Building a financial model

What is a financial model?

A financial model is a representation of an organization’s financial performance that is mainly prepared using Excel. A financial model normally consists of various financial statements linked to each other using various formulae so that a change made in one part of the statement is reflected throughout.

Who uses the financial model?

A financial model is used by the stakeholders of an organization both internal and external to make decisions about mergers, acquisitions, business growth, capital raising, allocation of capital, budgeting, forecasting, and so on.

Types of financial model:

There are a number of financial models. Some of them are explained below.

  1. 3 statement model, wherein the analyst prepares the three statements namely, income and expenditure, cash flow statement, and the balance sheet.
  2. Discounted cash flow model, which is considered to be the most popular and most important and it uses the time value of money concept.
  • Merger and acquisition model, which as per the name, focuses on mergers and acquisitions using earnings per share (EPS).
  1. Sum of parts model, also known as break up analysis, which specializes in divestment.
  2. Leveraged buyout model is another model that focuses on acquisition where the cost of acquisition is mostly financed by debt.

How to build a financial model?

The building of a financial model consists of the following steps:

  1. The building of a financial model consists of an analysis of purpose and the target audience or users of the financial model.
  2. The building of a financial model includes making financial assumptions based on past performance. It is very important to lay out the assumptions made in the financial model so that users of the financial statements can understand them better.
  • Profit and loss account is to be prepared.
  1. Preparation of cash flow statement to analyze the inflow and outflow of the cash.
  2. The final step is to prepare the balance sheet incorporating all the financial tools.

The Bottom Line:

Building a financial model is the first and the crucial step to understanding the internal functioning of an organization. It is the analysis of a financial model that explains the users, various important elements like the current situation of the market, the profitability of the organization, the value of the business, investment to be made if needed and explains the business and its nature. Generally considered to be a difficult task, the key to acing it and building a successful financial model lies in the understanding and breaking down of the various elements.

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