What Is Financial Modeling?
Let me explain financial modeling directly to you: it's the process where I create a summary of a company's expenses and earnings in a spreadsheet, allowing us to calculate how future events or decisions might impact things.
As someone who's worked with these, I can tell you that financial analysts like me use these models most often to analyze and anticipate how a company's stock performance could be affected by upcoming events or executive choices.
Key Takeaways
Financial modeling is essentially a numerical representation of some or all aspects of a company's operations. You use these models to estimate a business's valuation or to compare it against industry competitors. Remember, various models can produce different results, and a model's quality depends entirely on the inputs and assumptions you put into it.
How Financial Modeling Works
Financial modeling represents a company's operations in numbers, covering the past, present, and forecasted future. These models are your go-to decision-making tools. For instance, company executives might use them to estimate costs and project profits for a new project.
As a financial analyst, I use them to explain or anticipate how events affect a company's stock—whether from internal changes like strategy shifts or external ones like new regulations. You can apply these models to value businesses, compare competitors, test scenarios in strategic planning, calculate project costs, set budgets, and allocate resources. Common examples include discounted cash flow analysis, sensitivity analysis, or in-depth appraisals.
Example of Financial Modeling
The best financial models start with basic assumptions. Take sales growth, for example—it's the increase or decrease in gross sales from one quarter to the next. You only need two inputs: prior year's sales and current year's sales.
In the model, I create one cell for last year's sales (call it A), one for this year's (B), and a third (C) with a formula that divides the difference by A to get the growth rate. That formula in C is fixed, but you can change A and B as needed. This setup lets you estimate sales growth based on actions or events.
Ultimately, if you're a stock analyst, you're interested in potential growth, so you model any factor that could affect it. Comparisons between companies are key when deciding on stock purchases, and multiple models help you evaluate industry competitors.
Explain Like I'm Five
Financial modeling is like using the past to predict the future. Businesses create these models to make decisions, such as raising money, growing the company, or setting a budget.
What Information Should Be Included in a Financial Model?
To make a useful and easy-to-understand model, include sections on assumptions and drivers, an income statement, a balance sheet, a cash flow statement, supporting schedules, valuations, sensitivity analysis, charts, and graphs.
What Types of Businesses Use Financial Modeling?
Professionals across various fields rely on financial modeling. Bankers use it in sales and trading, equity research, and both commercial and investment banking. Public accountants apply it for due diligence and valuations. Institutions use it in private equity, portfolio management, and research.
How Is a Financial Model Validated?
Errors in these models can lead to expensive mistakes, so you might send the model to an outside party for validation. Banks, financial institutions, project promoters, corporations seeking funds, equity houses, and others request this to confirm that calculations, assumptions, and results are correct and reliable.
The Bottom Line
Financial modeling uses numerical techniques to forecast a company's future growth. Drawing from the income statement, balance sheet, and estimates of future economic conditions, you can create detailed projections of an investment's performance.
