Updated October 11, 2023
Introduction to Financial Modeling Basics
A financial model represents the financial performance of a company. It means the financial performance for both the past and future.
Let’s go through this financial modeling basics tutorial and stop making vague decisions and unnecessarily increasing our risk. Let’s learn financial modeling basics and think and make a decision in a more structured way. To get in-depth knowledge of preparing a financial model through a video tutorial, please go through Financial Modeling Training.
So, let’s start with understanding the essential point of the financial modeling tutorial.
What are the Financial Modeling Basics?
Historical and Assumption
Historical input data should always be taken from the right source. While making financial modeling basics assumptions for the forecasted year, historical data is one of the input criteria that must be considered.
The assumption is referred to as “drivers.”
- The other criteria that one should consider while making an assumption are
- No bias should get into the assumptions of the business
- Clearly, understand the expected changes in future performance.
- Understand Management expectations
- Check out what other financial modeling analysts think about the company.
Color coding is one of the essential formatting factors in Financial Modeling. This is done so that a person who has never seen your model can quickly know whether a particular financial data is historical input data, calculations, or linkages.
Financial Modeling Basics, One Formatting Tip
If your year 2009 comes in cell B2 of the income statement, then it is advisable that 2009 in other sheets like the balance sheet and cash flow statement should also come in cell B2. This financial modeling basics formatting helps during linkages.
Preparation of Financial Modeling Basics
The first thing to prepare a financial model is to understand the company on which the person is preparing the model. The person should also have a thorough knowledge of the industry and its competitors to which his company belongs.
To analyze a company, one should not only check the company’s annual report but also read the transcript, conference calls, and presentations published by the company.
Compilation of Historical
One should compile the past five years of historical data while preparing a financial model.
While compiling, please keep specific points in mind:-
- You are an “Analyst,” not an “Auditor.” So if the historical data available in the company’s annual report does not compile, don’t panic and sit to tally the financials. Just take the financials as they are.
- It would be best to refer to the latest annual report for the historical data. In other words, if your historical year starts from 2008 till 2012 and you are compiling the data for the year 2011, then you need to pick up the figures from the 2011- 2012 annual report, which is the latest one and not from 2010-2011 as the new annual report contains the revised figures.
- A financial model should always contain key financial terms like gross profit, EBITDA, EBIT, net profit, etc. If you cannot find these terms in the annual report, you must prepare your financial model and record the items accordingly.
This is how the format of an income statement should appear.
Financial Modeling Basics, BASE Equation
Certain items need to be added and subtracted to calculate the ending balance for this financial year.
Let’s understand this base equation in detail.
For Fixed Asset
To find out the ending fixed asset, we need to have an opening fixed asset, capital expenditure, Depreciation, and the sale of the asset. Let’s understand what amount needs to be added or subtracted to find the ending fixed asset.
|B (Beginning)||Beginning fixed asset||This is the fixed asset that is carried forward from last year.|
|A (Addition)||Capital expenditure||This is the extra asset you bought this financial year.|
|S (Subtraction)||Depreciation/ sale of the asset||Depreciation is an expense you must deduct. Since the assets are sold in this financial year, that amount must be deducted.|
|E (Ending)||Ending fixed asset||This fixed asset amount is generated after adding and subtracting all the necessary items in this financial year and will be carried forward in the next year.|
|B (Beginning)||Beginning shareholders fund|
|A (Addition)||Net income / Issuance of equity|
|S (Subtraction)||Repurchase of equity / Dividend paid|
|E (Ending)||Ending equity balance|
For Long-Term Debt
|B (Beginning)||Beginning long-term Debt|
|A (Addition)||Issuance of debt|
|S (Subtraction)||Repayment of Debt|
|E (Ending)||Ending debt balance|
An income statement is a financial statement that measures the company’s financial performance over a specific accounting period. It summarizes how the business incurs revenues and expenses through operating and non-operating activities.
Let’s see how we can project the income statement
Net Sales Calculation
One can calculate net sales as year-on-year growth or on CAGR, or if you find any information on where the management has discussed the expected sales growth rate in the future, you can also take that percentage.
Calculation of Direct cost and selling and admin cost
One can calculate the direct cost, selling, and admin cost as a percentage of sales. Calculate the historical, then calculate an average and find the forecasted figures.
It can be calculated as a percentage of fixed assets.
It can be calculated by multiplying the interest expense rate and the average closing debt balance.
One can calculate the tax rate using historical and the same rate in the future.
This is calculated by deducting expenses from the revenue
Fixed asset, long-term debt, shareholder’s fund
These items must be calculated using the Base equation and linked to the balance sheet.
Goodwill is not amortized, so it must be kept constant in the future.
The cash item must be linked to the ending cash balance from the cash flow statement.
Current Assets and Current Liabilities
These items need to be calculated in the working capital schedule. Now let’s understand the working capital schedule in detail.
Working capital schedule
- Accounts receivable
Calculate the accounts receivable in days for the historical using the ratio 365*Average debtor divided by net sales. The past historical data assumes the number of days for the forecasted years.
Calculate the inventory in days for the historical using the ratio 365*Average inventory divided by net COGS. The past historical data assumes the number of days for the forecasted years.
- Accounts payable
Calculate the accounts receivable in days for the historical using the ratio 365*Average payable divided by net purchases. The past historical data assumes the number of days for the forecasted years.
- Other current liability
One can calculate the other current liability for the historical as a percentage of the COGS, and then you can take an average and assume for the future.
After completing this working capital schedule, link it to the balance sheet.
Cash Flow Statement
Cash flow statements assess the amount, timing, and predictability of cash inflows and outflows and are used as the basis for budgeting and business planning.
It answers the questions:
- Where did the money come (will it come) from?
- Where it goes (will it go)?
The accounting data is usually presented in three main sections:
- Operating activities ( sales of goods or services),
- Investing activities (sale or purchase of an asset, for example) and
- Financing activities (borrowings or sale of common stock, for example).
The cash flow statement records the cash inflows and outflows corresponding to any changes in the amount of the item in the income statement or the balance sheet during the financial year.
Here are some articles that will help you to get more detail about the Financial Modeling basics, so go through the link.