In business, financial modeling proves to be a powerful tool. Though the future is uncertain, financial modeling may provide insights and forecast what is likely to happen tomorrow based on today's decisions. Everything you should know why you should use financial modelling, various financial modeling techniques, and software tools that you can make.
About financial modeling:
Financial modeling is a process in a company's profits, and also it costs to determine the impact of future events and decisions. The data involved includes the past, present, forecasted future. These insights empower executives and stakeholders to do the best business or conduct competitive analysis against other businesses in the same market.
How does financial modeling work?
How does financial modeling work?
- Dynamic: Each input may affect the calculations and results or output. Most models are created to be dynamic with built-in flexibility to understand the impact of variables.
- Displays forecasts: used to predict the future based on different variables that could take place.
- Relationship–driven: If you change one input, multiple variables may change in line with that single change.
- Structured: There may be a different financial model, but it consists of all the inputs, calculations and outputs.
How do you build a financial model?
In financial analysis and modeling, professionals have their method to create a financial model. Financial modeling can be broken down into steps. The typical steps are:
1. Historical data: Most of the model relies on historical data. You can extrapolate your assumptions for each historical period and use that assumption to fill in the future through calculations.
2. Income statement: You may be able to calculate the income statements top half by your forecast assumption
3. Balance sheet: Onto the balance sheet by calculating inventory and accounts receivable.
4. Supporting schedules: Without creating a schedule for capital assets, debt, and interest, you cannot finish the balance sheet. You may be able to fill in the property, plant, and equipment based on adding capital expenditures and subtracting depreciation from the historical period. The interest may be based on the average debt balance.
5. Complete statements: To finish filling the income statement and balance statement, you can use the information gained from set 4. By pulling last year's closing balance, you can calculate shareholders’ equity. You can subtract dividends and shares repurchased and add net income and capital raised.
6. Build cash flow: Once you have filled the statements, you can use the reconciliation method to build the cash flow statement.
7. Performance analysis: these 3 statement models calculate free cash flow and a business valuation.
8. Add scenarios: A critical step in financial modeling understands how much your assumptions will impact the company's value. You can understand it better through sensitivity analysis and adding scenarios into the model.
9. Create charts and graphs: You can create charts and graphs to visualize and communicate the results of your model.
10. Perform stress test: As per your expectations, you should make sure that the model will perform in the final step. You can perform stress tests or apply extreme scenarios to the model at this step.
Different types of financial models:
Financial models come in different shapes and also in different sizes, the most commonly used financial models are:
Three statement model:
The three statement model is the most basic financial model to build upon the income statement, balance sheet, and cash flow. You link the three with formulas and test various assumptions and their effect on these financial statements.
The merger model is used to analyze the accreditation or dilution of a merger or acquisition. Investment and corporate development utilize this model.
The budget model is used to allocate resources monthly or quarterly for financial planning and financial analysis.
Option pricing model:
In optical pricing model are straightforward to give mathematical formulas.
As the budget model, the forecasting model is used commonly in financial planning and analysis. Often, the two will be combined in the same workbook.
This model withholds information about different business units on different tabs. It is similar to the sum of the parts model. To sum up the business units, you can use the consolidation tab.
The above models represent a list of financial modeling options. Based on the model of the type you wish to create, you can benefit from using automation solutions to help source, transform, secure and format the data you need to reap the insights you seek