What is financial modelling

• Financial modeling is one of the most highly valued, but thinly understood, skills in financial
analysis.

• The objective of financial modeling is to combine accounting, finance, and business metrics to
create a forecast of a company’s future results.

• A financial model is simply a spreadsheet which is usually built in Microsoft Excel, that forecasts
a business’s financial performance into the future.

• The forecast is typically based on the company’s historical performance and assumptions about
the future, and requires preparing an income statement, balance sheet, cash flow statement,
and supporting schedules (known as a three-statement model).

Why financial modelling is used

• There are many types of financial models with a wide range of uses. The output of a financial
model is used for decision-making and performing financial analysis, whether inside or outside
of the company. Financial models are used to make decisions about:

• Raising capital (debt and/or equity)

• Making acquisitions (businesses and/or assets)

• Growing the business organically (e.g., opening new stores, entering new markets, etc.)

• Selling or divesting assets and business units

• Budgeting and forecasting (planning for the years ahead)

• Capital allocation (priority of which projects to invest in)

• Valuing a business

• Financial statement analysis/ratio analysis

• Management accounting 

TYPES OF FINANCIAL MODEL:

There are various kinds of financial models that are used according to the purpose

and need of doing it. Different financial models solve different problems. While majority of

the financial models concentrate on valuation, some are created to calculate and predict risk,

performance of portfolio, or economic trends within an industry or a region. The following

are the different types of financial models:

DISCOUNTED CASH FLOW MODEL:

Among different types of Financial model, DCF Model is the most important. It is
based upon the theory that the value of a business is the sum of its expected future free cash

flows, discounted at an appropriate rate. In simple words this is a valuation method uses

projected free cash flow and discounts them to arrive at a present value which helps in

evaluating the potential of an investment. Investors particularly use this method in order to

estimate the absolute value of a company.

COMPARATIVE COMPANY ANALYSIS MODEL:

Also referred to as the “Comparable” or “Comps”, it is the one of the major company

valuation analyses that is used in the investment banking industry. In this method we

undertake a peer group analysis under which we compare the financial metrics of a company

against similar firms in industry. It is based on an assumption that similar companies would

have similar valuations multiples, such as EV/EBITDA. The process would involve

selecting the peer group of companies, compiling statistics on the company under review,

calculation of valuation multiples and then comparing them with the peer group.

SUM-OF-THE-PARTS MODEL:

It is also referred to as the break-up analysis. This modeling involves valuation of a

company by determining the value of its divisions if they were broken down and spun off or

they were acquired by another company.

LEVERAGED BUY OUT (LBO) MODEL:

It involves acquiring another company using a significant amount of borrowed funds

to meet the acquisition cost. This kind of model is being used majorly in leveraged finance

at bulge-bracket investment banks and sponsors like the Private Equity firms who want to

acquire companies with an objective of selling them in the future at a profit. Hence it helps

in determining if the sponsor can afford to shell out the huge chunk of money and still get

back an adequate return on its investment.

MERGER & ACQUISITION (M&A) MODEL:

Merger & Acquisitions type of financial Model includes the accretion and dilution

analysis. The entire objective of merger modeling is to show clients the impact of an

acquisition to the acquirer’s EPS and how the new EPS compares with the status quo. In

simple words we could say that in the scenario of the new EPS being higher, the transaction
will be called “accretive” while the opposite would be called “dilutive.”

OPTION PRICING MODEL:

On, to buy or sell the underlying instrument at a specified price on or before a

specified future date”. Option traders tend to utilize different option price models to set a

current theoretical value. Option Price Models use certain fixed knowns in the present

(factors such as underlying price, strike and days till expiration) and also forecasts (or

assumptions) for factors like implied volatility, to compute the theoretical value for a

specific option at a certain point in time. Variables will fluctuate over the life of the option,

and the option position’s theoretical value will adapt to reflect these changes.

Start With Historical Facts: If

the company preparing the
financial model
has been in existence for some
time, it would be a wise move
to start with its
historical financial statements.
This is because an analysis of
the past statements often
reveals hidden trends which
may shape up the future.
However, it needs to be
understood that past trends are
only indicative, and the future
could be very different.
Start With Historical Facts: If the company preparing the financial model has been in existence for some
time, it would be a wise move to start with its historical financial statements. This is because an analysis
of the past statements oftenreveals hidden trends which may shape up the future. However, it needs to
be understood that past trends are only indicative, and the future could be very different. However, in
many cases, financial models are developed for start-up companies where there are no past details
available. In such cases, details of a comparable company can be used, or this step may have to be
skipped.

Step #2: Isolate The Parameters: The purpose of a financial model is to accurately forecast the revenues
and the expenses which may occur in the future. However, it is important to understand that these
revenues and expenses do not function in isolation. These revenue and expense numbers are actually
the result of an interaction between several underlying parameters. Therefore, if an attempt is made to
predict the numberswithout understanding the parameters involved, it is likely that the predictions will
notbe very accurate. Hence, understanding the key parameters which influence the business is of vital
importance. These parameters may be specific to the industry or even to a specific organization.For
instance, companies which use commodities as their input or output must be mindful of the effect of
fluctuations in commodity prices. For example, an increase or decrease in steel and cement prices will
have a huge impact on the real estate industry.Similarly, if a company derives a major part of its revenue
from exports, then it may be vulnerable to fluctuations in currency rates.

At the end of this stage, a financial modeler must have identified all the relevant parameters which are
likely to impact their business. These parameters must be isolated and provided as an input to the user.
This will provide the user with the ability to vary the parameters one at a time and validate the results.
The individual effect of each parameter on the breakeven level and the profitability can be identified if
the model has been designed well.

Identify Cost Behaviours: A profit and loss statement shows a static view of the expenses involved.
However, the reality is that not all expenses behave in the same manner when the volume of production
increases or decreases. For instance, depreciation charge remains the same, regardless of the output
that a machine produces. Similarly, labor charges remain more or less fixed in the short run, regardless
of whether they are used for production or not. However, there are costs such as raw materials, which
vary directly with the level of production. Also, there arecosts such as electricity which may increase
with the increase in production. This is because successive units of electricity are more expensive as
compared to previous ones

It is important that this behavior of different costs has been fed into the financial model. This will ensure
that the model gives reliable results when it is simulated to know the expected profitability at different
production levels.

Step #4: Identify Inter-relationships Amongst Parameters: A financial modeler must ensure that their
model is logical at all times. For this reason, it is important that they identify the inter-relationships
between various parameters and also model them. For instance, a rise in price would have an inverse
relationship with the quantity sold. Similarly, a rise in one expense may sometimes reduce or even
eliminate other expenses. The problem is that the relationship between parameters is often complex.
and non-linear. Identifying and modeling them accurately is an art which needs to be learned over
several years.

Step #5: Provide a Range for all Parameters: More measures need to be taken to ensure the logical
accuracy of the model. It is for this reason that all parameters whichhave been identified need to be
given a range. If the results of the financial model go beyond a certain range, it should throw an error.
Companies, then need to run thousands of iterations of these tests to ensure that all possible errors
have been identified and even rectified in the process. The end result would be a sturdy and dependable
model which can be used for decision making.6.

Step #6: Scenario Analysis: Lastly, the financial model should be built in such a manner that it does not
give only one result. The reality is that the future is highly uncertain, and decision-makers would be
better off if they are provided several scenarios. For example, the best-case scenario when revenues are
the highest and the costs are the lowest. The worst-case scenario when costs are the highest and
revenues are the lowest.

Benefits of Financial modelling

• The benefits of financial modelling are huge.

• Availability of information: for decision making in order to take strategic advantage.

• Even if a model is based on assumptions, this can help you to estimate the financial results.

• In a model, different scenarios can be created and tested. Thus, a company can adapt quickly to
a changing situation and avoid liquidity risk.

• Flexibility :

• Experienced Financial Modeller can make extensive changes to a model in a few hours.

• Efficiency:
 • Spreadsheet programs are installed by default on most computers and therefore no additional
investment is required. In addition, no programming skills are required

• Fosters deeper understanding

• By inputting every single figure from the annual report, an investor is forced to scrutinize each
and every account on a yearly basis.

• Such a process fosters a deeper understanding of a company and uncovers anomalies which an
investor might otherwise miss out

Disadvantages of Financial Modelling

The Cons

Time consuming.- Building a model is indubitably a time-consuming affair, depending on the level of
details, it can take between one to a few hours to get all the numbers in. Based on the 80-20 rule,
there is diminishing returns to the amount of additional information generated per unit time spent.
Time spent on modelling is likely to be more productiveif spent on other forms of analysis

Inaccuracy.
- Financial models are built on a
myriad of assumptions,
resulting in grossly inaccurate
forecast figures and misguided
investment decisions. This is
the most common gripe
against financial modelling, and
a valid one. On a more serious
note, financial models
are also extremely prone to
manipulation due to the large
number of assumptions it
requires. In this regard, a
financial model is hardly an
objective tool for investment
analysis, and can instead
exacerbate an investor’s innate
biasedness
Inaccuracy. - Financial models are built on a myriad of assumptions, resulting in grossly inaccurate
forecast figures and misguided investment decisions. This is the most common gripe against
financial modelling, and a valid one. On a more serious note, financial modelsare also extremely
prone to manipulation due to the large number of assumptions it requires. In this regard, a financial
model is hardly an objective tool for investment analysis, and can instead exacerbate an investor’s
innate biasedness