An introduction to financial modeling

An introduction to financial modeling

Financial modeling is the basic task of building an abstract representation of a real-world financial situation. This is nothing but a mathematical model that is designed to represent the performance of the portfolio of a business or a financial asset, any investment, or any other project. Financial modeling is therefore understood to be an exercise in corporate financing or asset pricing of a quantitative nature.

The entire process of creating a summary of the earnings and the expenses of a company in the form of a spreadsheet that can be used to calculate the impact of a decision or a future event is what financial modeling does.

It is more about converting or interpreting a set of hypotheses about the market behaviors of the agents into numerical predictions. The nature of financing modeling has invited some debate in the industry. People are confused about whether it is a science or simply a tradecraft.

In the accounting profession or corporate financing, financial modeling can be entailed typically by financial statement forecasting. Financial statement forecasting involves the preparation of detailed company-specific models that are used for the purpose of decision making.

The financial modeler creates one cell for the prior year’s sales, cell A, and one cell for the current year’s sales, cell B. The third cell, cell C, is used for a formula that divides the difference between cell A and B by cell A. This is the growth formula. Cell C, the formula, is hard-coded into the model. Cells A and B are input cells that can be changed by the user.

The typical application of financial modelling in the profession of accounting includes:

  1. Business valuation including the valuation approaches and discounted cash flows.
  2. Management decision making and scenario planning.
  3. Capital budgeting includes the cost of capital as well.
  4. Financial statement analysis.
  5. Project finance modeling.
  6. Forecasting of the cash flow.
  7. Credit decisioning that involves consumer credit risk and credit analysis as well as impairment modeling.
  8. Treasury and working capital management.
  9. Management accounting.

Financial modeling is all about representing some or all aspects of a company’s operations in numbers. Financial modeling is indeed one of the most integral tools of the decision-making process. Company executives usually use these models to estimate the costs as well as display the profits of the proposed new project. They are used by the financial analysts effectively to anticipate the impact of any change in the economic policy and or any other event that impacts the stock of the company.

Perhaps practice is the best way to learn financial modeling. It takes years of experience to become an expert at building a financial model and you really have to learn by doing. Reading equity research reports can be a helpful way to practice, as it gives you something to compare your results to.  One of the best ways to practice is to take a mature company’s historical financials, build a flat-line model into the future, and calculate the net present value per share. This should compare closely to the current share price or the target prices of equity research reports.