The Definitive Guide Financial Modeling – Meaning, Types, Future

When you are involved in the field of financial analysis, it becomes a necessity to have a solid understanding of financial modeling. But unfortunately, many people active in this particular area are not thorough with the workings of the same.

Since knowledge of financial modeling is greatly valued in the finance sector, it is no wonder then that a ‘financial modeling analyst salary’ falls on the highest pay grade bracket in most cases. So, you may begin wondering by now what exactly does the term ‘financial modeling’ really mean?

In the simplest terms, the person tasked with the financial modeling of a corporation will devise ways to draw a clear picture of the company’s monetary future.

In other words, a financial analyst will handle an organization’s accounts, finances, and other business benchmarks to compile data regarding where it would stand financially in the future.

One thing that you can be certain of is that going through this CrossVal article will be no less useful than signing up for a full-fledged financial modeling course – A complete financial modeling guide for founders.

What is Financial Modeling?

Financial modeling essentially deals with creating spreadsheets detailing predictions about the future of a business corporation. It revolves around how well a company is deemed to be performing in the current circumstance, and which way it is heading.

While calculating the results to be shown on the spreadsheet, analysts take into account a firm’s performance over the years in the past in order to come to a conclusion about its accomplishments in the future. 

As can be understood from all that we have discussed so far, preparing a spreadsheet having the details of a company’s financial fortunes is no small feat. Analysts gather balance sheets, income statements, cash flow statements, and supporting schedules before working to form a proper datasheet.

Usually known as the 3-statement model, this basic informational chart. Once this is made, one gets to build more advanced varieties of financial models such as leveraged buyout (LBO), sensitivity analysis, mergers and acquisitions (M&A), and discounted cash flow analysis (DCF model).

Therefore, the key points that we have learned in this section are :

• Financial modeling can be used to find out the value of corporations. Analysts utilize these models to determine whether or not firms should raise funds or rather get busy expanding businesses through acquisitions or organic means.
• The chief target of financial modeling remains the projection of a corporation’s future financial performance.
• For financial modeling to successfully predict the future finances of a firm, it carefully combines finance, accounts, and business metrics to reach a result.

What are the Objectives of Financial Modeling?

Creation of Profit

The primary goal of applying financial modeling is to polish a corporation’s daily operations. Companies across the planet are using these models to recognize how best they could put their resources to use. Typically, financial modeling allows corporations to determine the finest product mix for the greatest profitability.

Making predictions about a company’s future, using one of the many financial models available to us now, is not completely foolproof.

Creation of Liquid

It is a common practice worldwide that businesses take some amount of debt for business operations. This is a calculated move that companies take in order to see the expansion of their businesses at a more rapid pace.

However, if businesses do not handle their cash flow smartly, it runs the risk of bankruptcy. Hence companies use some financial models to help them to identify their solvency.

If a business corporation is busy integrating a financial model with the objective of creating more liquid, then it is very likely that it takes into account interest rates and valuations of currencies. 

To Structure the Flow of Credit

A lot of businesses run on borrowed money. With a greater borrowing rate, comes a greater risk of default.

This is where financial models step in to better allow companies to figure out how much credit they need to borrow from time to time from external mediums.

These models act like the guiding stars to business houses in their quest to draw up a proper credit chart for smoother functioning of operations.

Some of you reading this blog may wonder how financial models manage to accomplish such a difficult task. These models actually do this by gathering information from well-known credit-rating agencies such as Fitch, Standard and Poor’s, and Moody’s, as well as financial material available in the public domain.

For the Derivation of Output

We have come across private equity firms and investment banks making use of highly sophisticated financial models to prepare valuation charts of their respective businesses.

Every firm will modulate its own financial model to suit its needs. No two financial models are exactly alike. In each company, there will be an uncountable number of variables at play. To handle all these variables, a solitary program or a spreadsheet would never be enough.

To fill up this vacuum, there exist outfits that are solely into developing software required to execute this type of decision-making.

To Comprehend Financial Instruments

One of the most vital objectives behind developing financial models is their use of them in the process of valuation of complex financial appendages like bonds, futures, and options.

These models are essential in finding out paths around complicated financial products. On top of this, business houses are supposed to work out their fair value by the use of an automated process and in due time.

In today’s world, financial models are used heavily by all sorts of hi-tech trading platforms.

What is the Financial Model Used For?

Financial models come in various forms depending on their uses and properties. It does not matter if it is inside or outside a firm, whatever a financial model has produced, is taken into consideration before taking important company decisions and calling shots on the financial roadmap up ahead.

Here you will read about the types of decisions that are taken after studying the output produced by a financial model:

• While making business or asset acquisitions
• While raising capital, as in equity or debt
• During the sale or divestment of business units and assets
• To grow a business organically by penetrating newer markets, paving the path for new stores, and the like
• Accounts-related work in the management department
• Allocating capital to projects according to their priority level
• While planning, budgeting, and forecasting for the financial years ahead
• During the compilation of ratio analysis and financial statement analysis
• Finding out the overall value of a particular business

Who Builds Financial Models?

People from different walks of life could be tasked with building financial models. Those involved in investment banking, accounting, corporate development, equity research, and financial planning and analysis (FP&A), are primarily involved in this line of work.

But out of these, the analyst in the investment banking sector is most likely to be engaged in creating sound financial models.

Analysts spend most of their time building financial models, apart from researching industries they are part of, and understanding how their parent companies are performing in the long run.

Financial Modeling Basics

In the simplest of terms, financial modeling is the method by which you are able to construct models to aid you in the forecast of a particular business’s financial output in the days to come. This forecast may not be 100% accurate, but it can give company executives a clear picture of where their firm is heading.

This elaboration is based on a number of factors, such as the overall historical background of the company in question, and the expenses over the past few years. In a nutshell, financial modeling is undertaken by most business enterprises to showcase an estimation of the valuation of a trade or plan, and at the same time calculate the effects of vital financial decisions in the short and long term on the company’s fortunes.

Learn More:

To understand more about financial modeling basics, visit our blog ‘The Best Guide To Financial Modeling Basics’.

Financial Modeling Examples

As can be expected, there exist a variety of financial modeling types. We have listed the top five most commonly used models by corporations.

The Three-Statement Model

The most standard type of financial model, the Three-Statement model, uses three primary variables – the balance sheet, the income statement, and the cash flow.

These are then linked in a dynamic manner with the help of formulas in Microsoft Excel. This is done with the aim of connecting all the existing accounts, in order to derive a set of assumptions.

These assumptions are then expected to push for changes in the whole model. It is of paramount importance that the person using this model knows how to link the three financial statements.

To successfully accomplish this, companies look toward people with a deep understanding of finance, accounting, and Excel skills.

Discounted Cash Flow (DCF) Model 

This financial model is used to value businesses, conduct equity research, and analyze the same.

Leveraged Buyout (LBO) Model

This model comes to the fore when debt is the fundamental source of funding for a business. It is in most cases used by private equity firms, as they have the habit of borrowing almost 70% of funds.

Mergers and Acquisitions (M&A) Model

Also used to evaluate companies, this slightly advanced financial model comes in handy during instances of company mergers and acquisitions.

Sum of the Parts Model

Also used during valuation procedures, here singled-out units are added in the exercise to come to the summation of all valuations. This is a form of adding up several financial models to form the total asset net value of a particular business organization. 

Financial Modeling Using Excel/Sheets

A large amount of work pertaining to finance and accounting is done using Microsoft Excel. Excel has been the traditional mainstay for financial analysts for the past several years. 

However, in recent times with the advent of advanced AI-powered programming tools, the time for excel’s dominance is finally over. Financial modeling software is proving to be a far better choice for business organizations the world over.

Learn More:

To know more about automated financial models AI, read our blog ‘Why Financial Modeling In Excel Is Not The Future (With Alternatives)’.

Financial Modeling Tools

Financial modeling tools are those skills or sets of information that analysts need to have in their arsenal while going on to evaluate a given enterprise’s value and other such elements.

They also tell you to what extent a company is viable or not. The eight most crucial modeling tools that an analyst must possess are as follows:

• Knowledge of Finance
• Knowledge of Accounting
• Knowledge about the State of the Economy
• A Razor-Sharp Problem-Solving Mindset
• High-Quality Presentation Skills
• Knowledge of Colour Formatting
• Ability to Take Difficult Decisions
• Ability to Think Critically

Learn More:

To dive deeper into financial modeling tools, read our blog ‘Financial Modeling Tools To Make Better Financial Decisions’.

What Software is Best for Financial Modeling?

It is difficult to point to just one financial modeling software and say that this one is the best. This is because there are several of them that vie to be on top of the game. Financial models that are accessible to many and at the same time high on accuracy, naturally come under the limelight.

CrossVal is the best financial modeling software that you can use.

Best Practices for Financial Modeling

While engaged with financial modeling, experts would advise you to make the model easy to audit. In the section below, we have compiled a list of three of the best practices to be taken under consideration while building one’s financial models:

Always Plan Ahead of Time

To carve out a successful financial model, you will most definitely need to have a clear vision and a goal in front of you. Once you have a proper goal in your mind, you will find it easier to conduct future budgeting and sensitivity analysis.

Be Logical While Structuring your Model’s Metrics

Always keep in mind that a functional model will need three primary elements. 

• Inputs or assumptions
• The outputs
• Calculations

Simple Metrics are the most Functional

If you come across anyone who has the slightest idea about financial models, in more cases than one, you will hear from them that it takes only thirty seconds to realize if a particular model is right or not. It has been seen in most places that simple models are the most accepted in business circles.

To keep the model easy to use and clean, remember to keep the assumptions under 15. Along with this, one should also keep the lengths of the formula half the size of the formula bar. Limiting the use of cell names also helps on this front.