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

• Financial Model Applications

• Careers

• Types of Financial Models

• Skills

• Software

• Benefits

• Online Courses

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

Careers that Use Financial Modeling

There are many careers that use financial modeling to forecast 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.

There are lots of different careers that use financial modeling because financial modeling can be used for any business that wants to use their financial data to make business decisions. Some of the careers that use financial modeling are:

• Corporate Development

• Corporate Finance

• Equity Research

• Investment Banking

• Private Equity & Venture Capital

• Real Estate Development

Types of Financial Models

There are many different types of financial models used by financial analysts including:

• Three statement model

• Discounted cash flow model

• Sum of the parts model

• Merger model

• Budget model

Three Statement Model

Also known as an integrated financial statement model, three 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 by varying the inputs to understand how different operating, financing, and investing assumptions impact the forecast.

For example, a three 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 as the basis for valuing a business entity. The inputs to the DCF valuation can be derived from a three-statement model. Calculating NPV is a process of estimating the value of all future expected cash flows as if they were received today (i.e., discounting) and subtracting the cash outflow required for the investment today. A positive NPV means the investment meets the return requirements.

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 by estimating the value of each investment within the fund using a DCF and then calculating the sum of all the DCF values to determine the total fund value.

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 in determining whether the post-transaction earnings 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.

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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.

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.

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

To bridge the gap between theory and practice, the Foundations in Financial Modeling program provides a practical starting point for mastering the Excel-based projections used in investment banking and corporate development. For professionals ready to validate their expertise on a global stage, the Advanced Financial Modeler (AFM) accreditation offers a rigorous path to sharpen your skills and earn a distinct competitive edge. Through Kaplan’s partnership with the Financial Modeling Institute, you can enroll in either program for 20% off by using code KAPLAN at checkout. Learn More