Many outsiders often ask a question: what constitutes a financial model? The answer is not as simple as some may imagine. Because of the variety of intended uses, the definition of a financial model can only be a rather broad one. Simply put, a financial model is a spreadsheet (most commonly in Excel) created for the purpose of financial analysis of companies, projects, portfolios and other subjects. Financial models are used in Investment Banking and Corporate Finance fields, as well as Commercial Banking, Portfolio Management and Venture Capital / Private Equity applications. Different types of financial models exist:
Risk analysis models used to analyze different types of risk
Trading models – used in portfolio management and sales/trading functions
Portfolio allocation models determine asset type and other allocations within a portfolio.
But the most commonly used type of a financial model, and the core of the Financial Modelling Group’s courses, is the financial statements projection model. Financial Modelling Group’s flagship Financial Modelling in Excel and Valuation course focuses specifically on building a financial statement forecast model and later derive at a company’s valuation using the model’s outputs. Financial statements projection model forecasts the company’s future financial results and consists of:
Cash Flow Statement
Supporting schedules – CAPEX Schedule, Debt Schedule, Working Capital and other schedules.
The financial projections model is an essential building block for valuation and investment decision making analysis. Subsequent valuation models such as the Discounted Cash Flow (DCF) models, Comparable Trading and Comparable Transaction analysis models, LBO (Leveraged Buyout) models, and Mergers and Acquisitions (M&A) models build on the financial statements projection model.
The level of detail of a given model depends on its intended use. For example, if the model’s purpose is to analyze your company’s tax situation, then building a detailed tax schedule into your model will suit that purpose. In another example, if your company has a complicated debt structure with layers of senior and junior debt, adding a complex debt schedule outlining all debt segments and determining repayment order will be warranted. Finally, if you want to analyze the CAPEX program of your company , you need to build a more comprehensive CAPEX schedule to analyze different CAPEX inputs and their dynamics over time.
When building a financial statements projection model an analyst creates financial statements of a company that reflect its historical financial performance (usually 1-3 years), and forecasts the company’s financial performance over a certain period of time (usually 3 to 10 years). The forecast period can be monthly, quarterly or yearly depending on the requirements. The modeller focuses on the three main financial statements: Income Statement, Balance Sheet and the Statement of Cash Flows.
The Income Statement would typically have the following line items: Sales Revenue; Cost of Goods Sold (COGS); Sales, General and Administrative Expenses (SG Research and Development Expenses (R Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA); Depreciation and Amortization Expense (D Interest Expense; Earnings Before Taxes (EBT); Income Tax Expense; Net Profit (Net Income).
The Balance Sheet in the financial modelling context will consist of the following line items: Current Items (Cash, Investments, Accounts Receivable, Deferred Taxes, Prepaid Expenses, Inventory); Fixed Assets – mainly Property, Plant and Equipment (PP&E) net of Accumulated Depreciation; Current Liabilities (Short-term Borrowings, Current Portion of Long-term Debt, Accounts Payable, Accrued Expenses); Long-term Liabilities mostly Long-term Debt and Pensions; Shareholders’ Equity typically consisting of Common Stock, Treasury Stock and Retained Earnings.
The Cash Flow Statement acts as an indicator of sources and uses of cash. In a typical model it consists of the three main parts: Cash Flows from Operating Activities, Cash Flows From Financing Activities and Cash Flows From Investing Activities. Every year-to-year change in the model’s Balance Sheet is reflected on the Cash Flow Statement.