Financial Modeling: A Game of Monetary Assumptions
Financial Modeling (in the context of a company) refers to calibrating the assumptions about a company’s financial performance to forecast financial statements based on expectations about the future environment.
Financial modeling is an integral part of Corporate Finance practices of an organization, in which financial decisions are carried out through implementation of suitable financial strategies with a single goal of maximizing shareholder value. Financial modeling enables companies, investors, lenders and creditors to access the expected returns from a particular investment or to budget any critical contingency in the future.
Financial modeling is used to forecast Financial Statements (Balance Sheet, Income Statement, Cash flow Statement and so on). Financial statements are used for decision making purposes, such as whether to invest in the company's securities or recommend them to investors and whether to extend trade or bank credit to the company or not. Analysts use financial statement data to evaluate past performance and current financial position of a company in order to form opinions about the company's ability to earn profits and generate cash flow in the future.
Financial models can be developed using Microsoft Excel interface with its inbuilt financial formulas. The depth of modeling requirement depends upon the requirement of the model and the user. Basic models are sometimes more useful than the complex ones to run sensitivity cases without any requirement of vetting the same. Basic steps of building a financial model for forecasting cash flows of a company include the following steps:
- Defining the timeframe: The period for which projections should be prepared needs to be defined and if the required data is available, historical timelines can also be presented.
- Noting down assumptions on Revenue: In order to populate the top line of a company, the revenue-related assumptions are required to be incorporated in the model, which will be the first element for projecting a profit and loss statement.
- Developing Expenses Schedule: The third step would be work on the assumptions related to operational expenditure (variable and fixed expenses) of the company. These assumptions can be based on the historical figures or can be derived from market estimates. The expenses related to depreciation, interest and tax can be populated separately and can be lined to the profit and loss statement as briefed in the next points.
- Depreciation Schedule: Depreciation in the profit and loss statement is calculated as per Book Depreciation assumptions (in straight-line method). The schedule for Tax Depreciation also needs to be populated, which will be used for tax calculations.
- Debt/Interest Schedule: Debt schedule is an important element of a financial model that requires further assumptions about the expected leverage/gearing levels of the company. The estimated increase in long-term/ short-term loans needs to be forecasted separately to arrive at the yearend balance and cumulative debt drawn during a specific year. Subsequently, assumption related to applicable interest rate for the specific loans/bonds needs to be incorporated to calculate the interest burden in that particular year. Interest for working capital may be populated separately based on working capital loan requirement of the company.
- Balance Sheet Related assumptions:
- The fixed assets investments in every year need to be assumed to forecast gross fixed asset. Deducting cumulative depreciation from the gross fixed asset will provide the figure of net fixed assets.
- Working capital of the company (inventory, debtors and other current assets, creditors) is forecasted based on holding levels. The holding levels are estimated based on historical level and based on the market trend/average holding levels of similar companies in the same industry.
- Equity/preference capital of the company is forecasted based on expected infusion of equity in the future years. The reserves and surpluses are based on the retained earnings of the company (excluding dividend payouts, if any) for the particular year, which translates to the balance sheet.
- The balancing element in the financial projections is usually the cash balance. The cash balances are estimated by drawing cash flow statement from P and L and balance sheet. There are two methods of drawing the cash flow statement: Indirect method and Direct method.
Modeling is an essential skill set for students and practitioners in the financial domain. There are several courses providers/institutes that provide a basic understanding of financial model and how to build effective models. The models are always required to be vetted for the inherent assumptions, which affect the ultimate decision making of end users.
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