Last updated on July 2nd, 2024 at 03:44 pm
So I remember my first experience working with financial models, when I just started my career in finance. For me initially it felt as if it was something that sounded very complicated. I understood finally what is financial modeling, only after working with financial models for more than 15 years of experience in finance.
Here is a how a real; financial model looks like.
What is Financial Modelling?
In order for you to undetstand what is financial modeling, at the contextual level. You first need to understand various use cases. Let me illustrate some real life scenarios, where you would end up using financial modeling.
Use cases of financial modeling
- I am planning to start up a sugar cane production plant, versus venturing into the education space
In case of the above question, you are using financial modeling to take a decision between two industry choices.
- One of your friends, is confused between opening a hospital versus the business model of a pharmaceutical labs.
Pharmaceutical labs are less complicated and better margins compared to hospitals. So gives you insights on the delicate complications and details of a business.
- You are trying to decide between two stocks: Let say TCS versus Infosys. Both look good and reputed but which one will give you more higher returns?
We know that both these companies are great but what will matter is which of these is reasonably priced. Which means valuation.
What is the Process of Creating a Financial Model
So, now if you closely look at the above problems and situations that I have listed. Which will point out the common sensical process of creating a model.
First Decide the objective or Decision to take
This is the most critical step and requires careful thinking on what is the end goal.
There can be many decisions that you might get based on the circumstances.
- choose between two business opportunities,
- Deciding to choose a specific investment opportunity,
- Evaluating various financing options for a business,
- Planning an entire budget for a business and forecasting the business for the year or multiple years
Gathering Assumptions
This is the most important yet when I was starting out using and making financial models. I always felt that I wasn’t very confident about my model. That’s because I was not confident about my assumptions.
Again let me give you some real life experiences that I have had with this.
- In the early part of analysing sectors like telecommunication, I remember I was making a financial model on Bharti Airtel. May main assumption to be researched was the average revenue per unit. or ARPU.
- But my biggest mistake while making this model, was that I did not spend enough time understand the telecom industry.
- Later as the years past by I understood that telecom business is about tower infrastructure and running profitable regions.
- If you see after Reliance Jio entered the market, Airtel, Vodafone and Idea where still able to survive .
- However, what I failed to see was that data was very expensive in India and may be the ARPU won’t sustain for very long.
Creating a An Appropriate Excel Template
This is an easy step but still requires you to learn what kind of a template would be needed for the decision you want to take.
For eg a template for a algo trading model is going to be very different from a valuation model but similar to a budgeting and forecasting template.
Also this skill comes more with experience when you have worked with different situations and decisions.
Transforming & Collecting Data
Rarely will you ever see a financial model being made with non authentic data. So in the above example of airtel financial model, you have to go to the primary sources of financial statements.
I have summarised this basic process in this diagram below.
Analysis and Forecasting
Now, initially you did the assumptions research, which will become your base for forecasting the data for the future. Let me give you some of my own experiences on this.
- When I was making a financial model on consumer discretionary sector. The main forecasting driver, was the formalisation of the sector.
- For example, in case of the jewellery business in India, the market was cluttered with small jewellery shops. Hence Titan company made the best performer in terms of innovating this space.
- Another issue that I understood this business sector faced was high working capital needs. Because you need to buy and store gold in advance. In a way it blocks your working capital.
- In this case what Titan experimented was with on demand design. Which meant you first paid, looking at the sample design on a tab, and then get the wearable set later after you paid.
However, customers were ready to do this because of the best modern designs available.
Decision
This is the part of the financial model, which always made me nervous. Because, let say after so much of hardworking analysing and collection data You finally get an output that, it’s not worth investing. Or may be the stock is over valued. In case of project finance models, the decision could say that the IRR is too low.
Or in case of a discounted cash flow analysis
At this stage of the financial model, any analyst would attempt to sense check his own model. For example, if your financial model for a diagnostic testing lab assumed an average utilisation of 50%. Then may be you would try use other utilisation rates of lower than 50% to check if you are still profitable. This is also called as sensitivity analysis.
Brief History of Financial Modeling
This can be insightful how this skill became such an important requirement today, and it happened with a small case study thrown at MBA Students at Harvard. Dan Bricklin also known popularly as the god father of spreadsheet, was precisely that student who made this happen. Yea that’s right! An MBA student in a business school ! Making the long story short. Bricklin was attending his finance lecture at Harvard, in the spring of 1978 presented with an assignment to create a ledger sheet (Paper based) financial model for a merger. During those times creating spreadsheet, wasn’t exactly the job of a finance manager, it used to be done by data processors team using mainframe computers.
Applications of Financial Model
By Now you should have understood its importance and why this is such an important skill. You would be very uncomfortable if you didn’t have a financial model in situations where some serious money was at stake. It just simplifies the decision making process and gives you a road map for the future. So the basic types of financial model.
- Three statement Model – The most common- Basically creating three future financial statements of the company. Including income statement balance sheet, cash flow statement.
- Merger Model ( M&A Model)– In this type we are trying to see the effect of A+ B = C or A+ B =A. Meaning either merger or acquisition respectively and checking its effect on the future financial performance
- DCF Model (Discounted Cashflow analysis) – In this model we try to forecast the future free cashflows of the business and find the net present value of these cashflows. Its majorly used for valuation purposes
- Sum of Parts Model – Used when we deal with a large conglomerate. For eg TATA. Tata is a large company with different types of businesses, so it will be very difficult to model the entire business in one go. So we break the business into various parts and forecast them separately
- LBO (Leveraged Buy Out) Model – This is a classic model, in order to understand LBO, consider a real estate purchase done using home loan. You take loan to purchase the house and use the rents generated to pay off the debt and eventually reducing the debt in the house. Apply this exactly like it is to a private equity company purchasing a business using debt.
- Comparable Company Analysis – In this type of model, we try to value a business using competitors and how the market is pricing the business. It is very useful when you have a company which has negative cashflows, hence you can’t actually forecast future cashflows
- IPO Model – Very similar to a valuation model using DCF. The only difference is you are creating this model to take a private company public. Also in the process raising capital.
- Option Pricing Models – Used more for pricing options and is more statistical in nature. But the valuation principles remain the same
- Algo Trading Models – Algo trading is done not basis financial statements but price data and statistics and signals to buy or sell, how to position your trade, risk management etc. This is an advance application of financial modeling.
- Private Equity Models- the types of business’s which invest to private investors in private companies. These models are usually made by investment banks called as private equity firm.
Banking and Finance Roles which require financial modelling certification
Finance is the answer, any finance roles or business roles that you wish to be in would require you to have this skill under your belt . Not every role is going to ask you to put this in your resume but I can’t imagine being a CFO/ Product manager/ Treasury manager without knowing how to take decisions. Still for putting this in black and white here is the list
Check a full guide on careers in these fields
- Equity Research Analyst
- Investment Banking Analyst
- FP&A
- Corporate Banking Analyst
- Credit Analyst
- Management Accountant
- Wealth Manager/ Financial planner
- Entrepreneur
The best way to learn financial Modeling- My Complete Recommended list
There are many ways to learn it from doing it by yourself or watching YouTube videos all the way up to joining a financial modelling course but that depends on your previous understanding of finance, excel and also your preference of interaction and mentoring. Here is my top list on how to learning financial modelling
What is financial modelling best practices
Book: Simon Benninga: (Recommended for Advance Students)
This is the best option if you are already well versed with financial terminologies and can manage without a mentor or trainer. Read here.
Financial Modeling Online Full Course: (Recommended for Most).
There are many out there but I think all of them lack the common fundamental which is comprehensiveness and interactive.
- NSE Financial Modeling Training taught by Mentor Me Careers:
- https://www.mentormecareers.com/courses/financial-modeling
- Is one of the most comprehensive programs I feel is available in the industry, with placement assistance
- 12 specializations,
- Live Interactive Instructor led program,
- Financial Modeling NSE Certification
- Course Duration: 3.5 Months (200 Hours Training)
- Personalized mentoring even during off classroom hours.
- Plus its light on your pocket with easy instalment options.
- Check out our recorded live class here.
- Check Out Google Reviews and success here:
