“Someone’s sitting in the shade today, because he planted a tree long ago”

– Warren Buffet

Any successful individual will highlight the importance of foresight and planning in their lives! Financial modeling is one of the most valued but thinly understood skills in the field of finance. A financial modeler combines accounting, finance, and business metrics to create an abstract representation of a company in Excel.

Financial models are made to analyze the current financial standing of an organization and to build a picture for the future.

Financial Modeling teaches one to work with historical data of companies, competitors and the industry and use this data to analyze the company performance on the basis of relevant financial parameters. This data lets the board of directors analyze the performance of the company viz a viz the competition and understand if they have performed well and are in line for robust growth.

It is on the basis of these models that a management/ CEO/ MD is able to predict and announce the future financial performance. This gives investors an estimate of the valuation of companies and lets them decide whether they must invest or stay away from the stock.

What is Financial Modeling?

Financial Modeling is considered as the process in which a firm constructs a financial representation of some or all aspects of the firm or an underlying asset. The model is built by computing calculations. It also makes recommendations based on the computed data it receives. The model can also summarize particular events for the end user such as investment management returns. It also helps in understanding market direction, ex: Fed model.

The main aim for an analyst is to provide an accurate price forecast or future earning performance of a particular company. Financial analysts test numerous valuations and forecast theories by recreating all the business events in an interactive calendar called the Financial Model. A financial model always tries to capture all the variables in a particular event. It then quantifies the variables and creates formulas around these variables. The main software tool used for this is the excel spreadsheet. Spreadsheet language permits the financial modeler to reconstruct almost any cash flow or revenue system.

Uses of Financial Modeling:

Financial Models are used for different reasons. The most common are:

– business valuation,

– cost of capital calculations for corporate finance projects,

– scenario preparation for strategic planning,

– capital budgeting decisions and

– the allocation of corporate resources.

They are also used in the creation of trends and projections of forecasts and many other uses in relation to industry comparisons, ratio analysis and common size financial statements.

Example of Financial Modeling:

There are countless variables at play while building a forecast or a valuation.

Analysts can separate the most sensitive of these variables by creating models and then test the models with different inputs. The inputs are then used for creating a set of results that determine the impact of a change in one variable or another. The top financial models are very simple and provide their users with a set of basic assumptions.

Let’s take a case study of a company, Illinois Tool Works, which is an industrial manufacturing company. We’re given a set of assumptions here and we have to calculate the sales growth of the company.

Sales growth is a function of current sales and the prior quarter sales. These are the only two inputs a financial model needs to calculate the sales growth. The financial modeler now creates one input cell for the prior year’s sales, cell X, and one input cell for the current year sales, cell Y. In the third cell, cell Z, the analyst creates a formula that divides the difference between cell X and Y by cell X. This is called the growth formula. Cell Z is a formula and is hard-coded into the model. Cells X and Y are now considered as input cells for the user.

The main purpose of the model is to automate the calculation of sales growth for a particular company.    

Financial Models are generally built using excel, as it is very easy to use. Personal preference and needs dictate the difficulty of the spreadsheet. The key to understanding whatever data you do decide to include so that one is able to gain insight from it.

BSE Institute Limited provides a short-term online course on the Introduction to Financial Modeling using Excel on bsevarsity.com. This short course is best for working professionals who wish to learn about modeling in a short period of time, while they work. As this course is based primarily on MS Excel, professionals can easily implement all their learnings on their job immediately.