What is Financial Modelling

What is Financial Modelling?

Financial modelling is a numeric representation of a company’s financial condition in a spreadsheet format. It comprises all the past, present, and future values. Financial analysts use these values to analyze a company’s performance. 

It is an essential tool in the financial decision-making process. For example, analysts use these models to estimate company valuation or compare the company with its competitors in the industry. In addition, analysts also create this model to present in front of investors and raise capital. 

Analysts look into factors such as income statements, balance sheets, debt analyses, stock valuations, IPOs, and graphical analyses to create an accurate financial model. However, errors or miscalculations in financial models can generate adverse outcomes. As a result, companies sometimes use external auditors and professionals to verify the model.

Historical Background

Few know about Dan Bricklin, the founder of the modern spreadsheet and an MIT graduate. He created the first technical framework for a spreadsheet that is easier to develop and more understandable. Before that, data analysts would use enormous computer systems to maintain and document a spreadsheet.

Dan Bricklin thought to create a format of the spreadsheet that is edible and has advanced calculation options available. He and Bob Frankston designed VisiCalc (visible calculator) on 17th October 1979. This was an in-built software in all Apple II computers. In addition, this program minimized the use of pen and paper for budgeting and forecasting.

Today, Microsoft Excel is the leading spreadsheet program available to the general public. Although some financial analysts believe that there are modeling calculations that are beyond MS Excel’s capabilities. Such measures use AI-powered systems to handle and edit company data. 

Components of a Financial Model

There are several components of financial modeling. Each of these components requires accuracy and well-maintained documentation. 

  • Balance Sheet

The balance sheet is an official financial statement that states the assets, liabilities, and shareholders’ equity for a given period. It provides investors with information about the owned assets of a company and the debt it is obligated to pay to its lenders. 

To analyze a company’s past performances, analysts compare previous balance sheets with the current one (usually annual). Comparison will give investors an image of a company’s financial performance. Investors and analysts also use the data present in the balance sheet to formulate financial ratios such as the debt-to-asset ratio.

The accounting equation for a balance sheet is an asset equal to the sum of liabilities and shareholders’ equity. Private companies use personal analysts to verify their balance sheets. However, public companies must consider an external auditor to verify their balance sheet according to the securities & exchange commission.

  • Income Statement

An income statement, a profit & loss statement, is a comparative statement of a company’s revenue, income, and expenses. An income statement’s primary role is to report a business’s income in a particular period. In current business practice, private companies create annual or semi-annual reports apart from public companies that make quarterly income statements to offer financial insight to the general public. 

The income statement has four phases: gross income, operating profit or EBIT (earning before interest and taxes), EBT (earning before taxes), and net income. These stages of the income statement account for the difference between ratios and margins. For example, a higher EBIT but an EBT specifies higher interest payments by the company.

A company’s senior management use income statements as a medium of decision-making. Through expense and profitability ratios, managers can look for production capacities or an operational expansion toward a new location. 

  • Cash Flow Statement

A cash flow statement delivers data regarding a business’s cash inflows and outflows. The inflows include all the revenue from services provided and products sold by the company. It also comprises outflows going as expenses, interests, and taxes. 

Cash flow statements present investors with documentation on all the transactions involved in the company’s business. A cash flow statement has three components: operating, investing, and financing. All these components have different fundamental roles to play in creating the account. 

In accrual accounting, companies differentiate between cash position and income statement. As a result, such companies use cash flow statements as the cash positioning of a company. 

A negative cash flow statement states that more money is going out of the company than the inflowing revenue. It also shows negative if the company focuses on paying off the debt and interest payments. 

  • Debt Obligation

When a company borrows money from a bank or financial institution, it must pay the debt back with interest. Companies that struggle to pay debt payments are likely to declare bankruptcy in the future.

Debt is one of the most crucial components of any business. It is a widely accepted practice to use debt financing to develop a business. A company pays debt and interest payments first as soon as it generates operating profits. As a result, investors consider companies with high debt-to-equity ratios very risky. 

Types of Financial Models

There are several types of financial models according to the company’s business structure.

  • Initial Public Offering (IPO) Model

IPO is the first phase of stock offerings before a private company goes public. Publicizing a company can involve significant factors, such as improving the company’s capital position through public investments. After going public, companies list on stock exchanges and provide shares through verified stock brokers.

Financial analysts and investors begin creating a financial model for IPO after the board decides to make the company public. Analysts also use IPO models of other companies providing similar services for comparative analysis. IPO has an issued discount at the beginning of the term to compensate for the risk involved. 

  • Mergers & Acquisition (M&A) Model

Merger & Acquisition is a business practice that acquires or merges different companies to minimize risk and improve profitable market share. An M&A financial model is an advanced modeling technique to create spreadsheets on two companies’ development. These models clarify if merging or acquiring a company is profitable in the long term.

There are specific steps in the creation of an M&A model.

  • Initiating assumptions for the acquisition of another company
  • Estimating project worth
  • Generating value of each business
  • Merging businesses and making collaborations
  • Considering the change the online business would face due to merger or acquisition.
  • Leveraged Buyout (LBO) Model

In a leveraged buyout, a company develops a new operating body that occupies another business. The new functional body then becomes the initial company’s subsidiary.  

The LBO model is a high-functioning complex financial model. It is used by private equity firms, financial institutions, and investment banks to assess a company’s debt leverage. The most used program to create an LBO model is MS Excel. 

The primary goal of an LBO model is to enable investors to make high returns on their investments using a debt system.

  • Three-Statement Model

As the name suggests, a three-statement model uses a balance sheet, income statement, and cash flow statement to develop a financial model. Analysts build a linkage between these three statements using spreadsheets. 

It is the most basic structure developed by investment companies. Created with single worksheets, these models operate with basic formulas and are easy to navigate. They aim to estimate the financial position of a company. In addition, it generates an idea about how a company will perform in different scenarios.

  • Budget and Forecasting Models 

This model comes under financial planning and analysis (FP&A). It relies totally on the company’s income statements

Advanced financial models use budgeting and forecasting as initial steps toward investment decisions. The primary objective of these models is to maintain a budget profile for the company, usually every quarter. 

Financial analysts use envelope budgeting strategies to build budgeting and forecasting models.

Why Create Financial Models?

Analysts use financial models to justify a company’s position in the future market. In addition, it generates a company’s value or market capitalization and growth rates associated with its revenue. As a result, financial models play a vital role in decision-making.

Creating a financial model has several benefits, such as bringing in more investors, company valuation, mergers and acquisitions, financial ratio structure, and growth stability. In addition, a fresh graduate analyst uses excel to generate accurate economic models.

Combining Financial Modelling with Artificial Intelligence

Artificial intelligence and machine learning are part of today’s business industry. These programs are so unique that they can predict financial forecasts and budgets considering every micro and macroeconomic factor. 

Computer and data scientists are developing computer languages to create accurate financial models. The intelligence of an AI system can generate optimum results and contribute heavily to financial technology. 

One example of a fintech model is Modano. Modano is a software company that leads an online integrated financial model program. This program has monthly price packages to choose from. Other third-party financial modeling companies include Oak Business Consultants. Oak is an international financial service provider that uses advanced finance software to create professional business models. 

Spreadsheets might be one of many ways to build financial models with the evolution of financial technology. There can be a new way to prepare models using little human intervention.

Such AI-powered financial models will be able to read the change in accounts and change accordingly continuously. 

One major drawback of these advances is that people will lose their jobs. The labor-intensive workforce will face significant challenges as technology keeps developing solutions for businesses.

Wrapping it up

The financial model is an essential component of economic analysis. These models help in forecasting future scenarios for a company. Companies should provide analysts with accurate information to manage an advantageous financial position in the upcoming business years. This information leads to the creation of a superior financial model. Any errors in the data will generate faulty results, and the outcome will bring significant capital losses.

The future of financial modeling is under development and will soon nullify traditional practices. Businesses will acquire applications to create financial models without spreadsheets. All the current financial analysts should prepare themselves with technological skills for future challenges.

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