What is Financial Modelling and How to Build a Comprehensive One?

Investment banks decide a public-going company’s valuation by creating financial models. Private equity firms depend on financial modelling to make investment decisions. Mergers and acquisitions happen after creating detailed financial models. And due diligence into a company’s future is also decided by taking the help of financial models. In this fast-paced world where businesses are always looking to outrun the market, predicting the future is some way is important. Financial models help managers and executives do just that where decisions get based on facts and numbers instead of intuitions and assumptions.

With the above it is clear that people who know how to build a financial model will always be on-demand.

What is financial modelling?

Financial modelling is a technique with which businesses forecast financial futures to understand possible performances. Based on historical data and a few logical assumptions, financial models can paint the growth or dip curve in terms of cash flow, revenue, capital and more. In other words, financial models predict the business’s health a few years down the lane and help decision-makers to evaluate investment opportunities in the present day.

Going back to the examples stated in the introduction, company A creates a relevant financial model of company B to understand how their merger now will help both in the future. Similarly, investment banks build financial models to determine the right IPO value now so that they make a profit by selling to interested promoters later. As evident, by grasping what is financial modelling and becoming efficient in building one can propel any candidate’s career into sure shot success as the concept resides in the DNA of companies of all sizes.

How to build a comprehensive financial model?

Creating financial models involve a flurry of detailed steps. Each varies with the type of model that you intend to build. However, to give you a synopsis of how to build a financial model, here is an overview of the necessary steps.

1.     Assumptions based on history

All financial models start with collecting data from the company’s history. Hence, you will have to gather the financial statements of the company for the past 3-5 years and look at their growth trends. Accordingly, you make assumptions as to what the picture will look like in the future following the same curve.

2.  Calculate financial statements

Equipped with historical data and the necessary assumptions, you are now to calculate the parameters of the 3 important financial statements for a future time. You place calculated figures for gross profit, operating expenses, accounts receivable and inventory size. You also make necessary adjustments to accommodate depreciation and debt.

3.     Execute DCF analysis

Discounted cash flow helps you to come to the present value that you can safely invest. Based on your predictions and calculations, DCF discounts the cash flow of the future and returns the required intrinsic value. The DCF step also requires you to include sensitivity analysis so that your results are as close to the real world as possible.

4.     Complete with tests and charts

The final step of how to build a financial model is always depicting your analysis with the help of graphs and auditing every parameter to remove errors. Such complex nuances of financial modelling can only be mastered by training. Even testing can become complicated if you use large formulas in Excel and present in an unorganised form.