What Is Financial Modeling?

A financial model is simply a tool built into spreadsheet programs such as MS Excel to predict a company's future financial performance. Forecasts are typically based on the company's historical performance, assumptions about the future, and require the preparation of the income statement, balance sheet, cash flow statement, and support programs (known as the Three Data Model). From there, more advanced types of models can be built such as discounted cash flow analysis (DCF model), leveraged-buyout (LBO), mergers and acquisitions (M&A), and sensitivity analysis. Below is an example of financial modeling in Excel.

What is a financial model used for?

The output of a financial model is used for decision making and performing financial analysis, whether inside or outside of the company. Inside a company, executives will use financial models 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? (Job and career)

There are many types of professionals who create financial models. The most common career types are Investment Banking, Equity Research, Business Development, FP&A  and Accounting  (due diligence, transaction, valuations etc.).

How do you learn financial modeling?

The best way to learn financial modeling is to practice. It takes years of experience to become a financial modeling expert. Reading stock research reports is a useful way to practice as it provides something to compare results with. One of the best practices is to take historical financial data from mature companies, build flat models of the future, and calculate net present value per share. This should be closely compared to the current or target price in the stock research report. It is also important to deepen your basic understanding by taking specialized training courses on financial models provided by CFI in  North America or directly online.

What are financial modeling best practices?

1. Excel Tips and Tricks

 It is very important to follow best practices in Excel while creating forms. For more information, take our free Excel course, which outlines the following key topics:

• Limit or eliminate mouse use (shortcuts are much faster)
• Use blue font for codes and input (formulas can remain black)
• Keep formulas simple and break down complex calculations into steps
• Know how to use Excel formulas and key functions
• Use INDEX and MATCH instead of VLOOKUP to query data
• Use the CHOOSE function to create scenarios

2. Format

It is important to make a clear distinction between the inputs (assumptions) in a financial model and the outputs (calculations). This is usually achieved through formatting conventions, such as making entries blue and formulas black. You can also use other conventions, such as shading cells or using borders.

3. Template design

The structure of a financial model in the form of a logical and understandable project is essential. This usually means creating the entire model in one worksheet and using grouping to create different sections. This makes it easy to expand or contract the model and move around easily. The main parts that should be included in a financial model (from top to bottom) are:

1. Assumptions and stimuli
2. income proof
3. Balance Sheet
4. Statement of cash flows
5. Help tables
6. Evaluation
7. Sensitivity analysis
8. Graphs and diagrams.