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What is Financial Modeling?

By: Kaplan Schweser
August 16, 2022
What is Financial Modeling

Financial modeling is a widely used technique to forecast financial performance into the future. A financial model is one of the tools used to aid decisions, analyze essential business functions with financial metrics, and more accurately evaluate and understand potential investments. Commonly such models are built in a spreadsheet such as Excel, although more specialized software may be used.

TABLE OF CONTENTS:

The Application of Financial Models

Financial models, when used appropriately, can be invaluable tools that can help executives, investors, and analysts with decisions relating to:

  • Accounting
  • Acquisitions and investments
  • Business growth
  • Forecasts and budgets
  • Asset disposals
  • Valuations
  • Analysis of financial statements

Financial Modeling Careers

Many different types of financial models exist for forecasting the financial performance of an organization. Investment banking analysts may use multiple types of models to gain insights and formulate recommendations about investment portfolios for an investment banking team or their clients.

How To Become An Investment Banking Analyst >>

Types of Financial Models

Many different types of financial models exist for forecasting the financial performance of an organization. Investment banking analysts may use multiple types of models to prepare insights and recommendations about investment portfolios for an investment banking team or clients. 

What Do Investment Bankers Do? >>

Three Statement Model

Also known as an integrated financial statement model, 3 statement models are typically built in a spreadsheet as a single worksheet that links together income statements, balance sheets, and cash flow statements. The model is then manipulated – varying the inputs to understand how different operating, financing, and investing assumptions impact the forecast.

For example, a 3 statement model might be used to investigate the impact of varying assumptions such as:

  • Cost of goods sold
  • Interest rates
  • Inventory levels
  • Salaries and benefits
  • Revenue growth

Discounted Cash Flow Model

A discounted cash flow (DCF) model uses the Net Present Value (NPV) of projected cash flows (a more sophisticated version of profit, that takes account of the fact that cash flows in the future have less value than cash flows now) as the basis for valuing a business entity. Most likely the inputs to the DCF valuation will derive from a three-statement model and aim to capture the total value of a potential investment opportunity.

Sum of the Parts Model

The sum of the parts model takes the DCF model one step further by combining multiple DCF models together to determine the Net Asset Value of a group of assets/entities. Such a method could be used to determine the fair value of the shares in a mutual fund or exchange-traded funds.

Merger Model

The merger (M&A) model is an advanced financial model used to evaluate the quality of a proposed merger or acquisition deal. Accretion/dilution analysis plays a key role in M&A models – determining whether earnings post-transactions on single shares have increased or decreased. 

Budget Model

The budget model is a financial model to determine a future budget. Budget models give finance professionals a repeatable starting point to figure out how to allocate funds in the future and monitor performance throughout the year.

Financial Modeling Skills

In order to successfully create forecasting tools, individuals should possess certain skills, some of which can be unique to financial modeling. 

Accelerate your career with Kaplan Schweser’s Financial Modeling Course

Accounting Fundamentals

It is important that the builder of a financial model has a good grasp of accounting fundamentals. Concepts such as:

  • Accruals and prepayments (the matching principle)
  • Amortization and depreciation
  • Revenue recognition

play an important role in understanding how to read, dissect and build financial statements. 

Linking Financial Statements

Linking financial statements together is critical for multiple financial models and is the foundation for calculating critical financial metrics. For example, analysts will need multiple values from multiple financial statements to calculate the weighted average cost of capital (WACC).

Forecasting

Forecasting is a skill that takes time and experience to master. Developing accurate data-driven strategies to answer questions about the future is difficult. Soft skills like critical thinking and thoroughness help analysts balance assumptions about the future, all the while including historical data to make accurate predictions.

How To Become A Financial Analyst >>

Communication

Communication is an important skill to have when building and maintaining financial models. Analysts will need to process large amounts of data into an understandable format so everyone involved can decide on the best course for the future. 

Design

Design is crucial to developing a financial model that is easy to understand. A good financial model is formatted in a logical and attractive way. The layout should highlight important trends and provide users with an interface that is visually appealing.

Financial Modeling Software

What software to use when building a financial model is a common question and the answer depends on a few factors.

  • Time
  • Cost
  • Expertise

Before dedicated financial modeling software tools existed, analysts relied on spreadsheets such as Excel or Google Sheets. Understanding Excel is a great starting point – it can be fully customized to meet any layout, structure, calculations, or format desired, and often is the only tool needed.

Software designed for financial modeling can be expensive, especially when customized to accommodate specific business needs. They also offer analysts quick and easy generated reports and extra error prevention.

Learning the fundamentals of how a financial model works gives analysts the opportunity to really understand the inner workings of the ultimate business decision.

Excel

Given that Microsoft Excel is widely used to construct financial models, knowing how to work efficiently in Excel is critical for building and maintaining financial models. To become a successful financial analyst, you’ll need to understand how financial models are created using Excel.

Benefits of Learning Financial Modeling

There are many benefits to learning how to build and maintain financial models. From a career development perspective, having this skill will give you an in-depth understanding of the business being evaluated, which can lead to promotions and salary increases. 

Equipping yourself with financial modeling skills can enhance your career and give you a distinct competitive advantage when striving to outperform the competition.

Financial Analyst Career Paths >>

How is a Financial Modeling Course Beneficial for a CFA Charterholder?

The ability to create strong financial models is a critical skill for successful CFA charterholders. To be successful as a financial professional, you need to understand basic financial modeling in Excel. And if you’re looking to thrive in a career in institutional investment management, learning this skill will help you make smarter investment decisions in an efficient manner.

Online Financial Modeling Courses

Kaplan Schweser has partnered with The Marquee Group, to offer an industry-leading financial modeling course for anyone looking to move their financial career forward. 

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