WHAT IS FINANCIAL MODELLING?
Financial modelling is the process of projecting and estimating the financial performance of a business or project by taking into account all the relevant factors, risk assumption and growth, and interpreting the impact thereon. It enables the investors or user to acquire a concise and consolidated knowledge of all the factors involved in financial forecasting.
HOW DOES IT WORK?
Financial Modelling is either maintaining the existing model by implementing newly available inputs and data to it or building a model from square one. As we know, financial situations are of a volatile and complex nature. It helps the investor to gain a deep understanding of all the factors of the complex situation. In investment banking, it assists in forecasting the potential financial future of a company by making relevant assumptions of how the business or project is expected to perform in the forthcoming years, for example, how much cash flow is likely to be produced within 5 years from its start.
It is convenient to work on different individual legs of the model without affecting the whole structure and avoiding huge problems. It is useful when the data inputs are subject to change with newly available data. So there is a certain amount of flexibility one can have with the structure when working on Financial Modelling as long as they are to the pint.
WHERE IS FINANCIAL MODEL USED?
It can be done for various circumstances, for instance, valuation of an asset, valuation of a company, restructuring situations, pricing strategies, merger and acquisition among others. Some of the prominent areas where it is used are:
- Valuation of an asset of company
- Risk Management
- Option Pricing
- Mergers and Acquisitions
- Capital Allocation
- Raising Capital
BEST PRACTISES IN FINANCIAL MODELLING
It should be based on such formulas and assumptions that can be easily understood by others whether from the finance field or not.
The logical integrity is very significant. As the author of the model may alter, the system should be rigorous and integrity should be kept at priority.
Its scope should be flexible and adaptable in every situation as contingencies are a part of the industries. The flexibility of a financial model depends on how convenient it is to alter or modify the model whenever it is necessary.
It should not be cluttered with too many details. While producing a financial model, a good presentation of reality is very important so that the user does not need to find details, they should be laid in front of him.
PREREQUISITES TO FINANCIAL MODELLING
Building a financial model will only be fruitful when it is giving out the results that are dependable and accurate. To achieve efficiency in preparing a model, you should possess a required set of skills which can assist you in great ways. Let us see what these skills are:
1. Excel Skills:
The prime financial modelling is done in excel where a wide range of complex calculations are spread over multiple tabs which are interlinked to show the relation with one another. Having an in-depth working knowledge of excel like keyboard shortcuts, formulas, presentation varieties, Macros among others are a must while formulating a model.
2. Understanding of basic accounting:
Building a model is a pure financial document that uses financial numbers from a market or company. There are certain accounting concepts and rules that are constant in the financial world across the globe, for example, US GAAP, IFRS among others. These rules help in maintaining the consistency of the presentation of financial events and facts. Understanding these concepts and rules are of significant importance.
3. Interlinking of Statements:
A financial modelling statement needs to be interlinked together. Interlinks assist vital users in the model to flow from one statement to another, hence completing the inter relationship between them and showing the complete picture of the financial situation of the entity.
The skill of forecasting is significant because generally the purpose of it is to arrive at an understanding of the future scenario of any financial situation. Forecasting is both a science and an art. Using reasonable assumptions while predicting the numbers will give an analyst a close enough idea of how attractive the company or investment will be in the coming time period.
Financial modelling is full of numbers, minute details and complex formulas. Different groups use it like clients, management and KMPs. They will not decipher any meaning from the model if the model is looking messy and hard to interpret. Hence, keeping the model simple in presentation and at the same time rich in substance is the way.