A Comprehensive Guide to the Basics of Financial Modeling
There is a lot of fuss about finance. The field is extremely profitable, which explains why they’re in such high demand. Finance is a diverse topic, you will have many subsections and one of which is financial modeling. The task of creating an abstract representation (a model) of a real-world financial situation is known as financial modeling. A mathematical model is used to describe the performance of a financial asset or portfolio of a business, project, or other investment. And here you will be reading in-depth about the basics of financial modeling. Its various aspects and how you can get started with it.
Table of Contents
Basics of Financial Modeling
1) What is financial modeling?
2) Objectives of financial modeling
3) Why is there a need to create a model
4) Role of financial modeler
5) Steps to create financial models
6) Any previous Knowledge required
7) Qualities of financial modelers
8) How to get started
9) Why use Excel
11) Types of Financial model
12) Where is the financial model used
13) Future of financial modeling
14) Frequently asked questions
Financial modeling is the process of constructing a spreadsheet that contains a summary of a company’s expenses and earnings and may be used to evaluate the impact of a future event or decision. In a very layman’s language, financial modeling is integrating all the figures in one excel sheet where you can see them all.
For example, figures of company sales for the past 3 years can analyze past numbers and predict the future profit margins. To start with the basics of financial modeling in a very simple language would be representing complicated figures in a more sorted form in excel sheets.
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Objectives of Financial Modeling
The most obvious application of financial modeling is to improve a company’s day-to-day operations. Companies use this type of model to figure out how to best use their resources for maximum profit. A firm’s profitability analysis differs from capacity planning. Only operational concerns are taken into account while capacity planning. Profitability analysis and planning, on the other hand, adopt a holistic approach.
Typically, such models assist businesses in determining the best product mix for maximum profitability. Such models, of course, are operational. As a result, their complexity is low because they simply make predictions about the near future. Spending attention on long-term profitability planning is not realistic. This is because predicting the variables over long periods is impossible.
Debt is taken on by businesses all over the world. This is done to allow them to expand more quickly. However, as debt levels rise, so does the possibility of default. A corporation that fails to manage its cash flow properly runs the danger of going bankrupt. Some financial models allow businesses to monitor their solvency.
Interest rates and currency valuations are taken into account in these models. The models also account for loans with a call option, which could put a strain on the firm’s finances in the short term. Companies might mimic extreme economic conditions to test if they would be able to stay afloat if they occurred in real life.
Structuring Credit Flow:
The majority of business is done on credit. If businesses want to expand sales, they must issue loans. When credit is provided, however, there is always the possibility of default. As a result, businesses must determine if they are willing to lend credit to a third party. If that’s the case, the next question is how much credit will they extend. Financial models can assist businesses in making this decision.
These models use data from credit-rating organizations and publicly available financial data to determine how much credit should be granted to customers. These models have the drawback of only working if clients publish their financials or are rated by credit rating organizations.
Investment banks and private equity firms utilize sophisticated financial models to value entire businesses. These models are quite complicated and take into account several variables. These are the models that newspapers and other outlets have made famous.
However, the majority of these models are built in-house. Because there are so many variables to consider, a simple spreadsheet or simple programming will not suffice. Some companies specialize in developing the software needed for this type of decision-making.
Understanding Financial Instruments:
Finally, financial models for the valuation of complicated financial products such as futures, options, and bonds have been developed. Because financial products have become increasingly complicated in recent years, such models are required. In addition, businesses must calculate their fair value automatically and on time.
Modern technology-based trading platforms rely heavily on these financial models. This is because, first and foremost, these models can quickly factor in any changes in the underlying variables and arrive at a reasonable value in a matter of minutes.
Second, this value is sent into a trading algorithm, which buys these assets anytime their fair value falls below that determined. Many trading desks find that paying human traders is a costly proposition. Only understanding is not enough to finance is a vast topic and so understanding modeling means learning all aspects of finance.
Also Read: Financial Modeling Skills
Why Is There a Need to Create a Model
Financial models are the only tools that assist people in making business decisions. Whether or not to invest in a firm, asset, or security; whether or not to engage in a project (project finance); whether or not to perform a merger or acquisition (M&A); and whether or not to raise money (e.g., do an IPO); and other corporate finance transactions are examples of these decisions.
The financial model enables decision-makers to run scenarios, examine possible results, and, ideally, make an informed decision. There is a lot of discussion regarding software applications that can be used, but the truth is that Excel is used for the great majority of financial modeling.
Role of a Financial Modeler
Financial modelers are in charge of the model’s design and construction. They are also expected to oversee the financial modeling process from the commencement of the project to the delivery and implementation of the model.
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Steps to Create Financial Models
Because the processes required to develop a financial model cannot be predetermined. However, to develop a workable model, there is a general structure that must be followed.
- Understanding the historical facts:
- Understanding and deciding on the parameters:
- Cost behavior:
- Interlink age of parameters
- Assigning range to parameters
To summarize, financial modeling is an incredibly difficult undertaking. These steps provide a basis for a financial model framework for completing the activity. However, depending on the exact financial model being produced, various procedures must be completed.
Is Any Previous Knowledge Required?
Financial modeling is a complex process and hence having a good hand in numbers, accounting, and economics will come in handy. Financial modeling needs a very good understanding of the concepts as all companies have a different trajectory of profit creation understanding the individual company and throwing in assumptions accordingly is crucial. Understanding the basics of financial modeling is at least required to get you started.
Though Having an Accounting Background Is Not a Necessity
- Financial modelers come from a variety of backgrounds, although the vast majority are accountants. One of the reasons why the accounting industry is a hotbed for modelers is because much of financial modeling necessitates a thorough understanding of a wide range of financial concepts.
- This is not; however, the most important need for becoming a competent financial modeler. Perhaps more crucially, the modeler’s ability to swiftly assimilate massive amounts of data and then filter that data to accurately identify underlying issues is more important
- Despite the necessity of good data processing in financial modeling, not all modelers are adept at it. In fact, modelers’ ability to analyze and comprehend data is highly dependent on their prior experience. Modelers who lack business and industry knowledge, for example, are prone to making basic data processing errors. Take heart, if you’re an inexperienced modeler.
- Having a highly analytical and inquisitive temperament, as well as the ability to ask the right people the right questions to fill in the gaps in your knowledge of a project, will also benefit you. Finally, modelers should be at ease communicating with people from all walks of life and at all levels of an organization.
- Those without the basics of financial modeling education should not be discouraged from pursuing a job as a modeler. Although having an accounting background is advantageous, many modelers do not have one and have found that their job is not hampered in any way.
Qualities of Financial Modelers
- Capable of adding business logic to models
- Understands and can apply sophisticated financial principles to models, as well as be able to demonstrate that knowledge.
- Understands and can model risk.
- Ability to communicate and collaborate with individuals from a variety of business functions
- Ability to handle a project
- Capable of evaluating model results and presenting them to a wide range of audiences, including banks, investors, senior personnel, and the general public.
- Bound by some code of ethics, which does not require the modeler to have an accounting (Also having GST knowledge is a bonus) background, but rather that he or she has completed some form of professional training.
How to Get Started?
Firstly, are you interested in financial modeling is the question. Once you have set your mind then yes, start with a crash course on Accounting and brush up on your basics of financial modeling. Once that is sorted join a short course on the basics of financial modeling.
Recommended Read: Financial Modeling Courses in India
Why use Excel?
You might hear big software like python, and R programming is used by the companies, but for financial modeling, the most preferred and used is Microsoft excel. Excel’s powerful function helps consolidate and link the data’s with good picturization using charts. And hence having a good hand in excel is a must.
You can use the excel crash courses which are easily available online and free. The pointers indicate where the financial modeling software outperforms the excel spreadsheet and where it does not.
- In excel the models are created from scratch which gives room for customization which won’t be possible in pre-programmed software.
- High possibility of human error as most of the work done is manual while the software error is maximum and accuracy is high.
- In excel where the model is designed from scratch gives the developer the scope for critical thinking while in soft wares everything is already created.
- For analysis, excel has few limitations while in soft wares you can use a wide range of risk analyses that are accurate and reliable.
- Excel cannot handle big amount of data while the software can handle big data efficiently
Models are used for a wide spectrum of decision-making, including mergers and acquisitions, capital raising, internal planning, budgeting, forecasting, investments, and valuation. Basics of financial modeling are now well recognized for their potential to aid business decision-making and answer often complex future concerns.
The demand for skilled modelers’ has gradually increased over time. This trend will continue for a few years because more and more firms are discovering the importance of sustainability. Expert financial modelers can provide tremendous value to any project.
Types of Financial Model
- Three Statement Model: The three-statement model is the simplest basics of financial modeling configuration. The three statements (income statement, balance sheet, and cash flow) in this model are all dynamically connected via Excel formulas, as the name implies. It’s critical to understand the basics of financial modeling only then you will know how to connect the three financial accounts, which necessitates a strong foundation in accounting, finance, and Excel.
- Discounted Cash Flow (DCF) Model: The DCF model builds on the three-statement approach to value a firm based on its future cash flow’s Net Present Value (NPV). The DCF model collects the cash flows from the three financial statements, does the necessary modifications, and then by using Excel’s XNPV function to discount them back to today at the company’s Weighted Average Cost of Capital (WACC).
- Merger Model (M&A): 1. The M&A model is a more advanced approach for calculating the merger or acquisition’s pro forma accretion/dilution. It’s customary to utilize a single tab model for each firm, with Company A Plus Company B equaling Merged Co. The degree of complexity varies greatly. The most prevalent applications of this paradigm are in investment banking and/or company development.
- Initial Public Offering (IPO) Model: Investment bankers and corporate development experts use Excel to create IPO models to value their companies before they go public. These models combine an examination of comparable companies with an estimate of how much investors would be ready to pay for the company in question. An “IPO discount” is included in the pricing of an IPO model to ensure that the stock trades well in the secondary market.
- Leveraged Buyout (LBO) Model: A leveraged buyout deal, which is an advanced kind of financial modeling, generally entails calculating complicated loan schedules. The various layers of financing create circular references and necessitate cash flow waterfalls, making an LBO one of the most complicated financial models.
- Sum of the Parts Model: This type of model is created by combining different DCF models. The value of the business is then increased by any other components that would not be acceptable for a DCF analysis (for example, marketable securities, which would be evaluated based on the market). To calculate the Net Asset Value of the company, add the value of business unit A, business unit B, and investments C, minus liabilities D.
- Consolidation Model: Multiple business units are combined into a single model in this form model. Each business unit often has its tab, with a consolidation tab that simply adds up all of the other business units. This is comparable to a Sum of the Parts exercise, in which Division A and Division B are combined to form a new, consolidated worksheet. Check out the free consolidation model template provided by CFI.
- Budget Model: This is used to model finance for financial planning and analysis (FP&A) specialists who are putting together the budget for the upcoming year (s). Budget models are usually created using monthly or quarterly data and place a strong emphasis on the income statement.
- Forecasting Model: In financial planning and analysis (FP&A), this type is also used to create a prediction that compares to the budget model. The budget and prediction models are sometimes incorporated into one workbook, and other times they are kept separate.
- Option Pricing Model: Binomial tree and Black-Scholes are the two most used option pricing models. These models are more or less simple calculators built into Excel, as they are based solely on mathematical formulas rather than subjective judgments.
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Where Are Financial Models Used?
Basics of financial modeling to advanced level encompasses a wide range of functions, including data analysis, scenario analysis, financial management, information processing, software development, and project management. Models are unique to each context and frequently contain sensitive information. As a result, tangible examples of financial models are hardly available in the public domain.
- Investment Banking
- Corporate Finance
- Governments and institutions
- Outsourcing and BPO
- Retail Banking
Future of Financial Modeling
The future of financial modeling is undoubtedly bright for both modelers and models. When you look at history, this is undeniably true. Financial modeling was still a relatively narrow corporate discipline before the turn of the century. However, financial modeling is now regarded as critical in a variety of industries, including utilities, oil and gas, telecommunications, retail banking, business process outsourcing, and so on.
Furthermore, businesses recognize the benefit of competent financial modeling in allowing them to simulate the effects of various economic and environmental situations on their performance. And so understanding the basics of financial modeling will take you a long way.
A good financial model instills confidence in financial institutions, and it is increasingly becoming a requirement to furnish banks with solid models when seeking financing. Investments in infrastructure projects such as roads, airports, and alternative energy have all required reliable modeling to guarantee that the business case is financially sound.
This indicates that financial modeling will continue to gain traction in business and industry in the future, and I fully expect the use of models to accelerate faster than in the past as more businesses discover the value of effective modeling.
Frequently Asked Questions
Are our financial modeling courses worth it?
The finance field will forever thrive as business increases, the companies need finance graduates to take care of their finance. And hence there will always be a need for people and hence the job demand will sustain.
Do financial models have scope in India?
Yes, of course, India is a thriving economy with a lot of startups and hence the field there is very good scope in India.
Do financial model professionals earn a good salary?
According to Glassdoor, a base pay – is 7,60,644/y
What are the good online courses for financial modeling?
IIM Skills is one of the best courses to learn the basics of financial modeling.
Do I need an MBA degree in financial modeling?
An MBA degree in finance is a gateway to this profession but not mandatory
As a result, attempting to study the basics of financial modeling is equivalent to attempting to learn all of finance. Financial modeling is possible anywhere a financial decision needs to be made. As a result, becoming an expert in all aspects of financial modeling is impossible. Instead, a student might be better served by focusing their efforts on a certain topic. So here we bind up the basics of financial modeling.