Financial Modelling

What is Financial Modelling

• Financial modeling is one of the most highly valued, but thinly
understood, skills in financial analysis.
• The objective of financial modeling is to combine accounting, finance,
and business metrics to create a forecast of a company’s future results.
• A financial model is simply a spreadsheet which is usually built in
Microsoft Excel, that forecasts a business’s financial performance into the
future.
• The forecast is typically based on the company’s historical performance
and assumptions about the future, and requires preparing an income
statement, balance sheet, cash flow statement, and supporting schedules
(known as a three-statement model).
 Why financial model is used for
• 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 
Financial Model is used for…..
Types of Financial Models
• DISCOUNTED CASH FLOW MODEL:
• Among different types of Financial model, DCF Model is the most important. It is based upon the theory that
the value of a business is the sum of its expected future free cash flows, discounted at an appropriate rate.
• In simple words this is a valuation method uses projected free cash flow and discounts them to arrive at a
present value which helps in evaluating the potential of an investment. Investors particularly use this method
in order to estimate the absolute value of a company.
• COMPARATIVE COMPANY ANALYSIS MODEL:
• Also referred to as the “Comparable” or “Comps”, it is the one of the major company valuation analyses that is
used in the investment banking industry. In this method we undertake a peer group analysis under which we
compare the financial metrics of a company against similar firms in industry.
• It is based on an assumption that similar companies would have similar valuations multiples, such as
EV/EBITDA. The process would involve selecting the peer group of companies, compiling statistics on the
company under review, calculation of valuation multiples and then comparing them with the peer group.
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• SUM-OF-THE-PARTS MODEL:

• It is also referred to as the break-up analysis. This modeling involves valuation

of a company by determining the value of its divisions if they were broken
down and spun off or they were acquired by another company.

• LEVERAGED BUY OUT (LBO) MODEL:

• It involves acquiring another company using a significant amount of borrowed
funds to meet the acquisition cost.
• This kind of model is being used majorly in leveraged finance at bulge-bracket
investment banks and sponsors like the Private Equity firms who want to
acquire companies with an objective of selling them in the future at a profit.
Hence it helps in determining if the sponsor can afford to shell out the huge
chunk of money and still get back an adequate return on its investment.
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• MERGER & ACQUISITION (M&A) MODEL:

• Merger & Acquisitions type of financial Model includes the accretion and dilution analysis. The entire
objective of merger modeling is to show clients the impact of an acquisition to the acquirer’s EPS and how
the new EPS compares with the status quo.
• In simple words we could say that in the scenario of the new EPS being higher, the transaction will be
called “accretive” while the opposite would be called “dilutive.”
• OPTION PRICING MODEL:
• On, to buy or sell the underlying instrument at a specified price on or before a specified future date”. Option
traders tend to utilize different option price models to set a current theoretical value.
• Option Price Models use certain fixed knowns in the present (factors such as underlying price, strike and
days till expiration) and also forecasts (or assumptions) for factors like implied volatility, to compute the
theoretical value for a specific option at a certain point in time. Variables will fluctuate over the life of the
option, and the option position’s theoretical value will adapt to reflect these changes.
Steps to Create a Financial Model
• Start With Historical Facts
• Isolate The Parameters
• Identify Cost Behaviors
• Identify Inter-relationships Amongst Parameters
• Provide a Range for all Parameters
• Scenario Analysis
Benefits of Financial Modelling

• The benefits of financial modelling are huge.

• Availability of information: for decision making in order to take strategic
advantage.
• Even if a model is based on assumptions, this can help you to estimate the
financial results.
• In a model, different scenarios can be created and tested. Thus, a company can
adapt quickly to a changing situation and avoid liquidity risk.
• Flexibility :
• Experienced Financial Modeller can make extensive changes to a model in a few
hours.
• Efficiency:
• Spreadsheet programs are installed by default on most computers and therefore no
additional investment is required. In addition, no programming skills are required
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• Fosters deeper understanding

• By inputting every single figure from the annual report, an investor is forced to
scrutinize each and every account on a yearly basis.
• Such a process fosters a deeper understanding of a company and uncovers
anomalies which an investor might otherwise miss out
Disadvantages of Financial Modelling
• Time consuming.- Building a model is indubitably a time-consuming affair,
depending on the level of details, it can take between one to a few hours to get all
the numbers in.
• Based on the 80-20 rule, there is diminishing returns to the amount of additional
information generated per unit time spent.
• Time spent on modelling is likely to be more productive if spent on other forms of
analysis
• Inaccuracy. - Financial models are built on a myriad of assumptions, resulting in
grossly inaccurate forecast figures and misguided investment decisions.
• This is the most common gripe against financial modelling, and a valid one. On a
more serious note, financial models are also extremely prone to manipulation due
to the large number of assumptions it requires.
• In this regard, a financial model is hardly an objective tool for investment
analysis, and can instead exacerbate an investor’s innate biasedness