First Module Financial Modelling
First Module Financial Modelling
• Financial modeling is one of the most highly valued, but thinly understood, skills in financial
analysis.
• The objective of financial modeling is to combine accounting, finance, and business metrics to
create a forecast of a company’s future results.
• A financial model is simply a spreadsheet which is usually built in Microsoft Excel, that forecasts
a business’s financial performance into the future.
• The forecast is typically based on the company’s historical performance and assumptions about
the future, and requires preparing an income statement, balance sheet, cash flow statement,
and supporting schedules (known as a three-statement model).
• There are many types of financial models with a wide range of uses. The output of a financial
model is used for decision-making and performing financial analysis, whether inside or outside
of the company. Financial models are used to make decisions about:
• Growing the business organically (e.g., opening new stores, entering new markets, etc.)
• Valuing a business
• Management accounting
There are various kinds of financial models that are used according to the purpose
and need of doing it. Different financial models solve different problems. While majority of
the financial models concentrate on valuation, some are created to calculate and predict risk,
Among different types of Financial model, DCF Model is the most important. It is
based upon the theory that the value of a business is the sum of its expected future free cash
flows, discounted at an appropriate rate. In simple words this is a valuation method uses
projected free cash flow and discounts them to arrive at a present value which helps in
evaluating the potential of an investment. Investors particularly use this method in order to
Also referred to as the “Comparable” or “Comps”, it is the one of the major company
valuation analyses that is used in the investment banking industry. In this method we
undertake a peer group analysis under which we compare the financial metrics of a company
against similar firms in industry. It is based on an assumption that similar companies would
have similar valuations multiples, such as EV/EBITDA. The process would involve
selecting the peer group of companies, compiling statistics on the company under review,
calculation of valuation multiples and then comparing them with the peer group.
SUM-OF-THE-PARTS MODEL:
company by determining the value of its divisions if they were broken down and spun off or
to meet the acquisition cost. This kind of model is being used majorly in leveraged finance
at bulge-bracket investment banks and sponsors like the Private Equity firms who want to
acquire companies with an objective of selling them in the future at a profit. Hence it helps
in determining if the sponsor can afford to shell out the huge chunk of money and still get
Merger & Acquisitions type of financial Model includes the accretion and dilution
analysis. The entire objective of merger modeling is to show clients the impact of an
acquisition to the acquirer’s EPS and how the new EPS compares with the status quo. In
simple words we could say that in the scenario of the new EPS being higher, the transaction
will be called “accretive” while the opposite would be called “dilutive.”
specified future date”. Option traders tend to utilize different option price models to set a
current theoretical value. Option Price Models use certain fixed knowns in the present
(factors such as underlying price, strike and days till expiration) and also forecasts (or
assumptions) for factors like implied volatility, to compute the theoretical value for a
specific option at a certain point in time. Variables will fluctuate over the life of the option,
and the option position’s theoretical value will adapt to reflect these changes.
Step #2: Isolate The Parameters: The purpose of a financial model is to accurately forecast the revenues
and the expenses which may occur in the future. However, it is important to understand that these
revenues and expenses do not function in isolation. These revenue and expense numbers are actually
the result of an interaction between several underlying parameters. Therefore, if an attempt is made to
predict the numberswithout understanding the parameters involved, it is likely that the predictions will
notbe very accurate. Hence, understanding the key parameters which influence the business is of vital
importance. These parameters may be specific to the industry or even to a specific organization.For
instance, companies which use commodities as their input or output must be mindful of the effect of
fluctuations in commodity prices. For example, an increase or decrease in steel and cement prices will
have a huge impact on the real estate industry.Similarly, if a company derives a major part of its revenue
from exports, then it may be vulnerable to fluctuations in currency rates.
At the end of this stage, a financial modeler must have identified all the relevant parameters which are
likely to impact their business. These parameters must be isolated and provided as an input to the user.
This will provide the user with the ability to vary the parameters one at a time and validate the results.
The individual effect of each parameter on the breakeven level and the profitability can be identified if
the model has been designed well.
Identify Cost Behaviours: A profit and loss statement shows a static view of the expenses involved.
However, the reality is that not all expenses behave in the same manner when the volume of production
increases or decreases. For instance, depreciation charge remains the same, regardless of the output
that a machine produces. Similarly, labor charges remain more or less fixed in the short run, regardless
of whether they are used for production or not. However, there are costs such as raw materials, which
vary directly with the level of production. Also, there arecosts such as electricity which may increase
with the increase in production. This is because successive units of electricity are more expensive as
compared to previous ones
It is important that this behavior of different costs has been fed into the financial model. This will ensure
that the model gives reliable results when it is simulated to know the expected profitability at different
production levels.
Step #4: Identify Inter-relationships Amongst Parameters: A financial modeler must ensure that their
model is logical at all times. For this reason, it is important that they identify the inter-relationships
between various parameters and also model them. For instance, a rise in price would have an inverse
relationship with the quantity sold. Similarly, a rise in one expense may sometimes reduce or even
eliminate other expenses. The problem is that the relationship between parameters is often complex.
and non-linear. Identifying and modeling them accurately is an art which needs to be learned over
several years.
Step #5: Provide a Range for all Parameters: More measures need to be taken to ensure the logical
accuracy of the model. It is for this reason that all parameters whichhave been identified need to be
given a range. If the results of the financial model go beyond a certain range, it should throw an error.
Companies, then need to run thousands of iterations of these tests to ensure that all possible errors
have been identified and even rectified in the process. The end result would be a sturdy and dependable
model which can be used for decision making.6.
Step #6: Scenario Analysis: Lastly, the financial model should be built in such a manner that it does not
give only one result. The reality is that the future is highly uncertain, and decision-makers would be
better off if they are provided several scenarios. For example, the best-case scenario when revenues are
the highest and the costs are the lowest. The worst-case scenario when costs are the highest and
revenues are the lowest.
• Even if a model is based on assumptions, this can help you to estimate the financial results.
• In a model, different scenarios can be created and tested. Thus, a company can adapt quickly to
a changing situation and avoid liquidity risk.
• Flexibility :
• Experienced Financial Modeller can make extensive changes to a model in a few hours.
• Efficiency:
• Spreadsheet programs are installed by default on most computers and therefore no additional
investment is required. In addition, no programming skills are required
• By inputting every single figure from the annual report, an investor is forced to scrutinize each
and every account on a yearly basis.
• Such a process fosters a deeper understanding of a company and uncovers anomalies which an
investor might otherwise miss out
The Cons
Time consuming.- Building a model is indubitably a time-consuming affair, depending on the level of
details, it can take between one to a few hours to get all the numbers in. Based on the 80-20 rule,
there is diminishing returns to the amount of additional information generated per unit time spent.
Time spent on modelling is likely to be more productiveif spent on other forms of analysis
Inaccuracy.
- Financial models are built on a
myriad of assumptions,
resulting in grossly inaccurate
forecast figures and misguided
investment decisions. This is
the most common gripe
against financial modelling, and
a valid one. On a more serious
note, financial models
are also extremely prone to
manipulation due to the large
number of assumptions it
requires. In this regard, a
financial model is hardly an
objective tool for investment
analysis, and can instead
exacerbate an investor’s innate
biasedness
Inaccuracy. - Financial models are built on a myriad of assumptions, resulting in grossly inaccurate
forecast figures and misguided investment decisions. This is the most common gripe against
financial modelling, and a valid one. On a more serious note, financial modelsare also extremely
prone to manipulation due to the large number of assumptions it requires. In this regard, a financial
model is hardly an objective tool for investment analysis, and can instead exacerbate an investor’s
innate biasedness