Chapter 1 – Financial Modelling

Introduction

Financial modelling is a representation in numbers of a company's operations in the past,

present, and the forecasted future. Such models are intended to be used as decision-making
tools. Company executives might use them to estimate the costs and project the profits of a
proposed new project. Financial modelling is 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.

Objectives of Financial Modelling

 To create a summary of a company's expenses and earning.

 Financial analysts most often use it to analyse and anticipate how a
company's stock performance might be affected by future events or executive decisions.
 To estimate the valuation of a business or to compare companies to their industry
competitors.
 To estimate the valuation of a business or to compare businesses to their peers in the
industry.

 Financial modelling combines accounting, finance, and business metrics to create a

forecast of a company’s future results.
 The main goal of financial modelling is to accurately project a company’s future
financial performance.
 Modelling can be useful for valuing companies, determining whether a company should
raise capital or grow the business organically or through acquisitions.

Reason for Financial Modelling (Usage)

There are many types of financial models with a wide range of uses. The output of a financial
model is used for decision-making and performing financial analysis, whether inside or outside
of the company. Financial models are used to make decisions about:

 Raising capital (debt and/or equity)

 Making acquisitions (businesses and/or assets)
 Growing the business organically (e.g., opening new stores, entering new markets, etc.)
 Selling or divesting assets and business units
 Budgeting and forecasting (planning for the years ahead)
 Capital allocation (priority of which projects to invest in)
 Valuing a business
 Financial statement analysis/ratio analysis
 Management accounting

Who builds financial models?

There are many different types of professionals who build financial models. The most common
types of career tracks are

 Investment banking,
 Equity research,
 Corporate development,
 FP&A, and accounting (due diligence, transaction advisory, valuations, etc.).

Benefits of Financial Modelling

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1. A financial model is developed after having a deep insight into the business. The analysts
understand how a business operates and what the different factors that could impact such
business are.
2. To understand how a business is performing, it is important to do the variance analysis.
Financial models help in carrying out the variance analysis by comparing the actual results of
the business against the budgets.
3. Financial models provide clarity on the expected cash inflows and outflows. A business can
get to know the net cash flows that it would be required to arrange to run its affairs.
4. Companies that wish to know their worth can use financial models. A financial model helps
in determining free cash flows that are expected to accrue to a business at different points of
time which further helps in reaching the fair value of a business.
5. Since a financial model helps in carrying out due diligence by suggesting the financial impact
of a particular activity, thus, it helps the businesses in minimizing the overall risk in a business.
6. Businesses may take months to get answers to certain financial questions and to determine
the impact of a certain decision.
7. Financial models build financial budgets and forecasts based on business data and thus, tend
to be accurate. Businesses can use these budgets and forecasts for their business activities so
that their activities remain structured and within the defined structure.
8. The models also help in carrying out a cost-benefit analysis of new projects. Businesses can
use financial models to understand as investment shall be made in which areas and projects for
better profitability and growth.

Financial Modelling Skills

The most important financial modelling skills are:

1. A solid understanding of accounting

In order to build a financial model, it’s important to possess a solid understanding of accounting
fundamentals.

2. Strong Excel skills

In order to build a financial model, it’s important to possess a solid understanding of accounting
fundamentals.
3. Knowing how to link the 3 financial statements

Another skill that’s very important is being able to link the 3 financial statements. This means
taking historical financial statements (income statement, balance sheet, and cash flow
statement)

4. Understanding how to build a forecast

Being good at forecasting is definitely both an art and a science. An analyst can use regression
analysis to predict future results based on historical results.

5. A logical framework for problem-solving

A good financial analyst has the ability to think logically and in a very organized manner.

6. Attention to detail

This is an absolutely essential skill for financial modelling. Given the vast amount of
information and the intricate nature of a complex model, if you don’t have attention to detail,
you’re not likely to be great at financial modelling.

7. Ability to distil large amounts of data into a simple format

One of the hallmarks of someone with great financial modelling skills is their ability to distil
large amounts of complex information into a simple format.

8. An eye for design and aesthetics

One of the least discussed, yet most important, financial modelling skills is having an eye for
design and aesthetics.

9. Clear presentation skills

A great financial modeler will also be able to create an effective PowerPoint Presentation and
Pitchbook to communicate the results of the model to managers, executives, or clients.

10. The ability to easily zoom in on details, and zoom out to high-level strategy
Think about financial modelling as a systematic way to understand the company. Here is what
the name, ‘Integrated Financial Modelling’, means –
Financial = Indicates that we are working with the company’s financial statements
Modelling = Indicates that we are laying down a company’s financials systematically,
connecting these financial statements and subjecting the same to a bunch of equations. The
entire thing tied together is called a model, a model with specific input (financial statements)
and a specific output (valuations).
Integrated = Implies that all the numbers are interconnected, and no part of the financial model
is isolated. You will understand this better as we progress through building the financial model.
The end objective of any financial model is to help you build a perspective of valuation. The
final output of the financial models is the company’s share price after factoring in everything
that matters. You take the share price from the model, compare the share price against the
market share price, and figure if the stock is fairly valued, undervalued, or overvalued.

Tools of the craft

Let me break the ‘not so good news’ first – to learn, build, and benefit from a financial model;
it is mandatory to have some background knowledge about the following –

o How to read an annual report

o How to read the financial statements of the company – Balance Sheet, P&L,
Cash Flow

o It would be best if you were comfortable working with MS Excel or any other
software similar to MS Excel

The good part is that you can learn how to read the annual report, Balance sheet, P&L, and
Cash flow in the fundamental analysis module.