A quick examination of building financial models with a focus on building financial models for financial reporting, investment decision making, financial planning and budgeting purposes.
At a personal level the most common application of financial modeling for me has been building models for startups over the last fifteen years. New business need financial models to project and examine the impact of their plans in the future, raise investment rounds, allocate capital, examine specific growth and sales strategies and estimate projected cash flow needs. However that is not the only application of financial models.
Financial models can be built to examine the investment potential of any business or investment security (not just startups), to examine their credit worthiness and capacity to pay back loans (credit analysis), to plan and budget for an upcoming year, to simulate the impact of a change in direction, the launch of a new product or the financial cost of a rolling out a brand new strategy. At a different level we also build financial models to accurately price the value of a financial security (pricing and valuation), assess its risk (risk management) and estimate the capital required to support it (capital allocation), optimize portfolios (portfolio optimization).
This course is broken down into the following core themes:
An introduction to financial modeling
A series of introductory posts that examine design, process and output of financial models at a high level without getting into the details of building the model.
- Building Financial Models – An introduction.
- Building Financial Models for Startups
- Data Tables, Data Analysis in Excel – Sensitivity Testing – One.
- Data Tables and financial modeling – Sensitivity Testing – Two.
- Linking financial models to simulations – Sensitivity Testing – Three.
- The Zen of building risk models – balls or barrels
The posts above set the context for the work that is about to follow.
Financial Modeling Basics
Despite everything that we have said above the best financial models are ones that communicate the potential of a business idea in clear terms with as little effort as possible. The original objective of a financial model is to serve as a high level dry run without actually investing or starting a business. This means that we use our clear understanding of the business to showcase its promised potential. To do this well we need three projected financial statements.
- A balance sheet laying out the growth in net assets of the business.
- A statement of profit and loss also known as an income statement
- A statement of cash flows showing net changes in cash net of accounting adjustments.
The three statements are interlinked. Putting them together is covered as part of the AMD case study. The case study is a little dated (1999-2000) but covers the basics reasonable well. We will use it till we can find a better replacement.
While planning and budgeting is a key requirement an additional objective of the entire modeling exercise is to put together a valuation model that could be used to allocate ownership in the business to prospective investors for contributing capital.
The valuation model case study and the posts on valuation multiples and beta provide relevant context for this topic.
- Valuation case study – building a valuation model for an online education business.
- Where do valuation multiples come from
- Valuation multiple intuition
- Levering Beta
- The difference between Alpha and Beta
Building a transaction model
How would build a transaction model for a startup? Take a look.
Financial Modeling – other applications
Financial projections and valuations are not the only applications for building financial models. We present a few off the beaten track instances that review alternate applications of the financial modeling process.