Financial modeling is a business tool that companies use to recreate a fictive situation and forecast the organization’s future performance. Usually, financial modeling is based on the business’ previous achievements and capabilities. This task is a representation of a potential future financial outcome, assuming all of the existing predictive models come to pass in the real world.
Financial modeling is used extensively in domains such as accounting, investment banking, corporate finance, and more. Using this method, companies can forecast their financial statements.
What Is Financial Modeling?
A financial model represents a way in which a company develops a documented situation that might reveal some future aspects of the company’s performance. In many ways, this can also be called a mathematical model that shows the financial health of a specific organization.
The whole purpose of creating a financial model is to project dynamic statements regarding the future state of a company and then properly analyze the results. Furthermore, this method of forecasting the future helps in the decision-making process.
A common financial model presents the company’s statements such as depreciation level, revenue and profits, taxes, interest expense, and more.
Why Do You Need a Financial Model?
The financial modeling process is a crucial step for your entire operational planning. There are plenty of advantages that a financial modeling process can offer. Most companies use it to create scenarios and do research that can help future decisions and strategy development.
Furthermore, this kind of analysis can show you how long your company can function without revenue. However, this can be a helpful result only if you create a good financial model that shows all the costs in an accurate way.
Using this tool, you can even predict periods of cash flow growth by adding a revenue chapter to your financial model. You can even update the model in real time, to adjust it to new market requirements.
Things That Financial Modeling Reveals About the Company
Usually, a financial model shows the following things about a company’s needs and performance:
- The need of the company to attract additional funds
- The business’ reaction to a number of crisis situations as well as market conditions
- Comparative analysis results: what company is great for further investment that will also return a higher cash flow
- Analyzing the risk level and take proper action to reduce it as much as possible
- Potentially wrong strategies and faulty decisions that might have consequences such as loss of clients
- Designing the right business plans to discover the weak and strong points of the company
How to Create a Financial Model?
There is a relatively standard way in which you can create a financial model. However, there are some things to consider to make your company’s financial model different and unique in the eyes of potential investors.
A good and practical financial model should be simple, clear, and direct most of the attention toward cash flow drivers. Moreover, financial modeling should reveal how big the company’s risks are, and base all assumptions and estimations on reliable facts.
Simple Steps to Create the Basic Elements of a Financial Model
- Define your business model and design it the way you want the financial model to look like.
- Set the goals. Create a list of the most important objectives that you want to reach with this financial model.
- Choose the right financial modeling elements for your specific goals. There is no such thing as a standardized financial model that works for every business and every type of purpose.
- Make a list with some of your estimations and assumptions. There are two types of estimates. Top-down estimations refer to your potential market share. Bottom-up estimates are about crafting your assumptions starting from the smallest units.
- Determine start-up costs. If this is your first business and you are just starting it, then you should write down all the expenses involved in creating a company.
- Take into consideration all financial indicators such as fixed costs, gross margin percentage, as well as the breakeven point.
Financial Modeling Techniques
Creating a financial model means providing some projections regarding the business’ future state. There are four major elements that a good financial model reveals about the company: income statement, balance sheet, cash flow statement, and debt schedule.
Furthermore, every big element of those enumerated above contains some smaller indicators that you must follow and estimate when making your financial model. Building your whole financial modeling process with this method will eventually introduce a circulatory model. This particular model can be described as follows:
- Interest expense lowers net income.
- Due to net income reduction, also cash flow decreases.
- Lower cash flow leads to increased debts levels.
- Interest expense levels will get higher, which further leads to another wave of net income reduction.
This circular model can create serious problems for the whole financial modeling process. This is why you need to put a stop to it. There are a few solutions to end it that can easily be put into practice, especially if you work with an excel spreadsheet:
- You can break the circular model by replacing the interest expense column with zeros.
- Another financial modeling technique is the sensitivity analysis. This method is a common practice in building a strong financial model, and it is similar to the uncertainty analysis. Both of them show the percentage of uncertainty in the output of the model as well as in its inputs.
Excel Financial Modeling
When creating financial models, get ready to work with a lot of excel spreadsheets. Even though the amount of work is quite big, you can use some tips and tricks to simplify the use of reports. One of the recommendations made by specialists is to color-code all excel sheets. This way, you will quickly find what you need.
When it comes to financial modeling training, the most important thing to remember is to always format your work. When you are in charge of a big company you must pay attention to many important issues. Multitasking works only to a certain point. This is why it so important for you to organize your financial model planning carefully, to have easier and faster access to all the data you need. Nowadays, there are plenty of options when it comes to choosing the right financial modeling course. Training is important, especially for the uninitiated.
Furthermore, even if one person creates and finalizes the entire document, other employees might need to work with it too. This is why the color coding comes in handy when you want to juggle multiple data sources. Every input added to the initial financial model must be categorized after a standard norm so that everyone understands what they are dealing.
In conclusion, developing a financial modeling process is crucial for your company. However, this is not enough. You will also have to adjust regularly and update this model, considering that the market changes often. Furthermore, make sure that you include all the cash flow entries as well as all the expenses, and keep the model as accurate as possible.