What is Financial Modelling?

What is financial modelling

Financial Modelling is an exercise wherein an analyst prepares a detailed company specific financial statement forecast for some decision making purposes like valuation, financial statement analysis, M&A and project financing.

In other words, Financial Modelling is the process to make Financial Statement projections with the help of assumptions. Any model which does not include the projections of Income statement, Balance sheet and cash flow statement is not a financial model. A financial model must include the projections of three financial statements.

A standard financial model will include Historical financial statements, Historical analysis, assumptions, working schedule for projection of Revenue, expense, basic & diluted EPS, working capital, capital expense, depreciation & amortization, shares & equity, debt & cash flow statement.

Steps in financial modelling:

  1. Understand the objective of Financial Model.
  2. Understand the business of company, revenue drives and projection parameters
  3. Collect 3 to 5 years historical financial statements from Annual report of company
  4. Clean the historical financial statements from non-recurring items and prepare a non-GAAP or pro forma financial statement before you do the historical analysis
  5. Based on company specific drivers and projection parameters, perform historical analysis for each item of Income statement, Balance sheet and cash flow statement.
  6. Based on management guidelines, historical analysis, research reports, market consensus and your objective and knowledge about the business take your assumptions for all items of IS, BS, CFS and SOCE.
  7. Based on assumptions & schedules, prepare a robust dynamic integrated Financial statement model of the company.
  8. Perform ratio analysis to test the strength and weakness of company health
  9. Financial model will take its final shape after scenario analysis. We have to test the changes in the results if our assumptions goes wrong.
The accuracy of Financial model will depend on the accuracy of assumptions. If assumptions are wrong then financial model will also give you incorrect cash flows, profits and asset & liabilities. So accuracy of assumptions will depend on your knowledge of Business and availability of information and source of those information like research reports and databases and software like Thomson research and Bloomberg.

Financial model can be prepared in just 2 hours or it can take several weeks. It will depend on the scale of business and availability of information about the company.