| al modeling in Excel is one of the most versatile and | | | | Excel financial modeling techniques to achieve her goal. |
| powerful finance skills today. This skill is often a | | | | The model will contain a 5-year projection of the |
| sought-after add-on to well-known financial | | | | company’s income statement, balance sheet |
| designations such as CFA, CPA, CA, CMA and CGA. | | | | and cash flow statement and help the company |
| In a nutshell financial modeling is a process of building a | | | | assess future financing, staffing and operational needs. |
| multi-year forecast of a company’s financial | | | | The multi-year budget will be submitted to the |
| statements: income statement, balance sheet and | | | | company CEO for review. |
| statement of cash flows. The projected time period | | | | The financial modeling process is as much an art as it |
| varies from one model to the next, the norm being 5 | | | | is a science. Solid financial modeling training through |
| to 10 years. | | | | seminars and courses is a must for people seeking |
| Why is financial modeling so important? It is used in a | | | | careers in many finance areas. These skills are further |
| variety of finance applications such as investment | | | | honed and advanced through the real-life work |
| banking — initial public offerings (IPO), secondary | | | | experience of building financial models. |
| financings, mergers and acquisitions (M&A); corporate | | | | The financial modeling process begins with gathering |
| banking; private equity; venture capital; equity research; | | | | information. The analyst must become intimately |
| corporate strategic planning and budgeting; and | | | | familiar with the company he models, its industry and |
| numerous other important applications. Below are just | | | | competitive landscape, its plans and prospects, and the |
| a few financial modeling application examples: | | | | strength of the company’s management. Crucial |
| An investment banker builds a financial model of a | | | | pieces of information are the company’s past |
| mobile telephony software company that is going | | | | financial reports, management interviews, conference |
| through an IPO process. The main outputs of the | | | | call transcripts, research analyst reports, and industry |
| model will be metrics used in valuation: unlevered free | | | | publications. It must be noted that this information |
| cash flows (UFCF), earnings and net debt calculations. | | | | gathering exercise is much more challenging when |
| The financial model will be used in discounted cash | | | | modeling a private company as opposed to a public |
| flow (DCF) valuation. DCF, together with comparable | | | | company. Private company information can often only |
| trading and transactions valuation will be used in the | | | | be obtained through direct access to the company |
| company’s ultimate valuation. The end goal of | | | | insiders. |
| this modeling process will be to value the per-share | | | | An typical Excel financial model will consist of the |
| offering price of the company’s shares once | | | | following parts: |
| they are listed on the stock exchange. | | | | Assumptions. These are the model’s inputs. |
| A credit-focused financial model is being built by the | | | | Assumptions are based on the company’s |
| commercial lending unit of a major bank. This is a part | | | | historical information as well as its future plans and |
| of processing a large commercial loan application filed | | | | current market trends. |
| by a manufacturing company which is looking to | | | | Historical and projected financial statements — |
| expand its operations. The model’s emphasis is | | | | income statement, balance sheet, cash flow statement. |
| on the debt servicing ability of the company in question. | | | | Projections are based on historical performance and |
| The most important outputs that the commercial | | | | model assumptions. |
| bankers will look at are debt to equity ratio, interest | | | | Supporting schedules including working capital schedule, |
| coverage and fixed charge coverage ratios. | | | | capital expenditures (CAPEX) schedule, debt schedule, |
| An equity analyst builds a financial model of a | | | | and tax schedule. |
| company that his firm decided to initiate coverage on. | | | | The model’s outputs depend on the primary |
| The focus of the model is on DCF valuation and | | | | purpose for building the model. In many cases |
| unlevered free cash flows generated by the company. | | | | modellers focus on earnings, unlevered free cash |
| Based on the model’s results the analyst will | | | | flows, capital structure and debt capacity. |
| issue buy/sell/hold recommendations on the stock | | | | Scenario and sensitivity analyses are often |
| based on the relationship of his target stock price and | | | | incorporated into the models, including scenario |
| the current market stock price. | | | | managers, data tables and charts. |
| A private equity firm is considering a 50% acquisition | | | | Financial models often serve as foundation for more |
| of an early stage pharmaceutical company that needs | | | | detailed further analysis such as valuation, M&A |
| capital for sustaining its research and development | | | | merger modelling (accretion/dilution analysis), LBO |
| (R&D) program. The private equity firm sees value and | | | | analysis and Monte Carlo simulations. |
| significant upside in this situation given the target | | | | So what does it take to be a good financial modeller? |
| firm’s pending patent applications. The purpose | | | | Accounting and finance knowledge is compulsory. |
| for building the financial model is to determine the price | | | | In-depth understanding of financial statements and |
| at which the private equity firm is willing to purchase | | | | relationships between line items of the income |
| the 50% stake, given the hurdle IRR (internal rate of | | | | statement, balance sheet and the cash flow statement |
| return) rate of 35%. | | | | is an absolute must. Microsoft Excel proficiency is |
| A pulp and paper company’s CFO prepares a | | | | another prerequisite. |
| detailed multi-year budget of the company. She uses | | | | |