As the business world continues evolving, it is important to address how to build a financial model.
Most job listings in the finance sector list "financial modeling" as an essential, desired skill. It is seen that these skills have increased in demand almost exponentially.
Knowing how to build a financial model increases your employability in the finance sector and is a good thing to know if you plan on investing or starting your own business.
Understanding forecasting and preparing an income statement is just a small part of it.
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What is a Financial Model?
A financial model represents a business's past, present, and future operations, and it's a must in almost every business plan.
It's a type of business report that relies on accounting. It's important to have a solid understanding of basic accounting for business transactions when building one.
Understanding the building, using, and modifying of these models is a must.
Knowing how to build a financial model is a needed skill for those starting new businesses, starting new lines of business within existing companies, or assessing financial performance within a new or existing business.
Benefits of Building a Financial Model
When you build a financial model, you're representing a real-life situation with numbers so that decision-makers can make improved financial decisions.
If a financial problem in the real world needs to be solved, analyzed, or translated into an easy-to-digest numerical representation, a financial model is a big help.
Sometimes it's just a concept or idea that needs translating into an easy-to-understand proposal or use-case.
For instance, how can you convey the depreciation on a piece of equipment?
Or explain a free cash flow sensitivity analysis?
These models help you build working business plans that help with budgeting, financial planning, and more.
Once you become adept at financial modeling, you can help others understand the grandest of concepts, from the cost of goods sold (COGS) and corporate finance to investment banking and private equity.
You'll help put actual meaning into business ideas as you supplement details that officers can use to make decisions, garner investors, or hire staff.
As an example, financial models help investors choose which projects are worth their time and money. Models help executives discern the most plausible marketing campaigns having the highest ROI. They also help production managers choose when and if purchasing new equipment is right for the company.
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How to Build a Financial Model in 6 Steps
Knowing how to build a financial model is a must for financial officers, investors, and others involved in the financial operations of a business or organization.
Here are the six basic steps for building a financial model:
1. Gather historical data. You'll need at least the last three years of financial data for the company.
2. Calculate ratios and metrics. Using the historical data from the first step, you'll calculate historical ratios and metrics, like growth margins and rates, asset turnover ratios, and inventory changes.
3. Make informed assumptions. Armed with your historical data, ratios, and metrics, continue using this information to build future ratio and metric projections. Use assumptions to calculate future growth margins and rates, assets that may turnover, and projected changes in inventory.
4. Create a forecast. Use all the above data and reports to forecast the usual accounting documents, such as future income, balance sheet, and cash flow statements. Do this by reversing your original calculations for historic ratios and metrics. Specifically, use your previous assumptions to build out the forecasted statements.
5. Value the company. After you've forecasted, you can now value the company using the DCF, or Discounted Cash Flow, method.
6. Review. Once you have this information before you, use your drafted statements to decide how different scenarios may play out.
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How to Know If Your Financial Model is a Good One
As with anything in business, following best practices is important. When building a model, it must be easy enough for anyone in your organization to understand, yet detailed enough that it can account for the most complex business situations.
Your financial model is a good one if it:
- Is structured well
- Has a good, simple layout
- Is clear and easy to understand
- Makes forecast drivers and future assumptions clear
- Highlights important items fiscal officers care about
- Incorporates visuals
- Is accurate
Building a financial model isn't scary if you chunk it down—create all your steps before you begin. It doesn't hurt to have a game plan before building a financial model.
Have a clear picture in mind of how the structure should appear. This saves you from having to make costly adjustments later. To make the process even faster, you can begin with a financial modelling template.