Financial Modelling and its Different Types: The financial modelling is all about creating or constructing a replica or a dummy (model) representing the real world of the financial market situation. It is a logical-mathematical abstract model which simplifies the performance of a business, strategies based on finance, investments, tradings for a financial asset or an instrument.
The financial modelling is a summary of earnings, expenses pertaining to the finance of a company, industry, conglomerate or a business chalked out on a spreadsheet. It assists in decision making and knowing its impact in the future. The helps in forecasting the upcoming events by evaluating the historical performance concerning revenues, profits, losses and other aspects.
Tools Used For Calculations
For establishing an assumption, one may need cash flow statements, income statements, balance sheets, and supporting schedules as tools.
It can help in inditing ultra-advanced models including (LBO) leveraged buyout, sensitivity analysis, (DCF model) discounted cash flow analysis, balance sheet and mergers and acquisition and many more.
Usage of Financial Models
The primary focus and aim of financial models are to analyse and check the performance of various companies and industry hailing from an array of domains. It can take place within or the outside. Some decisions executed by executives inside of a company are:-
- Divesting of business units and assets.
- Forecasting and planning the allocation of budget for future projects.
- Boost the growth of a business and channelising it by organic means.
- Evaluating the capacity of a business model.
- Helping the company purchase or acquiring promising prospects.
- Raising capital and funds through IPO, equity or debts.
It organises a blueprint on which prominent to frivolous financial transactions take place.
Know The Basics of Financial Modelling
It represents the operational activities of a company in every sphere in the form of data or numbers.
The intent of tools used under the jurisdiction of financial modelling is to derive a decision that benefits the company. They can help find the estimates, time frame and costs of a project in totality, which results in putting a plan into perspective. Financial experts and analysts utilise them to know the underlying impact of a policy change before it getting on to the floor.
It can assist in testing scenarios and anticipate the allocation of resources required while scratching through a plan.
There can be plentiful models producing distinguishing results based on different findings. Remember, without a proper input or assumption, a model may collapse. Hence, accurate information must go into it.
The Building of a Financial Model
The development of these models may also depend on financial professionals and how they conceptualise it. Some streams of a company that use it casually and usually are financial planning and analysis, equity research, investment banking, transaction advisory, valuations, accounting etc.
The primary task that it handles in portfolio management.
How to Put Financial Modelling into The Best Practice?
A building is as good as the outlines on a piece of paper. Likewise, knowing the best ways to practice the phenomenon on an excel sheet.
Here are some ways:
- Minimise the use of mouse and learn to expedite it through the keyboard.
- For hard-codes and inputs, one can use a blue font, while formulas can remain in the black.
- For building scenarios use of ‘Choose‘ function is appropriate.
- Learn how to use excel formulas and their needs.
- To query the provided data, use index as well as match and not Vlookup.
- Use simple formulas for breaking the complex calculations into accessible forms.
Layout and Design
An improper layout or structure of a financial model can derail the project. Hence, keeping the design logical and simple is critical. It means drawing an entire model on a single spreadsheet, while for other sections utilising the grouping option. It can help around in moving the logistics of the model while expanding and contracting it as per requirements. The method also incorporates diligence and flexibility.
Some Important Sections:
- Charts and graphs
- Cash flow statements
- Balance sheet
- Income statement
- Sensitivity analysis
- Assumptions and drivers
- Supporting schedules
A work of proper formatting is half the job done. One can make out the distinction between the calculations and assumptions easily, where the former represents the output and the latter input. By marking formulas with different colours, it is achievable. Conventions like using borders and shading cells can assist in it.
A Step Guide For Building a Financial Model
The financial model is not about putting all the intelligence, but where and how to put it with due diligence. It is an unending passage that requires withdrawing and drawing sections and fields before the logic grips the attention. Sometimes hit and try formula may work, but there’s a method to the madness.
Some tips that can help in driving toward the detailed and thorough examination of learning to sketch out a unique excel model.
Beginning of Models
The starting of every financial model depends on its historical data and what transpired in the past. Based on the SWOT analysis, conclusions are drawn, and assumptions are made. It all begins with getting hands over three years of cumulative financial statements that have all the transactions from a plethora of streams and put them into an excel sheet.
After this, the process of reverse engineering is initiated on the historical data to find out the impact and method. For this, calculations for gross margin, fixed costs, revenue growth rate, inventory days, AP days etc. are deciphered. Through them, one can objectively assume the forecast for hard-codes (period).
Calculation of income statement becomes more comfortable once the forecast assumption is in place. The top revenue, operating expenses, COGS, profits, losses can be calculated to EBITDA. However, calculating taxes, depreciation, interest, and amortisation may take time.
Kick Start the Balance Sheet
Subsequently, after addressing the issue of the income statement, one can start with the balance sheet and fill the income column. One can begin with the calculation of inventory and accounts receivable. They are among primary functions of COGS, AR Days, inventory days assumptions and revenue. After that, one can start filling the payable accounts columns. That’s a function of AP Days and COGS.
Schedule For Capital Assets
Without the induction of capital assets like property, plant and equipment interests, loans or debts, one cannot complete a balance sheet and an income statement. Here, the historical period would be also used to pull the PP&E schedule. After processing it, one can subtract the depreciation and add capital expenses. The interest will depend on the debt balance (average).
The debt schedule will also arise from the historical period. Increase in debts can be added while repayment can be subtracted from it.
The Accomplishment of The Balance Sheet
The completion of the balance sheet and income statement happens when the information of supporting schedule reaches the final point. It can help in calculating income, revenue, taxes before and after earnings. After that, one can link closing debt balance and PP&E balance from the given schedules. By getting in the data of the previous years’ closing balance, the equity of a shareholder can get accomplished. For the totality, add the capital raised and net income and subtract it by stocks repurchased for reaching the final result.
The Building of Cash Flow
After completing the balance and income statement sheets, it is the time to create a cash flow statement. The reconciliation method is also useful to the process. Begin it with the net income, adjust changes in the working capital of non-cash, add the depreciation back. The practice will result in cash for operation. The utilisation of money in it is the cash expenditure function for the PP&E schedule. On the other hand, for raising equity and debt, cash from financing acts as a function for assumptions.
The calculation of free cash flow is necessary after completing the three statement model. It helps in acknowledging the valuations of businesses. Today, it gets discounted at the firm’s capital for cost.
Scenarios and Analysis
After the completion of valuation sections and DCF analysis, scenarios and sensitivity analysis come into the game of the model. The analysis finds out the impact of assumptions on the company’s overall value. It gives a fair idea of risks involved in investments or in the budget allocation while setting up a business.
Graphs and Charts
They represent the clear picture of the whole scenarios by giving the fair idea, how it all began and reached the crescendo. A learned financial analyst would also know the usage of graphs and charts to communicate a business model through precision. It is the professional and well-perceived way of covering a complete financial model. It saves time and provides a detailed picture of every financial detailing.
It is not over till it’s over. So, testing and auditing to find out that the entire model is working as per the requirements are essential. By doing so, one can make the necessary changes in time. One can check the formulas and the balance sheet and overall calculations. The process dwells deeper into accuracy.