Financial Modeling is a decision-making tool and skill used since 1978 for decision-making in any field where finance is involved. It is a non-negotiable skill you need as an investor, banker, or Investment banker, and research analyst. In this article, I shall take you step by step, on answering this question -“What is financial modelling?”
My name is Allen Aravindana and I am a trainer, CFA Charterholder and Fund manager for 11 Years I have been teaching and implementing financial modeling for quite some time. A serious understanding of financial modeling comes when you actually apply it in real life and I was fortunate to have done that early in my career to see its results in real time.
So here is how I am going to explain it.
What is Financial Modelling- Historically?
The Beginnings of What is Financial Modeling Today
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.
The Start of Organised Financial Modelling
Since Bricklin wasn’t the one who would just target grades but a problem solver by nature, supported by his MIT Degree he went on to discover a simpler solution. Bricklin connected with his programmer friends and the two designed “VISI Calc”, the first electronic spreadsheet released on an 80 kb floppy disk. It was made using the recently launched Apple computer. That was the beginning of spreadsheet and its use in finance as we know today. Today all the major companies like Apple, Google and Microsoft have their own spreadsheets but all of them came from this small case study at a business school. From there today financial modeling has evolved into every aspect of decision-making in finance, including equity research, project finance, financial analysis, Budgeting, Forecasting, Trading, Business plan, marketing plan, banking and many more.
You have to thank the professor at Harvard for this case study, else probably we won’t have spreadsheet after all!
You can read his entire story here: https://www.firmex.com/resources/blog/financial-modeling-history-spreadsheet/
What is Financial Modelling?- Model Building Process
A Financial Model is made in the following process
Decide the objective of a Financial Model
This is the most critical step and requires careful thinking on what is the end goal. There can be many like deciding to 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 by Research
Models are worthless and so will the decision be if your assumptions are not well researched. As we discussed in the first step, the objective was to take a decision and you conviction of the model will not be in its complexity but its assumptions. People usually are behind learning to create templates but the real work is in getting your assumptions as precise as possible. You could also research using models which are already made by other authors, it can give you a good start
Creating a 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. Creating a financial statements template is a skill which gets more, optimised over time with expereince.
I am putting this step because most of us understand financial modelling more for finance. If you were to take a financial model for a valuation case of a publicly listed company, at this stage you would gather all the historical financial statements data. That is the Income statement balance sheet and cash flow statement. How many years back depends upon how relevant it is. You won’t take 15 years old financial statement, because the business dynamics would have changed anyways. Hence the common sense is to go back as much as you think would help you in forecasting the future. Trust me this is the most painful part of creating a financial model, which is to add each and every line item.
Analysis and Forecasting
Now comes the fun part, you got all the possible data but you to use the processor given to you to understand the drivers of the business. For eg. If I take a financial Model for a IT Company and want to analyse it, then I would break its revenue into
What is a three statement Financial Modelling?
Domestic vs International and check its YOY Growth
Break down revenue into Price x Quantity- For an IT Company it would be Billing rate per hr x Man Hrs ( People multiplied with Hrs they work)
Check if their billing rate is increasing
Read con call reports, Interview IT professionals, and read IT magazines to see if there is any scope of the billing rate to increase
A similar exercise you will have to do to forecast their costs, Debt schedule, Asset schedule etc.
In fact predicting a growth rate for a company has more to to with understanding its revenue drivers, which means its business model rather than just a plain growth rate analysis.
- Ratio Analysis- While you make a financial model for a company, it is also very important to analyze the company’s key metrics with the help of ratio analysis. While you perform ratio analysis, you can analyse the company’s financial situation( Solvency), Profitability, Efficiency and return performance.
Ratio Analysis Tutorial
Check this simple video on ratio analysis, done on Asian paints vs Berger on activity ratios.
- Deciding on the valuation Methods or Other Decision Calculation
- There can be many methods to use to decide based on the type of financial model we are making. If it were a business plan then it would be returns calculation, NPV etc. Also the NPV and IRR is calculated on the free cash flow, which is calculaed from cash flow statement.If it was a stock valuation model then it would be either discounted cash flow dcf model or Relative valuation. Relative valuation could be used if the company doesn’t have positive future cash flows.
- Valuation assumptions like beta, which is basically a measure of relative riskiness is also calculation
- Simulation and Sensitivity
- Your financial Model was made on the basis of static assumptions, but as a decision maker you would want to know all the “ What If’s”. This is the step where we try to create data tables, and scenarios to check our decision metrics
- This is how a sensitivity analysis looks like, shown on image 6
What is Financial Modelling Applications?
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.
- Equity Research and Financial Analyst
- M&A Model
- Corporate Finance Analyst
- Portfolio Management
- Credit Ratings
- LBO model
- Budgeting and Forecasting
- Project Finance
- Treasury Management
- Trading Models- Back testing
- Business Forecasting
- Business Plan
- Budgeting Models
Types of Financial Models
- Three statement Model – The most common- Basically creating three future financial statements of the company. Check this full tutorial here
- 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) – 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.
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
- Corporate Banking Analyst
- Credit Analyst
- Management Accountant
- Wealth Manager/ Financial planner
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
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:
- 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:
What is financial Modelling Pre-requsites.
Now I will be honest with you that if you have a solid background on finance it does really help but the problem is that now a days with the quality of education at colleges, its really hard to differentiate anyone whether they come from finance or non finance background. My personal experience though, teaching non finance students has been much easier and I have seen a lot of success there. That’s true because of a simple reason- “ Half knowledge can be dangerous”. So the answer to that is no pre-requisites.
How Difficult is it to Learn
Well a simple answer to that is, easier then cooking a meal. Yes since its so practical and real life the the learning curve usually for most of the students is high. Although with a few hiccups in accounting and statistics, which we at mentor me careers, spend close to 15 sessions on. You can’t really become a soldier without learning how to handle a gun!
Check out our detailed syllabus of our program here: https://share.hsforms.com/124fUfmEUSvKd3KC8fjnzQQ8mmky
Free Resources for financial modelling course
Here is my list of free resources to learn to get a flavour of financial modelling
Relevance of Financial Modeling skill in 2021
Financial modelling is a decision making tool as we discussed time and again, and decision making is still pretty much a humanized. Although the sophistication of the models are rising. More than just building a model, learning financial modelling actually teaches you the process or a thinking map for taking financial decisions. Hence it has and will be always relevant until financial decisions get outsourced to computers. Financial Modeling is also one of the most important part of the investment banking course run by Mentor Me.
I have attached the Naukri research on the skill rank of financial modelling by recruiters above and also various industries like hiring for it like investment banking, KPO’s , Equity research , credit ratings etc.
Financial Modeling Tutorial
I would conclude this long detailed discussion on “ What is financial Modeling” with a few words of advice for young graduates, investors and entrepreneurs. Every company, every investment and all the successful folks out there are not successful because they are just talented, its also because hours and hours are spent on researching, preparing and then finally persevering through times when your decision might not be working according to you but that’s the time you need a plan to refer to check if you are in the correct path.
Not learning financial modelling is like telling an airline pilot not to create a flight plan, you don’t want to be on that plane without a flight plan.