Finance & Accounting

Financial Modeling: Top 6 Best Practices

What is a Financial Modeling?

Financial Modeling helps estimate a project or business’s financial position by considering all factors, growth and risk assumptions and interpreting their impact. It helps people to understand all the variables present in financial forecasting.

In Financial Modeling, creating a model from scratch or changing the existing Model according to the newly available data. 

Investment Banking forecasts a company’s future financial position and performance by creating a financial model with relevant assumptions, such as how the firm or a project is expected to perform in the upcoming years. For instance, from the initial stage, the amount of cash flow the project will likely produce within five years.

Uses of Financial Model

Financial model can build for various situations, such as the valuation of the company, valuation of the assets, pricing strategies etc.

Following are the area in which financial modeling is come to use:-

• Risk management
• Valuation of a company
• Valuation of an assets
• Budgeting
• Merger and Acquisition
• Capital Allocation
• Evaluating equity, debt and capital

Types of Models in Financial Modeling

Following 6 most important financial model for forecasting are:-

Three-statement model

Three statement model is a familiar and easy-to-prepare model compared to other models. These three statements are prepared: Income statement, Cash flow statement and balance sheet.

1. Income Statement – The income statement, also called the P&L (profit and loss statement). It illustrates a company’s profitability at different levels, and in the end, the company get its net income after deducting all the expense, interest and taxes.
2. Cash Flow Statement – In this statement, three activities are prepared: operating activity, investing activity and financing activity. The cash flow statement adjusts a company’s net income for non-cash charges and changes in net working capital and the above three activities.
3. Balance Sheet – As the name suggests, it balance all the company transactions in one statement. It represents the asset, liabilities and shareholder’s equity value. It provides a snapshot of the company’s financials (what it owns and owes)

Given historical financial data, a 3-statement model projects the future expected performance for a set number of years.

Discounted Cash Flow Model

The DCF (discounted cash flow) model is a type of financial modeling valuation method that calculate the forecasting of future cash flows of a company’s values and discounting them back to present value. The DCF model is an extensively used valuation technique but has several disadvantages.

The DCF model only considers cash flows expected to be received in the future. This means that it does not consider other important factors, such as earnings, dividends, or the value of assets.

The Discounted cash flow model can be challenge to understand and interpret. DCF model depends on a complex formula that discounts cash flows over time.

Comparative Company Analysis Model

The comparative company analysis (CCA) model is a type of financial model in which a company’s value is derived by comparing its stock prices to similar companies in the market.

The first task to do before starting the analysis is selecting the relevant peer group of comparable companies.

Many assumptions are used in this model for analysing the company’s correct value, such as the size of the companies, similarity of their businesses, and availability of data.

These assumptions can have a significant effect on the model’s outcomes.

This model only sees the financial details available in the market and does not consider other essential factors such as profits, dividends, or the value of assets.

Sum-of-the-Parts Model

In this model, the company’s value is the compilation of the values of its business units. This model uses the combination of values that companies own a business’s portfolio in various industries.

To build a sum-of-the-parts model, a company or an individual will need to project the fair value of each business unit and then add up these fair prices to get the total company’s value.

Leveraged Buyout (LBO) Model

• Leveraged buyouts happen when a company buys something using debt and equity. Utilizing the debt in a Leverage buyout increases the Transaction’s risk and can also increase the possible return.
• An LBO model is typically used to help assess the feasibility of a leveraged buyout transaction and to evaluate the potential return on investment.

Usually, this model is used by private equity firms and investment banks to help them examine leveraged buyout transactions. 

Merger & Acquisition (M&A) Model

In the acquisition case, the M&A model helps estimate a chosen company’s fair value. Investment banks also use this model to win new M&A business.

There are several ways to build an M&A model, but the inputs are typically similar. It comprises of: Purchase price, Synergies, Target Company’s stand-alone value, financing mix, interest rates, tax rate

Importance of Financial Modeling in the Organization

• Helps to make well-informed decisions about the future of the company.
• It helps to determine how much risk is involved in different decisions and how each will impact the bottom line.
• Helps to assess the feasibility of new projects.
• Analysing an existing project or business’s potential return on investment.
• Provide the complete picture of the company’s financial position

Best Practices in Financial Modeling

Plan the structure

Before creating the financial model, finance teams avoid preparing a structured plan. This leads to over-complicated models lacking essential features and failing to address operational needs.

There are various aspects people need to focus on that before creating a financial model, such as:-

• The financial problem the model needs to solve
• The end-users of the company and how they will use the model
• The inputs, outputs, and processes of the model
• All inputs will be in one place and quickly and easily accessible during the model creation.
• While preparing the model, keep the goal in mind to get an accurate and valuable financial model.

Logically structured financial model 

The model requires separate spreadsheets and must be appropriately structured to avoid navigational difficulties for the customer, a client, or a third person. 

First, need to find out the factors that impact the model and visualise the content so that users can easily jump on the other sheets quickly. The model includes three essential components: Assumptions, Computation, and Output.

The above model structure will ensure that the financial model is structurally sound and robust.

Keep the financial model simple. 

In the model, use simple and short language and avoid technical words. The basic structure of a financial model includes inputs, creating methods, and outputs. The model should be easy to understand and structured to get positive feedback. 

The following are the aspects included in the Financial modeling to make it simple: – 

• The limited number of assumptions 
• Use a formula which is short and not too long to understand. 
• Do not use repeated cell names.
• Use the same formula over the rows. 
• Follow consistent formatting.
• Try to add a summary

Use formulas instead of values 

There are several problems are facing while using values rather than formulas:

• The model looks complex and challenging for end-users.
• Assumptions are not explicit, which might be difficult for end-users to understand the model.
• The flow of the model is not proper or less clear. 
• Due to data reliability, end-users are less confident because they are unaware of where it comes from. 

Remembering the value while creating the model is easy, but if a person returns it later, they will surely forget the purpose of that value.

Fully integrated Cash flow calculations and balance sheets

The cash flow and balance sheet preparation are essential elements of a 3 statement financial model. When building a model or calculating the business cases, don’t allure to leave out the cash flow and balance sheet. They are fully integrated to ensure proper visualise the inventory turnover, debtor days, creditor days and other aspects that are a segment of the model. Lack of consolidation will lead to difficulties when the reader needs to estimate a cash flow position.

Check the accuracy of model

Several factors include to ensure that the model is accurate:

• Group the rows
• Check the formulas, placing
• Build a systematic naming convention for the file version
• Do not neglect the excel audit function
• Perform sanity checks
• A third person to go through the model

Conclusion

In financial modeling, the goal of creating models is to ensure that readers create a clear and constructive tool from which users can easily benefit. Building such models in Excel or other tools is complicated, with several information and factors to consider. Errors are almost unavoidable, but following the best practice tips above will clarify the path to creating a valuable and practical financial model and get to know that creating a financial model is essential for calculating the value of the company and determining how much risk involved in particular project or a company.

Read Our Article: Cash Flow Forecasting in Financial Model