**What is financial modeling?**

Financial modeling is a tool for

decision making, let me elaborate, whenever you want to make a decision or let’s

say a sensible decision, you need some data, some information, some calculation

to support that. That usage of information, data to decide something is nothing

but a financial model. Let’s narrow it down a bit more and most importantly will also learn how to build a financial model.

Financial modeling is an activity of

preparing any entity’s future financial statement, this future financial

statement is known as financial models.

Let me explain, based on the

information I have right now about the business entity, maybe I could use its

past three years of financial information, the current information about the

industry and my thoughts, my conclusions about How the future will unfold? How

sales of an entity would increase? Will the demand for the product that the

entity is offering will increase or go down? How the capital structure would

change? How will the profits increase? What are the assets required to maintain/increase

the level of sales?

Based on all these things I would try

to estimate how the future financial statements of any particular business

would look like. Though financial modeling is not only concerned about

financial statements, it goes far beyond but on the very ground level, this

exactly is the definition of a financial model. We are trying to prepare an entity’s

future financial statements using the information and the conclusion that we

are going to make about the business and industry information that we have

right now.

**Tools used to prepare financial models**

To build any financial model we need

to process a lot of information data and the best tool we have right now is

Microsoft Excel. Although financial models can be prepared on any spreadsheet

software but there is no other software that is as comprehensive and easy to

use as Microsoft Excel. It is widely used in the industry to prepare financial

models. So, it’s always beneficial to have a good grip on Microsoft Excel.

*(For more information on the usage of
Excel, do check out our other articles below)*

So, I hope, now you have a broad

understanding of what financial modeling is, now let’s move to the next

section.

**Types of financial models.**

**1. Three statement model: **

In this model, we are going to prepare the entity’s

future profit and loss account, balance sheet, and cash flow statement. This is

the most common and most popular financial model that is being used in the

industry.

**2. Merger model: **

When there’s a merger or acquisitions of

entities, it is required to anticipate the earnings, synergies, profit margin,

cash flow, the capital structure of new entities post-merger or acquisitions.

Some questions that are required to be answered before M&A are such as what

will be the revenue of the new entity, what would be the capital structure of

the new entity, etc. Hence, we need to predict all this information through merger

models.

**3. Discounted cash flow model, also known
as the DCF model:**

In this, we try to predict the future free

cash flow of the business and discount it using the appropriate rate and then

try to calculate the value of the business and ultimately value per share. This

is used for valuation purposes.

**4. Sum of parts model:**

When any business is deriving revenue from

multiple segments, for example, Reliance Industries is deriving revenue from

petrochemicals, telecoms, retail, and other sectors as well. So, it is very

difficult for us to calculate the value of entire reliance industries in one

go, as the assumptions and industry situation would change based on the

particular business. Considering similar assumptions for all businesses would

not give us fair results and thus what we will do is, We would calculate the

value of businesses one by one, for example, will value the petrochemical

business, then telecom business, then retail business and similarly the value

of other businesses and ultimately summing up all the different business values

to come up as a single value of the entire Reliance Industries.

**5. Leveraged buyout model, also known as LBO
model:**

This model is used by PE firms to make a

decision while buying entities by using heavy debts, so whenever any private

equity firm purchases any business using lots of debt and uses the cash

generated from this business to pay out the debts, ultimately reducing the

level of debts and increasing the level of equity, it is called as LBO model.

**6. Comparable company analysis:**

It is another kind of financial model that is

used to calculate the value of a business based on how the market is valuing

similar businesses or the businesses operating in the same industry. It is also

used for valuation purposes.

**7. Initial public offering model (IPO):**

It is very similar to the DCF model or

comparable company analysis. Although you have one extra element that is IPO

discount.

**8. Option pricing model:**

Under this, we use the BMM model or binomial

model which uses complex formulas to calculate so it is more or less

statistical in nature while other models were revolving around your accounting

principles, mathematical principle, and financial knowledge.

**Uses of financial model**

We saw multiple kinds of financial models;

they are prepared for the purpose of decision making. So, what are the

decisions you can take or what are the uses of the financial models, we will

have a look at those under this section.

**1. To assess the future operating
performance of the business:**

In order to increase sales we need to

increase the number of employees, so this kind of application can be done in

order to calculate breakeven units i.e. how much units are required to be sold

to reach a point of no profit or no loss, in simple words minimum units that

need to be sold to avoid losses.

**2. To assess future financial performance**:

That is how your profits will be in the

future i.e. in two years or three years or five years down the line, what will

be the profit margin? what are the sales that we need to achieve those profits?

**3. To estimate the capital expenditure
that a particular project required**:

How much money needs to be funded and

how that funded money will be used? what all will be invested in the fixed

assets and current assets? Etc.

**4. To understand the requirement of funds
in the future**:

It includes short-term fund

requirement that is your working capital requirement as well as your long-term

fund requirement that is equity financing or debt financing, getting funds from

PE funds.

**5. To understand what all the cash
flows/free cash flows my business is generating**:

You can estimate the free cash flow

that your business will be generating. We all know the value of any asset is

nothing but the present value of whatever earnings are going to be generated

from that asset in the future, discounted at an appropriate rate.

**6. To calculate the value of the business
or calculate the value of equity i.e. nothing but enterprise value. **

**7. To
perform ratio analysis:**

We can calculate ratios such as

profitability ratios, liquidity ratios, solvency ratios, capital structure

ratios, and many more. We can use the financial model to compute these ratios

and analyze the business performance

**8. To understand how my sales are
growing, how my profits are growing:**

That is nothing but the trend of

business it includes upward growth, static growth, downward growth, no growth,

negative growth.

**9. To perform stress testing, sensitivity
analysis, scenario analysis**:

Although these terms are used

interchangeably but there is a difference. Basically, three scenarios are built

in a financial model such as the worst-case scenario, the best-case scenario,

and the base-case scenario.

These are the multiple uses of

financial models and there could be n numbers of uses. Now let us move ahead to

our next section and also one of the very interesting section

**How to build a financial model?**

So these are theoretical steps which

are going to be discussed here, there is no way you could learn financial modeling

just by reading this article or watching online videos, it’s always about how

much you practice, still, this will definitely help you to understand the

basics and clear some important confusions or doubts you might have and help

you to create the financial models.

So, by this point, we know there are n

number of financial models that are possible, here I will be talking about the

basic financial model that is the “three statement model”. Now how do I make my

three-statement model?

So below are the steps we need to

follow:

**1. Input historical financial information
into Excel**, that means we have entered what we

have, the facts, the data which the company have already mentioned in their

annual reports (In order to learn how to read and analyze annual reports, Click here)

**2. Determine the assumptions that will
drive the forecast**, how much

revenues will increase, how much cost will increase, how much assets do I need,

these all need to be included in the financial model as an assumption.

For example, I am assuming my revenue will

increase by 10% every year based on facts and past performance of the company,

there can be n numbers of combinations and permutations. Basically, we have our

past data and industry information based on which I will be putting my

assumptions about how the future will unfold and what are the factor that will

drive those assumptions.

**3. Forecast the income statement**, once I have noted down my assumptions regarding

future revenue, cost, etc. I can calculate my profit and loss, right? Once I

have my income statement ready, we will move to the next point.

**4. Forecast capital assets**, in order to achieve that particular sale how

much money I need to invest in the machinery. For example, investing in any

particular kind of technology that will help me to boost my sales in the future.

**5. Forecast capital structure**, in order to buy these capital assets I need

funds, and funds can be sourced in two ways, one is debt and another is equity,

so I need to find out where I will be getting this debt, what will be the

interest rate, what will be the contribution of equity holders from where I

will be getting this equity. I need to put in all the assumptions related to that.

**6. Forecast the balance sheet**, once I have my capital structure ready, I

need to forecast my balance sheet, I have my assets, I have my sources of funds

than I can forecast my balance sheet. Once I’m done with the balance sheet, we

will move to the next point

**7. Forecasting the cash flow statement**, we already have the required information so

it won’t be a problem to forecast the cash flow statement, technically it would

be already done, just we have to complete it. (Very easy task)

**8. Prepare output sheet**, there will be some reason why you are

preparing the financial model it could be assessing the profitability of the

project or it could be to calculate the net present value of the project or it

could be calculating the rate of return of the project, whatever it would be we

are concerned with the reason why we are preparing the financial model and that

is something that would be included in the output sheet i.e. the sole motive of

preparing the financial model.

**Final Verdict – Decision**

Post this we are going to make a

decision and mention it separately, so let me explain the final part, if you

want to undertake a project only if the rate of return is say 20%, so after

preparing the financial model we will get the rate of return that would be

derived from that business and if it meets our requirement say it’s 20% or more

than it, then we will proceed with the project or else we will reject it.

I hope you enjoyed this brief overview

on what is financial modeling, it’s scope, uses, types, and how to build a

financial model. If you have any doubt, do let us know in the comment box

below.

Thanks for reading

The Finance Magic