Have you ever wondered how investors make decisions about a company’s future? Or how do they determine if an investment is worthwhile? Well, the answer lies in financial modelling.
Financial modelling is one of the most used tools in finance. It often seems like an intimidating and complex skill, and to an extent, it is. But if you think of it as trying to determine the future value of a business and what’s a reasonable price to pay for said business today, then you’re on the right track.
Financial Modelling & Financial Models: What Are They?
Financial modelling involves creating a mathematical representation of a company’s future performance. The process uses historical company data, investor assumptions and various financial techniques to project and value a company’s future earnings.
Financial models are the tools for projecting and valuing these outcomes. They help investors and analysts evaluate the viability and profitability of investments and can range from a simple budget forecast to complex multi-scenario simulations for mergers and acquisitions.
Who Uses Them & Why?
The primary purpose of financial modelling is to aid decision-making by providing insights into potential outcomes. Some of the users, with their use cases, include:
- Investment Bankers – to assess the feasibility of mergers, acquisitions and initial public offerings (IPOs).
- Equity Analysts – to value companies and recommend investment decisions.
- Corporate Finance Teams – to evaluate business expansion and capital budgeting.
- Private Equity & Venture Capitalists – to assess investment opportunities and potential returns from investments in private companies and startups.
- Entrepreneurs & Startups – to forecast cash flow needs and assess the sustainability of new ventures.
Financial modelling is a staple of finance – everyone everywhere uses it.
Key Components of Financial Modelling
There’s no one-size-fits-all approach to modelling, so each financial model will be unique to the person using it. Despite this, financial models typically include the following.
- Assumptions & Inputs – key model drivers like revenue growth, profit margins, interest rates and tax rates.
- Historical Financials – entire financial statements or extracts of financial statements that form the model’s foundation.
- Forecasts – projections of a company’s future financials based on investor assumptions and inputs.
- Supporting Schedules – additional details showing how some forecast figures were calculated.
- Valuation Techniques – to determine the value and potential return of an investment.
- Scenario & Sensitivity Analysis – to assess the impacts of different assumptions on forecasts and valuation.
Depending on the degree of control an investor or analyst wants on the outcomes, some of these components would be absent or summarised.
Types of Financial Models
There are several model types, each tailored to specific needs and industries.
Three-Statement Financial Model
This is the foundation of most financial models. It links the income statement, balance sheet and cash flow statements to help investors, analysts, and businesses understand how changes in one statement affect the others.
Discounted Cash Flow Model
This is used for valuation purposes (determining a company’s worth and how much to pay for its shares today). It estimates the present value of a company’s future cash flows by discounting them using an appropriate discount rate.
Mergers & Acquisitions (M&A) Models
A specialised financial model that evaluates the impacts of mergers (combining companies) and acquisitions (buying another company). It includes projections for revenue synergies and cost savings (how well the companies will complement each other) and accretion/dilution analysis (determines if a deal creates or destroys shareholder value).
Leveraged Buyout (LBO) Models
Designed for private equity firms to assess the feasibility of acquiring a company using a significant sum of debt. LBO models include detailed assumptions about financing structure, debt repayment schedules and the potential return based on an exit strategy.
Options Pricing Models
Used in financial derivatives markets, this model values options based on volatility, time-to-expiration, interest rates and the underlying asset’s price. The Black-Scholes Model and the Binomial Option Pricing Model are common types.
Real Estate Financial Models (REFM)
This model helps investors analyse the cash flow, financing structure and return on investment for real estate projects. Common model elements include net operating income (NOI), cap rates, and internal rate of return (IRR).
Financial Modelling Best Practices
An effective financial model is easy to use, reuse, read and understand. If you’ve built models before or are thinking about making them, here are some industry best practices to help you.
Simplicity & Transparency
Avoid unnecessary complexity and ensure clarity. A financial model doesn’t work if the person building it can’t operate or explain it.
Consistent Formatting
Adjust column widths and row heights, use borders and apply colour coding for a clean presentation and clear understanding.
Colour Codes For Financial Models
- Blue (RGB: 0, 0, 255 / HEX: #0000FF): For hard-coded inputs such as revenue growth rates and other non-calculated assumptions.
- Black (RGB: 0, 0, 0 / HEX: #000000): For formulas and other calculations.
- Green (RGB: 0, 176, 80 / HEX: #00B050): For formulas that pull data from another worksheet.
- Red (RGB: 255, 0, 0 / HEX: #FF0000): For any references to external workbooks/files to highlight dependencies.
- Orange (RGB: 255, 102, 0 / HEX: #FF6600): For error-checking formulas, such as balance sheet balancing checks.
Build For Flexibility
Make it easy to update inputs and assumptions without disrupting the entire model. A model that can only be used once is a waste of time.
Avoid Hardcoding Numbers
This ties into the previous point. Use cell references and dynamic inputs instead of embedding numbers into formulas.
Use Error Checks Consistently
Use built-in checks to flag potential errors…Ensure you make them orange 😉
Document Assumptions & Methodologies
Clearly outline key inputs and the rationale behind them. This enhances use, transparency and understanding for you and others (if you intend to share the model).
Rounding It Up!
Financial modelling is essential for everyone and everything in finance, investment and business. The financial world is built on models and spreadsheets (kind of a joke, maybe not).
Understanding the key components, types of models, and modelling best practices is a good starting point if you wish to get into finance.
Regardless of the use case (valuation, risk assessment or strategic planning), a well-structured financial model is a powerful tool for navigating the complexities of finance and investing.
