How To Prepare A Financial Model – Concept, Do’s & Don’ts
As businesses and financial markets grow across the world, the significance of finance for business projects and processes strides higher as well. The rungs on which most businesses stand today are footholds possible because of our data-rich world. Gaining a hold of financial figures or expecting economic policy changes over time is not a difficult feat. Furthermore, business capital has grown, and projects have grown subsequently. To reassure themselves of the financial viability of their projects, modeling services are utilized by many businesses today; their major task involves the creation of a financial model. Let’s look at how to prepare a financial model in detail in this article.
The financial model is a key term you might have seen floating on documents in your office or uttered by a fellow student of mathematics or finance. Have you ever wondered what a financial model is? Most likely not. These models are the technical aspect and are often classified as a combination of multiple statements. Not possessing an identity might be sad for humans, however, if we forget to properly follow financial model nomenclature then the repercussions for businesses may be hefty.
The aforementioned models are pivotal for business success today but to understand the complexity or rather apparent simplicity, you need to be aware of a few prerequisites. A financial model is a technique that you can only utilize if you are knowledgeable in the sphere of finance and its sub-disciplines that interact with businesses. These sub-disciplines also carry variables that affect a financial model depending on the strength of these variables to deter or prompt changes in economic conditions. So, a sharp acumen and familiarity with key financial terms to such an extent that a simple conversation can improve the financial literacy of the listener is necessary for the creation of a financial model.
Furthermore, models of the financial kind are not simply created to showcase trends and compiled as a work of art or glamour. They often serve the ends of multinational corporations or large-sized businesses and assist them in understanding the insights that have been developed for their business specifically. After we have clearly described the process of creation of such models; the meat of the article that is, we’ll also deliver you some insight into the financial services offered and the things that propose to do for your business that’ll enhance profitability or avert risk. Ultimately, it is the mark of any talented professional to turn a difficulty into an opportunity. As stated by the multiple-time New York Times bestselling writer in his book, The Obstacle Is The Way,” Whatever stands in the way, becomes the way…” and that is the attitude of a good professional and willing learner. So let us begin our journey to understand the minute details of a model and the services offered by first explaining.
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What is Finance & Its Pertinence to Modeling for Businesses –
Whenever you find yourself dealing with finance as a discipline, it is easy to get lost in the figures and numbers. Finance grapples with working to establish and clarify business goals, general accounting, drawing up financial statements, and numerous other fields of work. It is not straightforward in the least and is a subject that the layman finds problematic in his brief monthly dealings with it.
Like tendrils that creep along old apartment buildings that are termed ‘out-of-use’, finance pervades the economy and our lives in more ways than one. Businesses find finance even harder to tackle because of the necessity to maintain balance sheets, formulate market projections, and forecast apposite market & industry conditions for the explicit purpose of planned budgeting of its funds and heaps of other obligations. A financial model is developed only after all the necessary sustenance and balance sheet functions are completed. Finance as a subject, however, is usually divided into three major subtypes that each have notable effects on the working of a business. They are as follows:
Personal Finance –
The informed decision-making by individuals about the allocation or depositing of their monetary savings and investments for the advancement of personal gain or to avert financial in the long term relegates this section of finance to personal finance. In personal finance, an individual’s personal goals for the future and their self-founded goals/plans regarding risk, investment, security, and eventual retirement are entertained to varying degrees wherein a professional is frequently employed to render invaluable advice about the condition of stock markets and general business condition in an economy. These financial advisors are sometimes professionals who work with businesses to create a firm yet flexible financial model as well. Personal finance trends often have a major impact on consumer behavior and consumption patterns that directly influence the sales and revenue of firms. Therefore, a rise in consciousness about fast fashion empires and their murky practices may create a ridge between consumers and brands, which if not dealt with fastidiously, can have a long-lasting impact on this particular industry.
A business does not work in a vacuum and the idea would perk the ears of billionaire moguls like Elon Musk who would waste no time rushing to ideate over the benefits of shipping business proceedings overseas and straight into orbit or even better, Mars. Until then, businesses bear the brunt of the influences of being confined to a geographical location. Nations and countries exercise indirect monetary control on businesses that muddy well-established business metrics and raise business costs by spoiling the precious time of employed human resources. External factors like law & order and the availability as well as wide-ranging accessibility to vital business facilities can turn the efficiency of workers. All such aspects of an economy and country are squarely under the ambit of the government that officiates over the general economic policy of a country and the creation of a proper budget that is suited for business proliferation can lead to greater corporate profits accruing to shareholders and vice versa. Public finance also affects investment opportunities and loan interest rates as well for businesses in the country so public finance is an important consideration for financial planners & professionals alike. A consistent economic policy that mirrors enshrined economic goals permits predictability to enter the mix, leading to meaningful decision-making while undertaking business projects without any constraints.
Corporate Finance –
This is the subtype of the finance discipline that engenders the brandishing of a financial model for various financial programs and projects by supplying the ammunition for the cause of model development. Corporations manage tax regulations, restrictions, competition, and pricing of various inputs as well as ensuring purchases and setting up funds for problems of depreciation that beset businesses in the long term. Planning business funds as per previous patterns of expenditure and revenue and keeping a lookout for any new options that rear their head in an attempt to reduce business costs or exercise control over current profitability. It is a subfield that accounts for business actions and focuses on taking action by business goals. Ultimately, a model of finance is poised atop a business’s economic foundation; a superstructure akin to the beams of a lighthouse that provides direction and clarity in the darkest of nights.
These are some simple elucidations for the three major subtypes under finance and how they cast their shadow on the functioning of business transactions and production, which in turn positions models driven by financial figures in a direction of their own. Thus, with finance wrapped up with its general effects laid bare for your perusal, we can move on to illuminate…
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The Concept of a Financial Model:
In the quest to understand how to prepare a financial model, it is important to thoroughly understand the concept of a financial model. Models for business finance are considered to be nothing more than or short of spreadsheets of financial figures and data-laden over one another that are used to many effects, some significant to the extent that they can completely change the company’s direction or normalized that affect only efficiency and that too on a small scale. Under the conditions of uncertainty, businesses utilize these models to clear the clouds of uncertainty.
Models of finance so developed can fulfill this requirement with relative ease because they possess the ability to accurately forecast future trends or the results of a business action/project on the totality of the health of a business. The structure of the model is so formed that it does not grow insights over time and as soon as they are ripe, they can be harvested but it acts based on a set of assumptions.
The set of assumptions that are selected should be investigated before their insertion into these models. The assumptions should usually be derived from details that are credible and are key indicators or pillars of the model. Details of the customer growth rate, sale revenue rate, and growth ratios are termed valuable inputs for the fabrication of the foundation of a reliable model for financial decision-making.
Creating one model can be a painstaking task, requiring the collection of data, ironing out inconsistencies, and other tedious financial calculations. In the end, it is a powerful tool for forecasting future results and directing the company in the correct direction. It also processes complex and serves them on a platter after proper visualization for the stakeholders to consider during important company decisions. Other points that denote the importance of a model for financial decision-making are as follows:
- Even though the potential set of assumptions, in reality, will always be greater than those present in the creation of a model, it is a purposeful method to produce the vision of a company and put it front and centre as a tangible aspect of the business. This direction is not only a means to gain action plans that can be used to pinpoint future business goals that need to be established but also lends the business model a niche, subcategory, and an industry’s data and trends; coattails which can be ensured to orient models in a more sophisticated fashion.
- Models may be tools for a financial advisor or finance professionals in general, however, for a business, they are a means to market and a source of image building. It generates and floods the previous image of a business in the market with positive connotations. This phenomenon inspires trust in investors about rational decision-making at the upper echelons of the business hierarchy and attracts credibility to the firm in its industry.
These are just some of the characteristics of modeling for financial purposes and the necessity of this process for business finance and growth at scale. It is hard to come by a phenomenon so frequently underestimated in the public eye yet so crucial for accomplishing business goals and targets. Now let us try to weave a pattern of the elemental makeup of a real-life model.
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How to prepare a Financial Model: Knowing the Do’s & Don’ts
Building a model is not a difficult endeavor for those well-versed in the creation of these models; however, they are not child’s play either. Models of finance may be deemed a compilation of the data of the precompiled business balance sheet, income statement, and cash flow analysis. The definition of these models does convey the core idea but zooms past key interlacing processes and the importance of reviewing the credibility of numbers that serve as the underlying component of the model in its entirety. Therefore, a detailed study of the parts that turn into the gestalt; the whole model for business finance is essential. The steps and working variables are abundant but the following steps are valuable for creating the bone structure of a model for financial purposes:
How to prepare a Financial Model -Approaches to Modeling:
There are two fundamentally distinct approaches to creating a model –
- Top Down Approach – Top down usually refers to creating the big picture goal and enforcing a vision for the model to abide by throughout its work life. It expands on the bigger and larger goals of the organization and slowly trickles down to how they will be achieved methodologically. For instance – Entering a market of renewables, a multi-port enterprise invests heavily in research, development, and transportation of vital equipment for renewable energy converters to fulfil its goal of securing one-third of the entire market of renewable products for a region. This approach is often followed by firms that are well-off and are looking to diversify their asset portfolio or expand into new markets for banking on international policy.
- Bottom-Up Approach – Under this approach, modeling occurs with the view of the basics in mind. General demand for business, wages for employees required, the growth potential of the market, diversification portals for the brand, customer retention, or financial positioning in the industry are just a few of the many assumptions weighed while managing the construction of a model for managing business finances. Since assumptions are limited in their scope, these models necessitate testing the value these assumptions provide. If they fail to reflect the business’s finances truly or meander past the goals for modeling, they are replaced by assumptions that are more suitable to help derive quality results for business benefit.
These two approaches are most often employed to begin the procedure of creating a model.
A realistic approach is usually the bottom-up approach which is complemented well by the top-down approach by businesses that possess adequate capital for their undertaking. Moving on, let’s discuss the essential factors that create the makeup of a model.
Learn how to prepare a financial model with the key components:
The major parts of a model are:
- Input Assumptions
- Balance Sheet
- Income Statement
- Cash Flow Analysis
There can be plenty of other parts to models that are added when a company demands them specifically. Parts such as the sources of financial figures and data collected, valuations of different types, and sensitivity analysis. Sensitivity analysis and valuation often go hand in hand as dips in valuation due to risk and other factors being the basis of sensitivity analysis. Regardless of that, we shall focus on the essentials.
- When you begin filling the tabs out in a spreadsheet the assumptions must take center stage and priority. Giving them their due will allow for automatic adjustments as per the assumptions set up in your spreadsheet. Calculations are also streamlined, saving a lot of time and energy. Assumptions are not a set of generally accepted variables agreed upon. Most businesses select assumptions uniquely off on their variables like salaries and compensation rise, capital growth ratio, etc. Revenue and expenditure are primary assumptions in most businesses and they must be researched thoroughly for important metrics that can be utilized to evolve proficiency in the development of business insights. Relying on industry standards to bridge the importance of research can be deleterious to business health in the long term. The assumption list should be short and clear to avoid unnecessary processing complications. Ultimately, collecting evidence and conducting due diligence on financial figures is the only secure way to generate unshakeable solutions that possess a wide range of applicability.
- The next component is the all-important income statement. A business is only a business when it aims to produce profit and fulfills that aim. In the long run, it fails to be a business in any other scenario. An income statement is the true reflection of a business’s ability to serve its purpose. It contains the overall losses and profits of a company and branches them into two categories: non-operating and operating. The non-operating deals with financial transfers of sale and purchase whereas the core business process where sale and revenue are at stake is drawn up under the operating section of the statement. Revenue sources can be further added into this statement to differentiate among different sources and which among them is the most prominent. Every detail of revenue and expenditure is calculated and formulation of EBITDA and other aspects under consideration in an income statement eventually leads to the creation of a proper model for financial purposes.
- Next, follows the balance sheet which showcases the weightage of assets, liabilities, and the share/equity of a firm. These are essential to startups and businesses that are well past their glory days. They provide for the calculation of important metrics like net working capital which is a good indicator of cash flows into the business. Furthermore, it also helps plummeting businesses in pinpointing liabilities that are sinking their asset valuations. With the right assumptions for the model and properly calculated income statements, balance sheets are quick to work in comparison.
- The cash flow statement is the final hurdle you need to know about before creating your model in the blink of an eye. This statement might seem redundant at a point however, little can be said of the future profits. Optimism and expectation may be bullish but without stabilized cash flows for smoothly operating the business, there is little recourse for financial investment. As for models, this statement outlines the pipelines of cash allocation and the variegated business aspects that have been invested in for future growth. It showcases positive or negative cash flow from these areas and is key to predicting the future returns that may be possible due to investment; fruitful or otherwise. Free cash flow is an incredible business metric that has become a reliable source for knowing whether a company can handle the burden of its financial operations.
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FAQs on how to prepare a financial model:
Q1. What are the major skills required for modeling?
Modeling requires a fundamental understanding of finance and an in-depth understanding of the procedures of the trade. Summed up, they are three in number:
- Skills in accounting and financial skills including an understanding of mathematical modeling and statistics
- A good way over MS Excel
- The acumen for problem-solving, logical & critical analysis
Q2. What are the key steps for auditing a model?
The key steps involved in auditing a model of finance are:
- Simply Formulas & Cell Units
- Stray Away from Hard-Coded Formulas
- Sign Convention Is Important
- Excel Grid Logic Should Be Followed
- Linking Of Files To Be Avoided
- Don’t Hides Important Rows or Cells
- Tabs Size Reigns Supreme Over Sheer Quantity
- Review the Model for Errors Thoroughly
Q3. What are some of the most popular types of financial models?
Some of the most used financial models are:
- Sum Of the Parts Model
- Budget Creation Model
- Business Forecasting Model
- DCF Model
- Merger & Acquisition of Business Model
- Three Core Statement Model
Conclusion on how to prepare a financial model:
We hope you learned something of value through this financial modeling article and will see the value in models of such kind in a different light. And hopefully, this article gave you powerful insight into how to prepare a financial model.