiently carry out financial modelling, analysts first prepare income statements, balance sheets, cash flow statements, and supporting schedules. This is also commonly known as the 3-statement model.
As a budding expert in this field, having a detailed understanding of the concept of financial modelling is key. This article will provide you with a detailed understanding of financial modelling and how important it is in decision-making and cash-flow forecasting.
What is a financial model and what is it used for?
Financial models have many types and many use cases. Every financial model serves as an important part of economic decision-making and pinpointing KPIs that are important for business forecasting. All in all, it is an integral tool that helps perform financial analysis, both inside and outside the company. Financial models are used for making decisions concerning the following:-
- Getting acquisitions (assets or business)
- Raising capital (equity or debt)
- Organic growth of the business (e.g., opening new stores, entering new markets, etc.)
- Business forecasting and budgeting
- Disposing or selling business units and assets
- Allocating capital
- Business valuing
- Analysing financial statements or ratio
- Accounting management
What is Financial Modeling Used for
Financial modelling is a combination of business, accounting and finance metrics to develop a forecast of the future results of a company. It aims to forecast the future financial performance of a company accurately. Financial experts and analysts use financial modelling for the following:-
- To assess future finance-related events in the business and economic changes that affect the company's performance and market value.
- To make an estimate of the company's valuation and performance with its market competitors. The cost required to invest in new projects is estimated and assessed to evaluate their profitability. This facilitates rational decision-making.
- Financial models also help executives in raising capital via equity or debt, merging with or acquiring a company, diversification of business, investing in new projects, allocating the budget, and determining the business valuation.
- Financial models can help project the existing and forecasted financial position a company is in.
Role of Financial Modelling in Decision-Making
Decisions can make or break a company. Be it marketing, financing or business-related, the role of decision-making paves the pathway to either success or downfall of an organisation. The financial model of a company consists of important KPIs all compiled in a spreadsheet for stakeholders and executives to review and make finance-related decisions.
Financial modelling compiles accounting, business and finance metrics into one sheet. This spreadsheet is crucial as it forecasts future development and results of the company and the future performance of a company. Decision makers therefore heavily bank on financial models to streamline financial decision-making. Financial modelling is further used for determining company value and whether they should consider raising capital or growing business via acquisitions or organically.
Some of the key present value decisions that bank on efficient financial modelling are:-
- Linear programming decisions: Banks on the company’s background and its history of management techniques.
- Business value decisions: Banks on analysing the cost of capital, forecasting assumptions and Pro-forma financial statements.
- Pivot tables decisions: Banks on data analytics.
Businesses also depend on the following past value decisions that can only be facilitated via efficient financial modelling:-
- Financial dashboard decisions: Banks on common financial measures and dashboard principles.
- Budget management decisions: Banks on the development and management of budgets and cash-flows.
- Amortisation table decisions: Banks on corporate bonds, bank borrowing and PP&E (Property, Plant, and Equipment)
Role of Financial Modelling in Cash-flow Forecasting
Cash-flow forecasting is conducted to foresee the future financial position of a company to streamline financial management. It is a core planning tool that companies use in both decision-making and managing overall finances.
Cash flow forecasting helps project the company’s financial position in the market by taking into account the anticipated receivables and payments. A cash flow forecast is extracted from the income statement and the balance sheet. The Financial modelling involves forecasting cash flows from three types of activities:-
- Operating activities: The operating activities involve operating costs and revenues extracted from financial statements. For every operating asset or liability, the forecast year is compared with the previous year.
- Investing activities: Investing activities include purchasing and selling assets. All items related to investing activity are from PP&E (Property Plant & Equipment) forecasts and fixed assets. Fixed assets are forecasted based on the assumption that the assets are depreciated during disposal and there is no business-related activity (Purchase or sale) involved.
- Financing activities: Financing activities include raising debt and issuing shares. Financing activity items are mostly calculated via a simple comparison of the projected year with the previous year. For instance, Dividend cash flows can fall under either financing or operating activities depending on what the organisation wants. However, the financial statements should reflect them with accuracy.
Monitoring cash flows should be prioritised in every organisation. Forecasted cash flow is further compared with actual cash flow for the present period. Accurate cash-flow forecasting needs:-
- Efficient communication lines
- Proper detection of inflows & outflows
- Predicting several scenarios accurately
- Comparing the results.
However, forecasting is a crucial element in financial modelling and not only requires financial strength but also a team of experts to overcome cash flow crises.
Financial forecasting is a key process in decision-making because it accurately projects how a company will fare in the future. It is a crucial tool that analysts use to facilitate appropriate decision-making for businesses and organisations at large. Financial modelling, therefore, is a highly valuable skill to have.
The most ideal way to become a financial modelling expert is through regular practice and staying updated with equity reports. There are numerous professions and career tracks for which hands-on experience in building financial models can come in handy. Some of them include investment banking, corporate development, equity research, accounting and FP&A. To make it big in the field of investment banking, private equity or corporate finance, you can sign up for the Financial Analysis Pro-degree offered by Imarticus Learning.