Updated October 25, 2023

Building Financial Model Introduction

The motive behind building financial models is to help in a security valuation, forecast future company raw materials needs, or determine the benefits of a hostile takeover or merger. And hence, it is exclusively useful by financial analysts. A financial model software calculates, forecasts, or estimates financial numbers. A financial model for a project is simply a quantitative representation of the financial information of a business, organization, or government.

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The Gist of Building a Financial Model

The financial model for a project can range from simple formulas to complex computer programs that may take hours to run. These are the mathematical models in which variables are linked together. And let me tell you, if you want your Photographs to be taken in front of Wall Street, be sure you are excellent at building financial model software. Also, remember this Golden Rule: Microsoft Excel skills are a must to build or update financial model software. Some high-end programs are built for complex financial model software, such as Value-at-Risk (VAR) models, which are used in risk management.

Are There Different Types of Financial Models Used on Wall Street?

Yes absolutely. It is Wall Street, so it’s also got to have something big in financial models for projects. Most financial model software is focused on valuation. But these other financial models in Excel templates are meant to quantify and predict risk, portfolio performance, or general economic trends within an industry or region. Also, at the same time, several different methods are employed for valuation in financial modeling. The most common models used to assess the value of the security are the discounted cash flow models (DCF models) and capital asset pricing models (CAPM). However, the difference between the two is that; the discounted cash flow model is used to estimate the fair price of a security with respect to identifying undervalued securities. On the other hand, the capital asset pricing model focuses on the valuation of security within the context of its volatility or risk.

There are other types of financial models software that you can use as per the need:

Comparative Company Analysis Model
Sum-of-the-parts model
Leveraged Buyout (LBO) model
Merger & Acquisition (M&A) model
Industry-specific financial model
Option pricing model
Corporate finance models

These financial models for projects are used to solve different problems in the industry. The key here lies in identifying the time and type to use the correct financial model for a project. Hence, to gain expertise in financial modeling, you should know the basics of Excel templates.

Uses of Financial Models

Financial models are used in the following:

Historical analysis of a company
Investment banking
Equity research
Projecting a company’s financial performance
Project Finance
Real estate investments
Oil & Gas projects
Banks & Financial Institutions
Personal finances
Non-profit organizations
Government

Users of Financial Models

Four main groups of users specifically concentrate on building financial models. Those are as follows:

Business owners and entrepreneurs
Finance and Accounting professionals
Financial Modelers and Consultants
Individuals for personal finance

Let’s see the areas where you can use your financial modeling skills.

Forecasting future raw material needs
Valuation of a security
Benefits of a Merger or an Acquisition
Check the size of the market opportunity
Sketching the Roadmap to profitability
Evaluating the investment requirement
Quantifying and predicting risk
Evaluating Portfolio performance
Identifying undervalued securities

Bear in mind that if you are in financial decision-making for a large corporation, you would need financial model software daily. Thus, financial modeling is mandatory for investment bankers, project finance persons, bankers, equity research folks, PE & VCs.

The Basics of Building Financial Models

The first step in building financial models is gathering pertinent data from a company’s financial statements. This step of financial model construction is called financial statement analysis.
Also, you must know that a financial model in Excel templates may require additional information, like the comparative data from the financial statements of other companies. This is specifically true when a comparative company analysis is being conducted.
A financial model for a project may involve further sophistication. This may include the incorporation of financial model sensitivity analysis, which enables a model to track potential scenarios in the future.
Some examples of highly sophisticated financial model software used on Wall Street are the leveraged buyout model (LBO) and the merger and acquisition model (M&A model). Both these models are commonly employed in investment banking and closely related areas, such as private equity and venture capital.
Financial Models are usually with the X-axis serving as the time frame. The time frame may include quarters or full years. On the other hand, the y-axis breaks down the result by line item (i.e., revenue, cost of goods sold, EBIT, PAT, etc.)
Building financial models are relatively straightforward. You must make assumptions and estimates for certain items like revenue, COGS, SG&A, etc. The financial model assumption must lie between the proper limit and not be extreme.
At the same time, make sure that the mathematical formulas are correct. From this simple base, building sophisticated and interconnected models for the income statement, balance sheet, and cash flow statement is possible.
You can also build macros that allow investors to create “bull/bear/base” scenarios that can be changed with a simple click or two.

Steps in Building Financial Models

Now we come to the main point of building financial models. Here we will understand the crucial steps involved in building financial models.

1. Data Collection and Industry Analysis

Data collection and industry analysis are the first steps in building a financial model. This is where the real your real work will be concentrated. You need to go through the respective company’s annual report and read it until your eyes are red or your spectacle number increases at least by 0.5! Data collection is an important step to help you perform your historical analysis. Historical analysis will give you some trend values to start with your future projections and assumptions. And this is the basis for your projections.

Along with your data collection work, you may also want to concentrate on the Industry analysis part. Knowing your industry is quite important. Get the trends of how the industry has been performing for the last five years. You may carry out Porter’s five forces, PESTLE, or SWOT analyses. Identify the risks associated with your industry and try to gauge how much the industry has contributed to the nation’s GDP.

2. Deciding on a Layout

The second step in building a financial model is deciding on a layout. Identifying a proper layout for your financial model software is a must. The layout in Excel must be simple and presentable. Remember how we talked about running away immediately to get some fresh breath? We don’t want to choke ourselves, right? Asking yourselves the following questions will help you come up with a proper layout.

How much information would the model have?

If the information and data part is large, we will definitely not include it one after another. In this case, breaking the model into multiple sheets will make sense.

What kind of assumptions would the model include?

For better readability, we would try to make each of the schedules in different tabs and then link the values from them to the financial statements.

Some important tips that you may prove handy while building financial models are:

Your readability of the model enhances by using different fonts or formatting options.
Create logical modules for your model.
Keep your P&L, Balance Sheet, cash flow statement, and other schedules separate.
Make sure that the line-up items in the financial statement are proper.

3. Projecting the Future Values

The third step involved in building a financial model is projecting future values. This is the main crust of your entire financial model. Hence, consider all the corresponding scenarios and conditions before making any assumptions. Perform your forecasting for each schedule separately. Link the forecasted values properly to the income statement, balance sheet, and cash flows. Make sure that you use maximum Excel formulas to make your work easy. Use proper color coding for formulas, constants, and linkages.

1.     Focus on expenses
2.     Outline how the product or service is built, marketed, sold, or delivered
3.     Analyze your financial model assumptions and benchmark your projections
4.     Create detailed financial statements

Tips for Building Financial Models

Are you preparing for financial modeling jobs? Then only downloading financial modeling templates won’t help. This will help:

Ensure you are good in Accounting, Finance Valuation, and Excel skills.
Ask yourself one question that will easily help you choose the right path. “What problem I’m going to solve by creating this financial model?”
Understand the scope, benefits, and limitations of building financial models.
Remember one basic principle: Garbage in, garbage out. So, check your inputs necessarily.
The model should be simple and easy to understand.
It should be flexible enough to accommodate future revisions.
Your Time management skills will play a key role here. Don’t be stunned by numbers and calculations in your Excel sheets.
Lastly, ask yourself if you were able to come to a particular decision and conclusion at the end of the exercise. If yes, then you are doing things the right way!