What is financial modeling?

- [Instructor] What is Financial Modeling? At its core, financial modeling is really just a business
form of what we call a model. So what is a model? Well it's really a simplified representation of
reality. A map is a great example of this. If you think about what a map does, it helps us to
simplify reality. It tells us how to get from point A to point B, and only focuses on the details we
worry about or care about, like what streets to take to get to our destination. We avoid all of
the unimportant details that we don't care about. Things like what tress or buildings are along
the way, or what other cars might be around, things like that. If we had to represent the full
complexity of reality, including trees and buildings, the map would be much more difficult to
read. A financial model does exactly the same thing. Every major company decision is
decided based on how much the outcome of that decision is worth. Firms need a way to figure
out how to make those decisions based on the reality of the world without all the gory detail
that's unnecessary, and that's where financial modeling comes in. Financial Modeling involves
assessing a future level of cash flows for a particular business or project, and then the risks
around those cash flows. We put these things together, we take our current cash flows in
reality, what we project them to be in the future, and then we value those based on the risks to
the business. That's what a financial model does at its core. In particular, when we get
done, our financial model should help us to summarize a number of different factors from
reality into a single output that we care about. The particular output might vary depending on
the model or the business, but it could be something like net present value, or internal rate of
return. It might be the value per share for a company that we're considering buying, or for our
own company. It might be an internal metric, like debt service coverage. Whatever that metric
is, the financial model helps us to get there. In particular, the financial model lets us focus on
the key issues and risks. Just like the map helps us go from point A to point B, a financial model
lets us take our business from our starting point to our intended destination, without having to
worry about unimportant details along the way. Now a good financial model then needs to
have three characteristics. Number one, needs to be simple, but not so simple as to artificially
distort reality. Number two, it really needs to focus on the key cash flow drivers for the
business. What are the key factors that drive the business forward? These need to be captured
in the model so that decision makers understand them. And then third and finally, it needs to
convey the assumptions and conclusions that business decision makers care about. If we're
gonna assume that revenues will grow at 5% on an annual basis going forward, our financial
model needs to make that clear. There's nothing wrong with making those assumptions as long
as they're clearly identified for managers and business decision makers. In particular, a good
financial model should help us to evaluate risks around a business decision. We can use a
variety of techniques to evaluate those risks: Sensitivity analysis, break-even analysis, scenario
analysis, and more. The financial model helps us to understand the risks and complexities of the
business decision that we're making. There's a variety of alternatives to a traditional financial
model. For example, business decision makers often rely on gut feeling or back of the envelope
calculations. These are a great sanity check for a financial model, but they're not a
substitute. Smart business decision makers know that financial models are an important
starting point for most decisions. The financial models that we use can be either deterministic
or stochastic. Deterministic models set assumptions and then compute financial ratios and cash
flows based on those assumptions. We can also use stochastic models. These are really
involving a lot more probability theory. We won't talk about those as much in this course, and
they're more complex to implement in reality, so they're not as widely used. A couple of
important notes here: First of all, you can't model what you don't understand. For that reason,
we're making the assumption that you understand something about finance. If you need a
refresher or maybe help with the basics, I recommend two courses here on linked and
learn: Excel for Corporate Finance Professions, and Excel for Management Accounting. Each of
these will give you the background that you need to be able to succeed with financial modeling
going forward.

Why is financial modeling important?

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- [Instructor] Why should you care about financial modeling? In the next few minutes, I'll
explain what financial modeling is, and how understanding it can help you move your career
forward. For anyone pursuing or advancing a career in corporate development, investment
banking, FP&A, also called financial planning and analysis, equity research, commercial
banking, or any other area of corporate finance, building financial models is part of the daily
routine. The reality is that for many of the most lucrative and exciting areas of finance, financial
modeling is a critical skill that you need to have. In particular, financial modeling is really just a
tool to help decision makers make decisions. These kinds of decisions include, for
example, whether or not to invest in a company, an asset or security, whether or not to pursue
a project, like, for example, a new R&D project at a firm, or building a new factory, whether or
not to pursue a merger acquisition deal. Either to sell the company that you currently work for,
or to purchase another company. Or whether or not to raise capital from the outside
markets. All of these kinds of decisions are critical to the future of any company that's out
there, and financial modeling is what helps us make those decisions. In particular, a good
financial model allows decision makers to test scenarios, observe potential outcomes, and
hopefully make an informed decision, that's the idea at least. Now, the reality is that today,
there's a lot of talk about new software programs being used in modeling. But, take it from me,
based on my experience, and based on the experience of countless other corporate finance
professionals, Excel is still the dominant software tool for financial modeling, the vast
majority of financial modeling takes place in Excel. There was a newspaper report a few months
ago about how certain companies were moving away from Excel, and starting to use other
software programs in financial modeling, but a follow-up survey to that, and the vast majority
of user response to that article showed that Excel is still the dominant tool in this space. If
you're going to be an effective financial modeler, then, you need to understand Excel, and you
need to be able to perform financial models in Excel. At this point, hopefully you understand
the basics of when and where financial modeling is useful.
Business questions and financial models

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- [Instructor] Financial modeling lets us evaluate very specific sets of circumstances and make
decisions based on those situations. Since the kind of decisions we make in business differ
under various circumstances, the models that we use to evaluate those decisions differ as well.
There's a few major types of financial models that you'll encounter in a business setting. The
first of these is what we call a corporate financial model, or a three statement model. The goal
in a corporate model or three statement model is just to understand how the firm is performing
and how it's expected to perform in the future. So it helps us to evaluate where the firm is
going if things continue as they have been in the past. To build this kind of model, we're gonna
use the corporation's history. All firms generally have a history unless they're a brand new
startup. We assume that that corporation will last indefinitely in the future. Now that probably
won't happen in reality of course, but it does mean that we can make an assumption about the
firm's terminal value in the end. So we take the firm's historical cash flow figures, project them
for a period of time, and then assume that at some point in the future we just wanna have the
corporation sold or shut down or closed, and the terminal value is the value at the conclusion of
our financial model. The second type of financial model we'll encounter is a project finance
model. This is typically built around what we call a DCF or discounted cash flow model. A
project finance decision involves a company looking at a particular investment option. Be it a
new R and D project, a new piece of equipment, perhaps building a new facility, et cetera. All of
these different kinds of projects have different phases. An investment phase, a revenue
generation phase, and then a closing phase. So we buy a new piece of equipment for example,
we have to install that equipment, it operates for a while, and then eventually the equipment
wears out, and we throw it away or scrap it or sell it. So we have no history in the case of a DCF
model. Instead we're just gonna focus on our projected cash flows of the future, and we're
gonna project them throughout the entire history of that particular project or investment. And
that'll let us make a decision about whether this investment is a good choice or a bad choice.
Third, we have what we call a leverage buyout model. Leveraged buyout models are closely
related to M and A or merger and acquisition models. These kinds of models involve a defining
transaction for a company. One company buying another. These have important characteristics.
For example, what is the purchase price for the acquired company? What's the holding period
for this company investment? And then do we sell or exit that investment in the future? These
kinds of models need to show how any alternative financing sources are repaid. Are we
borrowing money from the bank? Or issuing bonds, perhaps. Those kinds of financing decisions
need to be taken into account by the model. We also need to demonstrate the return earned
by an equity investor. Following up on an M and A model, we have what we call an integrated
consolidation model. These will compute the earnings per share and other financial ratios
before and after an acquisition. And this lets us get a better handle on whether that acquisition
was successful, and whether or not we have successfully combined the two companies as we
initially intended to.

Data for a model

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- [Instructor] Effective financial modeling is driven by data, but different types of models require
different kinds of data. In the next couple of minutes, I'll show you how to determine what data
you will need to build an effective financial model. All businesses have access to lots of data.
There's a variety of different sources of data that you can use when it's time to start gathering
data to build a financial model. You'll probably have access to proprietary data, like customer
data, for example, you certainly have access to publicly available data, for example from the
U.S. Census Bureau or the Federal Reserve. But you probably want to start with internal data.
Most financial models begin with internal data, for example, data about historical financials for
the firm, revenue, costs, profits, et cetera. You wanna build in some external data for scenario
analysis, though, or where you are trying to model something that's particularly complicated,
and where external factors may play a big role on the outcome the company sees. So where
can you get the data you need? You have three choices: buy it, build it, or gather it. Those are
the three options to get any piece of data that you need, and they're the only three options. If
you're going to buy data, there's a variety of vendors out there that you can choose from,
depending on the type of data that you need. Building data is more difficult, but it won't
necessarily cost your company any money directly. If you're trying to build a data set, you
might, for example, be able to rely on internal data the company already has, or at least be able
to build data based on an existing customer base, your CRM, et cetera. And then finally, you can
gather data from a variety of public sources to build your data set. So, what type of data do you
need for the project? Well, that's the key question in any financial model. Your data needs are
driven by your project needs. So ask yourself, what are you trying to model? Is this a short-term
financial model, meaning less than a year, or is it a long-term financial model over multiple
years? Is this a model where external factors are gonna play a major role in the decision making
process? If so, you probably want external data about the marketplace and competitors. Or is
this primarily an internal financial model, where success or failure of the decision will be driven
by internal decisions made by the company. In that case, you may not need any external data at
all. So start by thinking about what you're trying to model, and then ask yourself what the
characteristics are of that decision, and that'll tell you what data you need for your project.
Now you're ready to start identifying and collecting data specific to your firm and its particular
needs and issues.

Sources of data

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- [Instructor] Identifying the data you need for a financial model is just the first step. You also
need to actually go out there and gather that data from various sources. Fortunately, this is
easier than it once was. Thanks to some great tools and databases that are available online.
Traditionally, one big issue for firms in complex financial models was the lack of external data.
You usually had to pay for that data that could be very expensive. Today, there's a variety of
great sources for free external data. Three top sources you'll wanna consider, depending on
what you're trying to model, are the BLS or Bureau of Labor Statistics, The Fed or Federal
Reserve, and the U.S. Census Bureau. Each of these has different data sets that you could use
depending on the financial model that you're trying to build. For something like in the model of
how your company's labor costs will change over time and as a result how your profits will
change over time, BLS data might be more helpful. For conditions related to the financial
system as a whole and perhaps the economy, Federal Reserve data is more likely to be more
helpful. And for issues related to your customers and your market share, and your ability to
raise prices, data on those customers from the U.S. Census Bureau might be key. In addition
you can also gather data on non traditional metrics that you might care about. Google Trends
has a variety of different kinds of data related to searches that are done through its search
engines. This is great data to use in a variety of different scenarios. Now, in addition to external
data that you could gather, if you want data on specific industries or competitors, there's a
good chance that you're gonna have to buy it. In particular, buying that data is most realistic if
we're talking about gathering data specific to a particular industry and the competition we face
in that industry. Be aware, though, that it can be very expensive to buy this kind of data. So
make sure that it's data that you really and truly need for the project in question. An alternative
to buying data can be surveys. There's a variety of new online tools for conducting surveys. And
this gives you the ability to get data on OPCs, other people's customers. Understand what it is
your competitors are doing that you're not doing and then how that will influence your market
share over time. The key, though, is to understand what kind of biases you introduce by using a
survey. Remember, any survey that you do needs to be representative of the rest of the world.
So if you're trying to figure out how to sell to other customers or new customers you need to
ask yourself if the existing customers you're surveying are representative of your target
customers. Now you should have a handle on where to go to get data in general for a financial
model you might wanna construct.

Gathering data from FRED for Excel

- [Narrator] While many financial models may not require special data, some do. In particular, if
you're making projections about the future, or about the level of market share a firm will have,
it's helpful to have outside data as part of that process. You can often get this data through
Excel. In particular, I'm gonna show you how to use a tool called "FRED" to do this. Now FRED,
or the Federal Reserve Economic Database, is available for free from the St. Louis Federal
Reserve. You will need to download a special free Excel add-in, and generally you'll want to use
the Excel 2013 version. Go ahead and download that Excel add-in, and you'll be ready to use it.
Once you're in Excel, you're prepared to begin downloading data from FRED, but to do this, you
need to install the add-in. So you'll want to go to File, then down to Options, come over to Add-
Ins, and then come down to Manage Excel Add-Ins and click Go. Once you'll do that, you'll see a
variety of different add-ins you can use, but you won't have FRED just yet. You need to figure
out where you've downloaded that FRED add-in to. Typically you'll find the FRED add-in in your
Downloads folder. Go ahead and add that add-in, then click OK. Once you do this, you should
see a new tab pop up at the top that says FRED. Now FRED is great because it gives you the
ability to directly download data into Excel for a variety of different areas you might be
interested in. Let's pretend that we're doing a financial model related to auto sales. Well we
could go and buy data from someone like Hoovers for example, or Merchant, but we could also
get data related to auto sales from the federal reserve. If we click Browse Popular US Data, we'll
see a variety of different types of data that we might be interested in. Everything from
production and business activity data, like industrial production numbers or housing starts, to
data on payroll, job openings, number of hours worked, data on gross domestic product, and
other overall national level indicators to the health of the economy. And of course data on
inflation and money supply. We even have data available internationally, from a variety of
major countries around the world. Now, let's go ahead and download some data that might be
useful to us in certain settings. For example, maybe we're trying to do some sort of an analysis
related to future market share around a company that's in the automobile business. Well,
wouldn't it be helpful to understand how fast auto sales are growing over time? To do that, we
can download data on like-vehicle sales, and we'll add to that perhaps a couple other factors
that we care about. So maybe we are also interested in, for example, inflation... And perhaps
we're interested in oil prices. As I clicked each of these different indicator variables that we're
interested in, you'll notice that an acronym, or pneumonic, popped up in the top of the column.
That's the code that tells FRED which data point we're interested in. Once we have this data,
we're ready to click "get FRED data" and now the data will auto-fill over time. This shows us, for
example, the level of automobile sales in millions of units sold each month from 1976 through
2018. Now, maybe we're not interested in going back as far as 1976. Perhaps we want to start
with 1990 data for each of these different variables. To do that, we'll change the year in the
date shown in row four for each column. So I'm going to change automobile sales from starting
in 1900, or as early as the data is available, to starting in 1990. I'll do the same thing in column
C, in cell C4, which will tell me about inflationary data, and then again in E4, as it relates to oil
prices. Once I do this, I can click "get FRED data" and all of my data now updates so that it starts
in 1990 and goes through present time in 2018. At this point, you should understand how to
use FRED to pull in outside data that's relevant to your financial modeling needs.