Important Financial Modeling Terms Explained For You

Don’t you think it is important to understand the key Financial Modeling Terms before you make recommendations for the company’s growth? Yes, It is crucial to learn about the glossary to understand the correct usage of them in financial reports. Speaking of financial models, there are many kinds of templates. However, the most common one is the 3-statement model. Today, we will learn about the basic terminology and financials included in it; balance sheet, income statement, and cash flow statement. 

What is a Financial Model?

A model that is created on a spreadsheet to project and forecast the future of a business is called a financial model. The main purpose of preparing it is to help the company’s stakeholders and management to make informed decisions post considering key elements such as expenses, past performance, revenue assumptions, and expenses. 

Financial Modeling is the main cause of the creation of a financial model. There is a range of models, however, the most preferred one is the three-statement model. This is why we will learn about the aspects of it today. But before that, we shall go through some critical Financial Modeling Terms. A few terms are explained below. 

Direct Sales: These are sales directly made to the customers.

Income: Income is usually money received by a business or an individual in exchange for selling a good or service. Sometimes anything that has equivalent value to money obtained from the sale of a good or service is also considered income. Some entities view money received as an outcome of investing capital as income. This is not just a word included in Financial Modeling Terms but a term in the income statement of the company.

Cost of Goods (COGs): The costs incurred for producing goods that are for sale are called Cost of Goods (COGs). This is the amount spent on labor and materials for the production of goods. It only involves direct costs and not indirect costs.

R&D Expenses: The money spent on Research and Development is categorized under R&D expenses.

R&D Payroll: Wages and Salaries paid to employees for Research and Development come under this section.

Gross Income: Gross income is the balance obtained from deducting the cost of goods sold (COGS) from a company’s revenues. This is one of the important Financial Modeling Terms used in the financial model template and other financials of the company.

Operational costs/operations: The costs incurred by the business for its day-to-day administration and maintenance activities are operational costs.

S&M: These are expenses related to sales and marketing.

S&M Payroll: These are payments linked to salary and wages in the sales and marketing department.

G&A expenses: The name is self-explanatory; General and Administrative expenses.

G&A Payroll: This is one of the Financial Modeling Terms that is used in the valuation field. Salary and wages for the people in the G&A department.

Income tax: Income tax is the amount charged on the income of individuals and businesses. This is collected by governments as per the jurisdiction of the businesses and individuals.

Income before taxes: This is the income before deducting taxes. Simply put balance after subtracting expenses from revenues of a business.

Net income: This is sometimes called net earnings. These are obtained by subtracting general, selling, administrative expenses, cost of goods sold, depreciation, taxes, interest, operating expenses, and relevant expenses from sales.

Shares: Shares represent part of ownership in a company.

EBITDA: These are earnings that are free from deductions; taxes, amortization, interest, and depreciation.

IRR: IRR stands for Internal Rate of Return. It is a kind of measurement parameter employed in financial analysis to get an estimate of the profitability of potential investments. It is used in the Discounted cash flow method to make cash flows’ net present value (NPV) zero.

NPV: The abbreviation of NPV is Net Present Value. It is the current value of future cash flows in comparison to the initial investments. Investment planning and capital budgeting employ NPV to find out the profitability of a project or a projected investment

ROI: This is a kind of measurement tool to find out the profits earned by making an investment. Sometimes Rate on Investment is also used for comparing the performance of different investments. In simple words, it is calculated to know the difference between the investment cost and return

Return on Investment(ROI) = Net Return on Investment/Cost of Investmentx100%

Cost of capital: The cost incurred on resources with an expectation to receive a return in the future is referred to as the cost of capital. This is used for pursuing investors to assist the company in dealing with a capital budgeting project. A company may choose to finance its operations through equity or debt. Most companies combine equity and debt to finance their operations

Cash inflows: The inflow of cash into the business is a cash inflow. The inflow could be from investment, financing, or sales

PV: It is the present value of future cash flow. These values are obtained by discounting the future cash flow at different levels of discount rates; higher and lower discount rates.

Costs: Costs are expenditures incurred for the production or sale of a product or preparation of an asset for daily use. To make it simple for you, it is the amount a company incurs for manufacturing a product, purchasing inventory, selling merchandise, and getting equipment ready for use

Cash outflow: The outflow of money from the business is cash outflow. This could be in any form; payment of wages to staff, office rent, or payment of dividends to shareholders

MAU: This word stands for Monthly Active Users.

Subscription: It is a recurring revenue model which involves customers paying weekly, monthly, or yearly fees to the business for availing of its products or services.

MRR: The full form of MRR is Monthly Recurring Revenue. It is an expected revenue made from monthly subscriptions. This is usually an estimation.

ARR: Annual Recurring Revenue is the revenue company expects to make on a yearly basis through subscriptions

CPA: As the name suggests, it is the Cost per action.

ARPU: The definition of ARPU is self-explanatory; average revenue per user

MoM growth: Month-on-month growth is a kind of measurement tool to find out the growth of the business by comparing two months’ data on a recurring basis

Churn rate: It is the rate at which end users discontinue doing business with the company

Conversion: Conversion rate is the percentage of visitors who have become customers for a business.

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Financial Statements in a 3-statement Financial Model

Financial statements are reports that show an organization’s cash flows, financial position, and financial results. There are four kinds of financial statements; income statements, cash flow statements, balance sheets, and owner’s equity-linked statements. 

As we are discussing the Financial Modeling Terms, we will learn about the statements used in one of the common financial models; the three-statement model. This model is an integration of income statement, cash flow statement, and balance sheet. Let me enlighten you about each one today. Some of the words present in the relevant financials or so-called Financial Modeling Terms, because they are linked to a financial model are listed below.

Balance sheet

It is a sheet that gives an overview of a business’s liabilities, shareholder’s equity, and assets. The date at the top of the financial will let you know the period considered for collection of data. The balance sheet has different sections, each one is explained below. 

Importance of Balance Sheet

Preparation of balance sheets is important for every company irrespective of its operating industry and size. They allow the business executives and investors in identifying the risk. The presence of a detailed financial will display things owned by a company and its debts or liabilities. 

Whoever Views a Balance Sheet Can Observe the Following:

• The company’s borrowing nature; overextended or not
• The value of the company’s liquid assets to pay off debts 
• Current cash balance to handle current debt obligations

They are a means to protect investment capital. Business owners are supposed to share the balance sheets with potential investors be it large corporations or individual investors. This is done to help the investor make decisions relating to investing in the company. These are most useful to managers as they can use them to determine liquidity, profitability along with other metrics. They can accordingly make decisions for the welfare of the company

Assets:

Assets category is further divided into the below parts

• Cash and cash equivalents: These are liquid assets that can be certificates of deposits or treasury bills. 
• Accounts receivables: These are payments from customers that are yet to be received by the company.
• Inventory: Inventory is goods held with the company that is for sale. These can be finished goods, partially finished goods, or raw materials brought for the production of goods. 
• Prepaid expenses: The term ‘prepaid’ gives a hint about the nature of expenses; payments that are paid in advance for goods or services that will be received in the future are prepaid expenses. These are called prepaid expenses because the value of the assets is to be realized in the future. 
• Plant, equipment, and property: are the company’s capital assets for long-term benefit. These are usually heavy machinery that is purchased for processing raw materials or buildings dedicated to manufacturing tasks. 
• Investments: These are seen from an investor’s point of view. They are made with an expectation to receive them with an appreciated value in the future. 
• Patents, goodwill, trademarks, and remaining intangible assets: cannot be seen or touched but will benefit the company in the future. 

Liabilities:

These are broken down into different sections as below.

• Accounts payable: Amounts that are yet to be paid by the business for availing of resources are called accounts payable. Rent invoices, purchase of raw materials, and utility bills are included in accounts payable. 
• Wages: These are salaries paid to employees for rendering their services.
• Notes payable: These are agreements in which the company borrows money from its financiers and promises to pay them back with interest. 
• Dividends payable: The profit portions intended to be sent to the shareholders that are yet to be paid are dividends payable. 
• Long-term debt: A range of obligations including mortgages, bond funds, and related loans that are due for payment by the business come under long-term debt. Whereas short-term debts are recorded under current liabilities. 

Shareholder’s equity:

The balance left after the subtraction of total liabilities from total assets is shareholder’s equity. It is called stockholders or shareholder’s equity as it represents money that would be distributed to shareholders if all the company’s debts were paid off and assets were liquidated

• Retained earnings: These are the earnings left with the company after meeting payment obligations; indirect costs, direct costs, dividends, and income taxes.

Income Statement

The income statement is prepared to share an overview of expenses, revenues, earnings per share, and net income. This is a useful report as it will enlighten the shareholders if the company has made a loss or profit for a given period. This financial along with the cash flow statement and balance sheet allows the concerned parties to understand the financial health of the company. There are two main categories in this statement; revenue and expense. Before you go ahead and read the Financial Modeling Terms available in the income statement, let’s read out its importance. 

Importance of Income Statement

Income statements are needed to assess the financial performance of a company. Businesses get to use variance analysis to create budgets on understanding the revenues and expenses of the company. Many organizations use income statements to set financial goals for themselves. 

Investment banking firms and financial analysts utilize the EBITDA to evaluate target companies from entering mergers or acquisitions contracts. Income statements are analyzed by ratios to determine metrics. Many profitability ratios are included in the metrics. They also help in tracking ratios for each reporting period alongside using KPIs to track performance trends.

The usage of ratios, income statements, and other financials will facilitate the companies to benchmark their results for comparison with competitors and accordingly make improvements to thrive in the industry

Revenue:

The revenue that is earned by the sale of a company’s products and services is called operating revenue. Core business activity generates operating revenue. In the case of an auto manufacturer, the operating revenue is obtained from tasks related to producing and selling autos. 

Income that is earned from non-core business activities is referred to as non-operating revenue  These are not part of the earnings made from business primary functions. Examples of non-operating revenue are:

• Accumulated interest on cash balance in a bank
• Rental income from buildings or other property types
• Income earned from strategic partnerships. For example, royalty payment receipts
• Income generated from the display of advertisements on the company’s property

There is another category of income and that is called other income. It is the amount generated from other activities. The other tasks could be the sale of high-value assets such as vehicles, subsidiaries, or land. The gains from such activities are referred to as other income.

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Expenses:

Costs that are incurred to generate revenue from primary business activities are called primary expenses. General, administrative, and selling expenses, research and development(R&D), depreciation or amortization, cost of goods sold(COGS) are included under expenses. 

Sales commissions, employee wages, and utility bills like the costs related to transportation, and electricity are typical expenses.

Secondary activities also lead to expenditures like interest on loans or debts. Losses recorded from the sale of assets are also considered expenses.

The crucial purpose of income statement preparation is to communicate a business’s financial results and profitability with the shareholders and its management. It is effective in finding out the rate of revenues or sales for chosen periods.

This statement lets the investors understand the company’s management’s efforts to manage expenses and thereby boost profits and compensate for losses.

Cash Flow Statement

It is a statement that sheds light on the company’s ability to meet its debt obligations, fund investments, and operating expenses. It focuses on how a company generates cash to handle commercial tasks. The Balance sheet, income statement, and cash flow statement are known to complement each other. 

The short form for the cash flow statement is CFS. This statement will help the investors understand the functionality of the business, its sources of funds, and the management of cash. This tool also lets the stakeholders get a glimpse of the company’s financial footing. Below are a few Financial Modeling Terms explained from a CFS. 

Importance of Cash Flow Statements

The Preparation of a CFS Allows the Company to Enjoy the Below Two Main Benefits:

• Appraise performance: A cash flow statement facilitates the analyst to understand the performance of individual teams or companies. This is usually done by comparing projections and cash flow statements. 
• Tracks expenses: A cash flow statement will help the employee understand and know the payments-related information; details of debts, purchases, creditors, suppliers, Tracking of expenses is very critical as negligence to look at them can negatively impact the company’s health. 

They present a clear picture of payments to the management. The best part is they also include all cash transactions which could be missed being recorded in other financials. 

The cash flow statement is not based on calculations. It has three main sections which display the flow of cash in the company. Those three categories are

Operating Activities:

This section on the cash flow statement includes sources of cash along with the usage of cash for the business. How the business uses cash for its running and sale of goods and services can be figured out from the CFS. Changes in cash movements in relation to depreciation, accounts receivable, accounts payable, and inventory. Income-tax payments, wages, rent, interest payments, and cash receipts linked to the sale of products and services are also included in these transactions. 

Investing Activities:

These activities are tasks that revolve around the uses and sources of cash from a business’s investments in connection with its long-term future. A sale or purchase of an asset, payments related to an acquisition or merger, loans received from customers, or loans given to vendors is included in this section.

Purchases related to fixed assets such as plant, equipment, and property are also recorded as investing activities. In simple words, any cash movements related to investment are displayed in this section.

Financing Activities:

This part of the cash flow statement has sources of cash from banks or investors along with the amount transferred to shareholders. These activities include equity issuance, loans, stocks repurchase, debt issuance, debt repayments, and dividends paid.

This is a form of reconciliation of the balance sheet and income statement using a cash flow statement.

Conclusion

Financial modeling is an important valuation method used in various companies to evaluate their performance and make decisions accordingly. Understanding the Financial Modeling Terms is important to begin a valuation process for a company. They allow you to clearly understand the uses of the model and make the best of the financial models. In simple words, they will prevent you from misunderstanding the concepts or struggling to find seniors for help.

A three-statement model is a common kind of financial modeling method employed in many companies. It is made of three financials; balance sheet, income statement, and cash flow statement. The terminology used in those reports allows the investors and management to have a better understanding of the company’s functioning and operations. This is why every section tagged under the balance sheet, income statement, and cash flow statement is clearly explained.  

FAQs

Q. Why is it important to understand the Financial Modeling Terms?

If you are interested in joining a valuation team or dealing with financial analysis for a company, it is necessary to learn the basic terms used in the process. Knowledge about the words will make your employment journey easy and progressive. It also prevents you from misinterpreting the content in the financial models or outcomes of the valuation process.

Q. What is a three-statement model?

A three-statement model is a kind of financial model used in companies for the evaluation of their performance and to make decisions as per the outcomes. It involves three financials for performing the financial analysis; balance sheet, income statement, and cash flow statement. All the statements are integrated for the purpose of business valuation.

Q. What are the two key benefits of maintaining cash flow statements?

Assessment of a company’s performance and tracking its expenses are the main advantages of preparing a CFS. This is being said so because the management and investors can make decisions as per the value and financial strength of the company.