What is a financial model?
To put it simply, a financial model is a decision-making tool built through spreadsheet software. By using this model, companies can forecast future financial performance, along with estimating the outcome of any major decisions.
There are a large variety of financial models, all used for a different purpose. One of the most common is the 3 statement model. This model combines the income statement, balance sheet and cash flow statement into a single financial model. Once created, the model can be used to forecast the financial position of a company as a whole, providing a consolidated view of its financial history, current performance and future projections.
The 3 statement model also acts as a basis for creating more complex financial models including DCF models, merger models and LBO models.
What can financial models be used for?
Financial models can be used for multiple reasons, which is why they are so useful. Some common areas in which financial modeling is used include:
- – Valuation of a company
- – Valuation of assets
- – Budgeting and forecasting
- – Mergers and acquisitions
- – Raising capital
- – Capital allocation
- – Management accounting
In addition, there are five key objectives that can be used to sum up the purpose of financial models. These are as follows:
- – To project a financial forecast
- – To link a company’s historical financial statements together
- – To value a business
- – To estimate how a company will perform in the future
- – To model different potential scenarios/decisions
Why are financial models important?
Financial models are extremely useful tools that should not be underestimated. These models provide data-driven analysis and metrics that allow companies to understand exactly where they stand and what their future may look like.
When an important decision needs to be made, it must be based on real-time data. For this reason, having a visual representation of a company’s historical performance, along with trends and expectations, allows the impact of any major decision to be estimated beforehand.
Plus, creating financial models can help company directors or executives to develop a deeper understanding of their business. The process requires all drivers which impact a company to be listed, along with any potential internal or external changes. For this reason, companies are essentially forced to understand and acknowledge every aspect of their business.
What are some financial modeling best practices?
There are many best-practice modeling techniques that can be used to ensure accuracy and efficiency. When creating a financial model, it’s essential to follow a structured approach, so that errors can be avoided. Furthermore, stress-testing is an essential technique to check the model operates as expected.
Excel is the most commonly used platform for producing financial models. Therefore, learning some Excel tips and shortcuts can help to quicken the process whilst maintaining accuracy. Some of these tips include:
- – Using keyboard shortcuts
- – Developing your knowledge of important formulas and functions
- – Using INDEX and MATCH rather than VLOOKUP when querying data
- – Only using one formula per row
- – Avoiding complicated formulas where possible
- – Clearly separating inputs and outputs (e.g. through formatting conventions)
When it comes to building out a financial model, the best method is to divide it into sections. Generally speaking, every model can be split into inputs/drivers, calculations and outputs. Of course, the whole model can be built on one worksheet, but grouping can be used to differentiate the sections.
The main sections to include within a financial model are:
- – A cover page
- – Assumptions and drivers
- – Income statement
- – Balance sheet
- – Cash flow statement
- – Supporting schedules
- – Valuation
- – Sensitivity analysis
- – Charts and graphs