Building Financial Model – Introduction
Have you ever sat in front of your computer for building financial models? And how was your experience? If that was your first time I am sure you switched off your computer and ran out to take a deep breath of fresh air. Believe me; building financial model is not a layman’s job. But then why all the Hype and the hustle bustle? And let me tell you one more fact that will blow your mind completely. No financial model software is 100% accurate. Yes, you heard me right! But it’s vital to create one anyway. I have tried my hands at building financial models and the journey was not easy. But let me tell you, even though the starting point is hazy, it all makes sense when you understand the main gist. Then you have your mind all cleared and there you are all confident and proud sitting in front of your computer for building financial models. Financial model software is important in equity related decision making. It will definitely guide you in evaluating whether you are rooting for the right company and the right stock.
The gist of building financial model
A financial model software is used to calculate, forecast or estimate financial numbers. A financial model for a project is simply a quantitative representation of financial information of a business, organization or a government. the financial model for a project can, therefore, range from simple formulas to complex computer programs that may take hours to run. These are the mathematical models in which variables are linked together. The motive behind building financial models is to help in a valuation of a security, forecasting future raw materials needs for a corporation, or determining the benefits of a hostile takeover or merger. And hence it is exclusively used by the financial analysts. And let me tell you if you want your Photograph to be taken in front of Wall Street, be sure that you are excellent in building financial model software. Also always remember this Golden Rule that Microsoft Excel skills are must to build or update financial model software. There are also some high-end programs built for complex financial model software such as Value-at-Risk (VAR) models, which is used in risk management.
Are there different types of financial models used on Wall Street?
Yes absolutely. It is Wall Street, so it’s got to have something big in financial models for projects as well. Most financial models software are focused on valuation. But there are these other financial models in excel templates that are meant to quantify and predict risk, portfolio performance, or general economic trends within an industry or region. Also at the same time, there are several different methods employed for valuation in financial modeling. The most common models used to assess the value of the security are the discounted cash flow models (DCF models) and capital asset pricing models (CAPM). However, the difference between the two is that; the discounted cash flow model is used to estimate the fair price of a security with respect to identifying undervalued securities. On the other hand, the capital asset pricing model focuses on the valuation of a security within the context of its volatility or risk.
There are other types of financial models software that you can use as per the need:
- Comparative Company Analysis model
- Sum-of-the-parts model
- Leveraged Buy Out (LBO) model
- Merger & Acquisition (M&A) model
- Industry-specific financial model
- Option pricing model
- Corporate finance models
These financial models for projects are used to solve different problems pertaining to the industry. The key here lies in identifying the time and type to use the correct financial model for a project. Hence to gain expertise in financial modeling, you should definitely know the basics of financial modeling in excel templates.
Where can you use financial models?
Financial models are used in:
- Historical analysis of a company
- Investment banking
- Equity research
- Projecting a company’s financial performance
- Project finance
- Real estate investments
- Oil & Gas projects
- Banks & Financial Institutions
- Personal finances
- Non-profit organizations
Users of Financial Models
There are four main groups of users who specifically concentrate on building financial models. Those are as follows:
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- Business owners and entrepreneurs
- Finance and Accounting professionals
- Financial Modelers and Consultants
- Individuals for personal finance
Let’s see the areas where you can use your financial modeling skills.
- Forecasting future raw material needs
- Valuation of a security
- Benefits of a merger or an Acquisition
- Check the size of the market opportunity
- Sketching the roadmap to profitability
- Evaluating the investment requirement
- Quantifying and predicting risk
- Evaluating Portfolio performance
- Identifying undervalued securities
Bear in mind that if you are involved in financial decision making for a large corporation, then you would definitely need financial model software day in and day out. Thus financial modeling is a mandatory activity for investment bankers, project finance persons, bankers, equity research folks, PE & VCs.
The basics of building financial models
- The first step in building financial models is gathering pertinent data from a company’s financial statements. This step of financial model construction is called financial statement analysis.
- Also, you must know that a financial model in excel templates may require additional information, like the comparative data from the financial statements of other companies. This is specifically true in a case where a comparative company analysis is being conducted.
- A financial model for a project may involve further sophistication. This may include the incorporation of financial model sensitivity analysis, which enables a model to track potential scenarios in the future.
- Some of the examples of highly sophisticated financial models software used on Wall Street are the leveraged buyout model (LBO) and the merger and acquisition model (M&A model). Both these models are commonly employed in investment banking and closely related areas, such as private equity and venture capital.
- Financial Models are usually built with the X-axis serving as the time frame. The time frame may include quarters or full years. On the other hand, the y-axis breaks down the result by line-item (i.e., revenue, cost of goods sold, EBIT, PAT etc.)
- Building financial models are relatively straightforward. You need to make assumptions and estimates for certain items like revenue, COGS, SG&A etc. The financial model assumption made must be lie between the proper limit and must not be extreme.
- At the same time make sure that the mathematical formulas are correct. From this simple base, it is also possible to build sophisticated and interconnected models for the income statement, balance sheet and cash flow statement.
- You can also build macros that allow investors to create “bull/bear/base” scenarios that can be changed with a simple click or two.
Steps in building financial models
Now we come to the main point of the building financial models. Here we are going to understand the crucial steps involved in building financial models.
#1 Data collection and Industry Analysis
The first step involved in building financial model is data collection and industry analysis.This is where the real your real work will be concentrated. You need to go through the annual report of the respective company and read it till your eyes are red or your spectacle number increases at least by 0.5! Data collection is an important step which will help you to perform your historical analysis. And this is the basis for your projections. Historical analysis will give you some trend values to start with your future projections and assumptions.
Along with your work of data collection you may also want to concentrate on the Industry analysis part. Knowing your industry is quite important. Get the trends of how the industry has been performing since the last five years. You may carry out Porter’s five forces or PESTLE analysis or SWOT analysis for the same. Identify the risks that are associated with your industry and try to gauge how much the industry has contributed to the GDP of the nation.
#2 Deciding on a Layout
The second step involved in building financial model is deciding on a layout.Identifying a proper layout for your financial model software is a must. The layout has to be prepared in excel and needs to be simple and presentable. Remember how we talked about running away immediately to get some fresh breath? We don’t want to choke ourselves, right? Asking yourselves the following questions will help you come up with a proper layout.
- How much information would the model have?
If the information and data part is going to be large we will definitely not include it one after another. In this case, it will make sense to break the model into multiple sheets.
- What kind of assumptions would the model include?
For better readability, we would try to make each of the schedules in different tabs and then link the values from them to the financial statements.
Some important tips that you may prove handy while building financial models are:
- Your readability of the model can be enhanced by using different fonts or formatting options.
- Create logical modules for your model
- Keep your P&L, Balance Sheet, cash flow statement and other schedules separate
- Make sure that the line-up items in the financial statement are properly placed.
#3 Projecting the future Values
The third step involved in building financial model is projecting the future values.This is the main crust of your entire financial model. Hence all the corresponding scenarios and conditions need to be considered before you make any assumptions. Perform your forecasting for each schedule separately. Link the forecasted values properly to the income statement, balance sheet, and cash flows. Make sure that you use maximum excel formulas to make your work easy. Use proper color coding for formulas, constants, and linkages.
1. Focus on expenses
2. Outline how the product or service is built, marketed, sold or delivered
3. Analyze your financial model assumptions and benchmark your projections
4. Create detailed financial statements
Tips for Building financial models
Are you preparing for financial modeling jobs? Then only downloading financial modeling templates won’t help. This will help:
- Be sure that you are good in Accounting, Finance and Valuation and Excel skills.
- Ask yourself one question that will easily help you to choose the right path for you. “What problem I’m going to solve by creating this financial model?”
- Understand the scope, benefits, and limitations of building financial models.
- Remember one basic principle: Garbage in garbage out. So, check your inputs necessarily.
- Model should be simple, easy to understand.
- It should be flexible enough to accommodate future revisions.
- Your Time management skills will play a key role here. Don’t be stunned by numbers and calculation in your excel sheets.
- Lastly, ask yourself that were you able to come to a particular decision and conclusion at the end of the exercise? If yes, then you are doing things the right way!
This has been a guide to building financial models as You can get easily bored when you are dealing with tons of information and data. We don’t want to make the experience boring for you. Hence excel shortcuts can come handy in such circumstances. If you remember a bunch of keyboard shortcuts, then nothing like it! Here are some resources to get you started:
- Benefits Of Investment Bankers Lifestyle
- Project Finance Jobs (Tips & Tricks)
- Different Types of Financial Model
- Important of Financial Modeling Jobs Descriptions and Skills
- Types Of Discounted Cash Flow
- Awesome Excel shortcuts for building financial models.
- Explore some awesome excel shortcuts to audit financial model
Building Financial Models Infographics
Learn the juice of building financial models in a minute through Building Financial Models Infographics