Understanding Financial Modeling
Financial modeling can be understood as a process of creating a company’s financial summary based on the income and expenses incurred in a spreadsheet format that can be used to calculate the impact of a major event in the future. It’s a mathematical model that helps to predict the future financial performance of an enterprise or a project based on historical data. It is the numeric representation of all the company’s operations which generates income and incurs the expenditure.
The forecast based on financial models takes multiple factors into account such as historical performance, future assumptions, macroeconomic trends, etc. There are various types of financial models, the most basic one is known as the 3 statement model; it requires preparing income statement, cash flow statement, balance sheet and supporting schedules. Some of the more complex models are discounted cash flow analysis model, sensitivity analysis, leveraged-buyout, etc.
What is the purpose of preparing financial models? Well, there are numerous applications of financial models. Some of the most mainstream uses include financial performance analysis and investment decision making. These use cases apply to both internal and external parties who are interested in the growth prospects of the company. Financial models help an analyst to facilitate complex multi-variable analysis and make models that closely represents a real-world scenario.
Investment-related decision making might include decision regarding the capital structure, acquiring business or assets, growing operations, asset diversification and sale, valuation, budgeting, capital allocation, etc. The internal party has numerous applications of financial modeling when it comes to decision making. Different types of models paint different pictures; it all depends on the inputs and assumptions related to that particular model. It is also used to compare the overall financial performance of one corporation with another or for two different industries.
Best Practices in Financial Modeling
Now that we have understood what financial modeling is all about, let’s jump into some of the best practices in the financial modeling arena.
Financial modeling is all about closely representing the real-world variables that might have an impact on financial performance. The model should focus on simplifying the variables rather than complicating them. It’s paramount to create a financial model in a logical and easy format. You can achieve that by building the complete model on a single worksheet and then use grouping for segregation. This helps to easily expand and contract the models.
The pattern of the flow of contents in the financial model is significant. A commonly used pattern in sections that can simplify your model is as follows (from top to bottom).
• Income statement
• Balance sheet
• Cash flow statement
• Supporting schedules
• Sensitivity analysis
• Graphical data
Formatting the contents of your model properly is considered more as a necessity than the best practice. It is very crucial to differentiate between the inputs and outputs in a financial model. Inputs here can be the assumptions and the calculations can be the output. You can easily apply the basic formatting conventions to reach the standard by making inputs in blue and outputs in black. Other basic formatting conventions in financial models include using borders, shading cells, etc.
As a financial analyst, your primary job is to build financial models on spread-sheet applications like excel. You need to be aware of the best practices in applications like Excel. You need to master the shortcuts and other hacks related to the tools being used. You need to use your keyboard more often and avoid using a mouse for making alterations. You should be mindful of the formulas and should try to keep it short and break down complex calculations into easy steps.
Also Read: Best Way to Learn Financial Modeling