Financial Modeling Guide for Beginners
March 17, 2025
What is Financial Modeling?
Financial modeling involves building various financial statements to create a representation of a company’s financial performance. It includes inputting historical data, calculating ratios, making forecast assumptions, and linking interest to the income statement.
Where is Financial Modeling Used?
A model serves as the foundation for any decision involving the projection of a company’s future potential. It allows analysts to measure a company’s historic performance as well as create forecasts for future performance. This helps to make better-informed investment decisions.
These are some examples of when financial modeling can be used:
- An M&A (mergers and acquisitions) analyst constructs a model to evaluate whether the merger of two companies would result in better financial performance compared to each company operating independently
- A credit rating model projects future outcomes to assess whether a company can sustain certain financial ratios and fulfill its debt obligations, thereby preserving its credit rating
- A valuation model estimates the future cash flows of a company and determines the present value one might invest in those future cash flows
- This is referred to as Discounted Cash Flow analysis, which produces a figure known as Net Present Value
- An operational model concentrates on forecasting a company’s revenue and costs, subsequently adjusting the model’s assumptions to ascertain whether performance can be enhanced through strategies such as cost reduction
Types of Financial Model
Financial models are employed across investment banking, accounting, and corporate finance. Unlike basic spreadsheets, they include evolving variables like inputs, outputs, calculations, and scenarios. This means that any change or update in assumptions will alter the model and its calculations.
There are different types of financial models, used to suit a variety of needs. These include:
- Three Statement Model – comprised of the company’s three financial statements: the Income Statement, Balance Sheet and Cash Flow statement. Analysts collect historical and recent company performance data to predict future revenue, profitability and cash flow.
- Forecast Models – used to analyze performance within a company or a particular business division.
- Leveraged Buyout (LBO) Model – helps to identify a company’s debt capacity, taking into consideration current market conditions. Private equity funds and their financial advisors will use these models to structure an LBO acquisition, assuming a target investment horizon.
- Discounted Cash Flow (DCF) Model – DCF analysis focuses on cash generation within a company to determine its valuation.
- Merger & Acquisition (M&A) Model – brings the financial models of two companies together and assesses the impact of the transaction on the acquirer’s financials.
- Sum-of-the-Parts Model – This type of financial model is also known as the break-up analysis. It focuses on valuing separate divisions within a company, using a variety of valuation methodologies such as DCF and trading multiples.
- Comparable Company Analysis Model – a relative valuation method that uses the ratios of similar firms in the same industry to aid the valuation of the company in focus.
- Initial Public Offering (IPO) Model – a financial tool used to represent and forecast the financial performance of a company that is planning to go public by offering its shares to the public for the first time.
- Divestiture Modeling – taking the current group consolidated financials and converting them so that a divested business is no longer included.
- Option Pricing Model – a mathematical framework used to calculate the theoretical value of an option. These models consider various factors such as the current market price of the underlying asset, the strike price, the time to expiration, volatility, and interest rates.
Why Build a Financial Model?
Financial models are built to make better-informed investment decisions. Typically, they are used to forecast a company’s performance over a specific period, say 3 to 5 years. A large part of the skill in building a financial model is creating sensible assumptions to fill in the blanks and maintain the model’s integrity. Having assumptions that are justifiable helps in forecasting various elements of financial statements and validating the investment case which results from the modelling.
How Do You Build a Financial Model?
To build a financial model, you need to input historical data, calculate ratios, make forecast assumptions, build various financial statements, and link interest to the income statement. Most often this is provided by the company being analyzed – if it is listed then all the financial data should be publicly available. If it is a private company, details of financial performance will have to be sought from the management.
Ratios can be calculated from the information provided or from peer group analysis.
What Are the Steps for Building a Financial Model?
These are the steps required to create a model:
- Inputting historical data, both public and private
- Constructing ratios and statistics based on this data
- Making future assumptions based on past trends
- Forecasting financial data using these assumptions
The process involves preparing the company’s balance sheet, income statements, and cash flow statements, along with supporting schedules. This information is usually inputted into Excel using hard-coded entries and formulas. From the gathered data, models like Discounted Cash Flow (DCF), Sensitivity Analysis, Leveraged Buyout (LBO) can be created.
How to Build a Three Statement Model
Let’s look at one type of financial model in more detail. Building a three-statement model involves several key steps to ensure accuracy and prevent errors. Here is a summary of the process:
- Preparation: turn off the iteration setting to prevent accidental circular references. This is found in the excel settings and is invaluable step when starting the model to avoid populating the cells with “#REF” whilst building the forecasts.
- Input Historical Data: input historical data for the income statement and balance sheet from the latest financial statements or management accounts if working on a deal. Cash flow information may also be available or created from the other details provided.
- Calculate Ratios and Statistics: use historical data to calculate ratios such as revenue growth, margins, CapEx ratios, and working capital days. These ratios help understand the company’s recent performance and business drivers.
- Build Forecast Assumptions: use ratio analysis to build forecast assumptions. For example, if revenue growth last year was 10%, and 4% came from non-recurring foreign currency moves while 6% came from growing market share, forecast next year’s revenue growth at 6% (or similar based on your expectations for market conditions).
- Build the Income Statement: start with the income statement revenue line (at the top) and work down to the tax line. Leave out the interest line initially as it requires cash and debt balances which can be completed later.
- Build the Balance Sheet: build the forecast balance sheet from top to bottom, starting with assets, then liabilities, and equity. Leave out cash and the revolver (short-term debt) as they require the cash flow statement.
- Build the Cash Flow Statement: use the rules of cash to build the cash flow statement. Make sure you keep an eye on any formulas used to make sure it is correctly capturing cash inflows and outflows.
- Plug Cash and Revolver Balances: use the cash flow statement to ‘plug’ cash and revolver balances into the balance sheet using the max and min functions in Excel. This ensures a positive ending cash balance is included as cash and a negative ending cash balance as short-term debt.
- Finalize the Balance Sheet: ensure the balance sheet balances perfectly by using the cash flow statement to calculate cash and revolver balances.
- Calculate Interest: use cash and debt balances to build interest calculations. Link the interest into the income statement and address any circular references that may arise.
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Basic Pre-Requisites for Financial Modeling
The basic pre-requisites for financial modeling include setting up the template, adjusting column widths for optimal display, using the navigator column for major headings, and ensuring dates are formatted correctly.
Financial Modeling Best Practices
Best practices for financial modeling includes ensuring the output looks reasonable, the excel formatting is consistent and that the layout is intuitive. Complex calculations should be broken down into steps and the model documented where necessary to provide all information. The model should then be saved with the correct settings. By following these best practices, analysts can create transparent, maintainable, and robust financial models.
Once up and running, models may need updating to reflect new information or current market conditions. Follow these guidelines and tips to make sure editing and updating line items in a financial model doesn’t catch you out!
1. Preparation Before Editing
- Save a backup copy of the file with a new name to avoid losing data.
- Turn off iterative calculations in Excel to prevent circular reference errors.
- Plan changes and predict their effects on the financial statements.
2. Systematic Editing
- Make one edit at a time and update all relevant sections before moving on.
- Label new items clearly and consistently to aid understanding for future users.
- Trace dependencies before removing old items to avoid #REF errors and maintain model integrity.
3. Clear Labeling and Dependency Management
- Ensure all changes are reflected across the balance sheet, income statement, and cash flow statement.
- Remove redundant cells after deleting old items to keep the model clean and efficient.
Conclusion
Financial modeling is an invaluable tool when analyzing companies and evaluating performance versus the market. A model serves as the foundation for any decision involving the projection of a company’s future performance. It helps to make better-informed investment decisions and allows analysts to measure a company’s historic performance as well as forecast future performance.
Working methodically and consistently through these steps of financial modeling provided will ensure analysts are able to create accurate models and forecasts for both themselves and future users.
Additional Resources
Essential Excel Shortcuts Financial Modeling