Financial Modeling for Beginners

Financial modeling is a fundamental skill that is important for performing financial analysis. Industry professionals use it to derive a company's current value based on an analysis of its future performance. 

Financial modeling is used in banking, private equity, and other related finance and investment industries to value businesses, structure deals, and advise on transactions. On the other hand, corporate analysts use financial models to analyze trends in their company's performance and help managers make critical decisions on future business operations. Hence, financial modeling skills are a must-have for those looking to get started in the world of finance.

What is Financial Modeling?

Financial modeling is the process of predicting and analyzing the company's future performance, generally through spreadsheet software like Microsoft Excel. This includes calculating future cash flows, determining funds and their future needs, evaluating company performance, and more. 

Financial models often help decision-makers, such as business managers or parties, to an M&A transaction. As a result, they are probably one of the most common tools used across the financial modeling industry.

Types of Financial Models

There are various types of models that are used in finance. The decision to use a particular model type is based on its objectives. We have highlighted some of the most common types of models a beginner would need to be familiar with for a career in finance:

• Three Statement Model: It is the foundation of all other models. It links together the Income Statement, Balance Sheet, and Cash Flow Statement. 
• Discounted Cash Flow (DCF) Model: This starts with forecasting a company's future cash flow. The forecasted future cash flows are discounted to their present value. This model is a vital component of all valuation models as it relies on fundamental analysis.   
• Merger (M&A) Model: This is used to forecast a possible merger or acquisition of a company. It helps to understand the financial impact of a merger on both companies (acquirer and acquiree). It is also known as the accretion-dilution model.
• Initial Public Offering (IPO) Model: Before an IPO, an analyst will create an IPO model to determine the price of an IPO. It involves making assumptions about how the share price will trade in the secondary market.
• Leveraged Buyout (LBO) Model:  This is considered the most challenging model to build. LBO models account for various factors of an LBO transaction, such as debt repayment and issuance of shares. It is mainly used in Private Equity.

Building a Financial Model

The first step to building a financial model is understanding the model's objectives and deciding what type of model meets those objectives. Your model exercise will almost always begin with building the three-statement model. 

Next, make a list of inputs that are needed for your model. Some examples of inputs include the costs of goods sold, wages and salaries, sales revenue, operating expenses, capital expenditures (CAPEX), depreciation expense, interest expense, or income. 

The next step is to figure out the sources from which to obtain these inputs. They can often be located on the historical financial statements and equity research reports. Other places include 10-K and 10-Q filings, as well as merger proxies.

Lastly, fill out and connect the formulas or equations used in the model. Many different formulas or equations can be used depending on the type of model you're building. For example, if you're building a three-statement model on the income statement, one equation might be sales revenue minus the cost of goods sold equals gross margin. Wages and salaries can be reduced from it to arrive at operating profit. 

Who Builds Financial Models?

Financial models are built by professionals who work in the finance industry. Examples of such industries include investment banking, private equity, valuation, and accounting. 

Financial modeling is usually performed by those working in junior roles. They build these models to help their seniors make the right decisions and provide essential input to the overall decision-making process. At the senior levels, the skill lies not in financial modeling itself but in interpreting the model's output. However, someone who has never built a financial model will have a hard time figuring out what the output means and how they are related to the model's inputs. 

Requirement of Accounting Knowledge

To understand financial modeling, you must have good familiarity with accounting. Accounting includes the study of transactions and analyzing and presenting historical financial data. It is a subset of business administration and finance.

A strong background in accounting allows you to understand financial models and comprehend how their various components interact with each other.

Excel for Financial Modeling

Financial modeling is usually performed on tools that make number crunching and data analysis easier and faster. Excel is the most commonly used tool for financial modeling. It is a versatile software that meets all the requirements required to build models, such as versatility, flexibility, and built-in formulas, among many others. 

An often underrated and underutilized functionality is the possibility of creating informative dashboards. This feature is mainly used in corporations, where data is presented periodically in reports. 

An example of this is the treasury department. This organization is required to manage the cash flow in the business and hence have to generate reports for follow-up on receiving payments from debtors, or structure payments to creditors, to ensure that there is no shortage of funds at any point.

Excel Skills Required for Financial Modeling

Understanding how to build and interpret a financial model is only one part of the equation. Having a strong background in Excel is one of the essential prerequisites to land a role in finance. 

Since finance is a fast-paced industry, it is of utmost importance that anyone looking to break in matches the pace. This means cranking out a financial model every day instead of taking a fortnight. 

Being efficient with Excel can mean the difference between going home at 10 PM instead of way past midnight. Unfortunately, it is one of the reasons why new analysts tend to suffer a lot after landing a role in finance. 

The Hallmarks of a Good Financial Model

A good financial model helps achieve the objectives for which it was built, is readable and understandable to an independent reviewer, and balances flexibility with accuracy.

The five considerations to consider to build a great financial model are:

• Granularity: Refers to the level of detail that the model considers. Higher the accuracy required from the model, the higher its granularity, and vice versa.
• Flexibility: The model's flexibility depends on whether it needs to be reused or used by other team members. In both cases, it is essential to have a highly flexible model.
• Transparency: An excellent financial model does not obscure the data flow through the model. It is crucial to ensure that the source of all hard-coded inputs is correctly documented.
• Circularity: Circularity happens when a cell refers to itself and is best avoided unless it is required. An example of a model that needs it is the LBO model.
• Transferability: Models must be easily transferable to other users without compromising their data or structural integrity. One way is to ensure that no model directly takes inputs from local files, or if it does, then the documentation mentions it.

Careers that require Financial Modeling

Various careers in finance and accounting require proficiency in financial modeling. These careers include:

• Investment Banking: Investment Bankers build financial models for transactions such as mergers, acquisitions, equity raising, debt raising, and valuation. The models help senior bankers determine the factors that will affect their deal or capital raising abilities. 
• Private Equity: Private equity firms acquire businesses with debt to hold them for about 5 years, after which they exit the investment at high multiples. This transaction is known as a leveraged buyout (LBO). Most of the modeling work in private equity revolves around these LBO transactions.
• Equity Research: Research analysts develop ideas that determine whether to buy or sell securities. They spend a lot of time building various models to test their hypotheses and better understand the stock's performance they cover. 
• Corporate Finance: These roles use financial models from an internal reporting point of view. Modeling here involves creating and using dashboards and extensive macros to automate the repetition in fetching and reporting dates.  
• Venture Capital: Venture Capital (VC) firms invest in early-stage "startup" companies. While difficult to model for these early-stage companies, VC firms do their best to value the company, given whatever data they can access. Models here rely more on non-profit measures like the number of visitors to value since most startups rarely generate profits. 

More about financial modeling

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Advanced Financial Modeling (AFM)
• Financial Modeling Best Practices
• What Makes a Good Financial Model?
• Top Financial Modeling Courses
• Valuation Modeling in Excel