What is Financial Modeling?
Investopedia defines financial modeling as:
“the process of creating a summary of a company’s expenses and earnings in the form of a spreadsheet that can be used to calculate the impact of a future event or decision.”Investopedia
Financial modeling is a numerical depiction of a business’s activities in the past, present, and projected future. Models like this are meant to be used as decision-making aids.
What is the purpose of a financial model?
Either inside or outside the business, the results of a financial model is useful for decision-making and financial analysis. Financial models will be used by executives inside a business to make choices about:
- Obtaining funds (debt and/or equity)
- Buying (or selling) enterprises and/or assets
- Organically expanding the business. For instance, innovating.
- Selling business assets
- Projecting and budgeting to plan for the future
- Determining the worth of the business
- Accounting for management
- Ratio analysis/financial statement analysis
- Allocating capital
How to Build Financial Model
1. Preliminary findings and assumptions: Every financial model begins with a company’s past performance. You start by extracting three years of financial data and entering them into Excel to create the financial model.
Then you calculate things like revenue growth rate, gross margins, variable expenses, fixed costs, and inventory days, among other things, to reverse engineer the assumptions for the historical period. From there, you may use hard codes to fill up the forecast period’s assumptions.
2. Begin your income statement: With the projected assumptions already set, you can compute sales, COGS (cost of goods sold), gross profit, and operating expenditures all the way down to EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) at the top of the income statement.
3. Begin your balance sheet: You may begin filling up the balance sheet now that the top of the income statement is complete. Start by computing the revenue and COGS functions of accounts receivable and inventory and the AR (Accounts receivable) days and inventory days assumptions. Fill in the accounts payable section based on COGS and AP (Accounts Payable) days.
4. Establish the relevant schedules: You must first develop a schedule for capital assets such as Property, Plant & Equipment (PP&E), as well as debt and interest, before you can finish the income statement and balance sheet. The PP&E schedule will increase capital expenditures and deduct depreciation from the historical period.
The debt schedule will also use historical data to add debt rises and deduct repayments. The average debt balance will be used to calculate interest.
5. Make a profit and loss statement and a balance sheet: The income statement and balance sheet are completed with the data from the relevant schedules. Align depreciation with the PP&E schedule and interest to the debt schedule on the income statement. You may then figure out your profits before taxes, taxes, and net income.
Connect the closing PP&E balance and closing debt balance from the schedules on the balance sheet.
6. Create a cash flow statement: After you’ve completed the income statement and balance sheet, you may proceed to create the cash flow statement. To calculate cash from operations, start with net income, subtract depreciation, and account for changes in non-cash working capital.
7. Make graphs and charts: Charts and graphs are the most effective approach to display the outcomes of a financial model. Because most executives don’t have the time or interest to investigate the model’s intricate details, charts are handier.
Note: A comprehensive financial model will typically include at least three outputs: financial statements, and operational cash flow projection, and a KPI summary.
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