7.3. Building Financial Models

Financial modeling is the process of creating a detailed, quantitative representation of a company's financial performance or a specific financial scenario. It involves using Excel to create models that help in forecasting, budgeting, decision-making, and evaluating investment opportunities. In this section, we'll explore how to build financial models step-by-step, covering essential concepts, the components of a financial model, and best practices for effective modeling.

Key Components of Financial Models

1. Assumptions: Every financial model begins with assumptions. These are the foundational inputs that drive the entire model and represent the estimated values for key variables such as revenue growth, costs, taxes, interest rates, and capital expenditures.
   • Examples: Revenue growth rate, cost of goods sold (COGS), tax rate, inflation rate, capital expenditure, debt levels.
2. Income Statement: The income statement (or profit & loss statement) provides a summary of a company’s revenues, expenses, and profits over a specific period. It is crucial for understanding how a business generates profit and where it spends money.
   • Key items: Revenue, Cost of Goods Sold (COGS), Operating Expenses, EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), EBIT (Earnings Before Interest and Taxes), Net Income.
3. Balance Sheet: The balance sheet shows a company’s financial position at a given point in time. It lists assets, liabilities, and equity, providing a snapshot of what the company owns and owes.
   • Key items: Assets (Current and Non-current), Liabilities (Current and Non-current), Shareholder's Equity.
4. Cash Flow Statement: The cash flow statement tracks the flow of cash in and out of the business. It is divided into three sections: operating activities, investing activities, and financing activities.
   • Key items: Cash from operations, Cash from investments, Cash from financing.
5. Financial Ratios and Metrics: Financial ratios such as Return on Investment (ROI), Debt-to-Equity Ratio, Gross Margin, and Current Ratio help in assessing the performance and financial health of a company. They are often used to evaluate the model’s assumptions and to track performance against industry standards or benchmarks.

Steps to Building a Financial Model

1. Define the Purpose and Scope of the Model: Before diving into the numbers, clearly define the purpose of the model. Are you forecasting future revenues, valuing a company, or analyzing an investment decision? The purpose will guide which financial statements and assumptions you need to include.
2. Gather Historical Data: Collect historical data for the company or project you're modeling. This might include past financial statements, industry reports, market trends, and economic indicators. Historical data serves as the basis for forecasting future performance.
3. Input Assumptions: Enter the key assumptions into your model. These assumptions could include sales growth rates, cost projections, capital expenditures, or financing costs. Be sure to provide a range of values for assumptions to enable sensitivity analysis later on.
4. Build the Financial Statements: Using your assumptions, create the income statement, balance sheet, and cash flow statement. Ensure that the financial statements are interlinked. For instance:
   • Net Income from the Income Statement should flow into the Equity section of the Balance Sheet.
   • Depreciation and capital expenditures from the Income Statement impact the Balance Sheet’s assets and liabilities.
5. Link the Financial Statements: The financial statements should be connected. Changes in one statement (e.g., a change in revenue) should flow through to the others. This ensures that the model is accurate and reflects real-world relationships. Use Excel formulas such as SUM, IF, and VLOOKUP to make these links.
6. Forecast Future Performance: With your historical data and assumptions in place, forecast future performance over the time period you’ve chosen (typically 3-5 years). This involves projecting revenues, expenses, profits, capital expenditures, working capital, and debt.
7. Create Scenarios and Sensitivity Analysis: Incorporating multiple scenarios can help assess how changes in assumptions will affect the outcome of the model. For example, you can create "best-case," "worst-case," and "base-case" scenarios for revenue growth or cost changes.
   Sensitivity analysis is also important for understanding how sensitive your model’s outputs are to changes in key assumptions.
8. Analyze Financial Ratios: Calculate key financial ratios (such as Return on Equity, Debt-to-Equity Ratio, Gross Margin, etc.) to assess the company’s profitability, liquidity, and risk. These ratios will provide insights into the model’s reliability and performance.
9. Refining and Stress Testing the Model: Continuously refine the model to account for new data or changes in assumptions. Stress testing the model under extreme conditions (e.g., a significant market downturn) ensures that it remains robust and can withstand uncertain scenarios.

Best Practices for Financial Modeling

• Keep It Simple: Start with simple assumptions and build complexity as needed. Complex models are often prone to errors, so clarity is essential.
• Use Clear and Consistent Formatting: Color-code inputs (assumptions), calculations, and outputs to distinguish between them. This makes the model easier to navigate and understand.
• Link Financial Statements: Ensure that the Income Statement, Balance Sheet, and Cash Flow Statement are all linked so that changes in one statement automatically reflect in others.
• Document Assumptions and Sources: Always document your assumptions and the sources of your data. This transparency allows others (or your future self) to understand how the model was created.
• Test the Model: Run multiple scenarios and perform sensitivity analysis to ensure the model is functioning correctly and provides meaningful insights.
• Use Excel Functions Effectively: Leverage Excel functions like NPV, IRR, PMT, and IF to perform complex calculations. These functions can help automate and simplify many aspects of the modeling process.

Examples of Financial Models

1. Valuation Model (Discounted Cash Flow - DCF): A DCF model is used to estimate the value of an investment based on its future cash flows, discounted back to present value. This model typically involves forecasting free cash flow, determining a discount rate (often the WACC), and calculating the terminal value.
2. Budgeting and Forecasting Model: A company’s financial forecast is based on estimated revenues, costs, and capital expenditures over a period. This model helps with resource allocation, tracking performance against goals, and preparing for future challenges.
3. Investment Appraisal Model: This model evaluates the profitability of an investment by calculating metrics such as NPV, IRR, and payback period, helping businesses or individuals decide whether to invest in a new project or venture.
4. Merger and Acquisition (M&A) Model: This type of model assesses the financial impact of merging with or acquiring another company, helping to determine whether the deal will be accretive or dilutive to earnings and how it impacts the company’s overall financial health.

Conclusion

Building financial models in Excel is an essential skill for financial analysts, business owners, and anyone looking to understand and forecast financial performance. By combining assumptions, historical data, and Excel’s powerful features, you can create models that inform business decisions, investment strategies, and financial planning. Mastering this skill enables better decision-making and a deeper understanding of financial dynamics.