How does a retail organization decide when, where and how big a store to open? How does an entrepreneur decide whether his idea makes sense or how does a venture capitalist decide if he should fund that idea? How does an investment banker decide how much money will a company be able raise and at what cost or how does he help his client arrive at a valuation for a merger and acquisition transaction.
Financial Modeling is a core skill that is almost mandatory for anyone who wants to build a career in finance. It is also important for anyone who wants to start his or her own business and even useful for sales/marketing professionals as it comes in handy in bidding for projects, determining payback/utility of campaigns etc.
Whenever, we need to make a financial decision, we make a projection of what revenue and costs are likely to be and on the basis of such projections, evaluate if that is a wise decision. In a stock market analysis, we look at the past performance of a company as project what the revenue, costs and profit of the company are likely to be and therefore if we should buy, sell or hold that share.
Investment Banking / Equity Research:
Financial Modeling is the basic tool for fundamental analysis and valuations. Investment banker use it to arrive at a valuation in M&A or fund raising transactions. Equity Analysts use it to value stocks and come up with buy/sell/hold recommendations.
Project Finance/Credit Rating:
Financial model help bankers, credit analysts to project future revenues and costs and to make an informed judgment about a projects viability. They are then able to decide if they should extend loans or what the credit rating of a project or company should be.
Financial Modeling is used by companies to assess their own finances and projects. It is hence an input in creating funding plans for corporate projects.
Entrepreneurs use Financial Models to present their plans to potential investors as much as to plan their strategies. Running different simulations can often be an important tool in avoiding potential risks
Types of Financial Models
Financial Models can vary in from, type and complexity based on the purpose for which they are built. It can be a one sheet model for a quick analysis or it can be a multi-sheet, multi workbook model with several cross links for a company or an industry. Some of the common applications of financial modeling are:
Valuation using DCF
Discounted Cash Flow (DCF) analysis is one of the most common methods of valuation. DCF analysis gives the result of a company’s current value, known as “net present value,” by forecasting its future free cash flows. It functions on the principle that the value of a business is the sum of its projected future free cash flows, discounted at a suitable rate.
Leveraged Buyout Model (LBO)
In a leveraged buyout a firm finances an acquisition through large amount of debt. So the LBO modeling exercise is done to estimate whether the business is likely to sustain the debt or what level of business performance will be required to make an eventual sale and retire the debt.
The entire objective of merger modeling is to understand the impact of an acquisition to the acquirer’s EPS and how the new EPS compares with the existing one. If the new EPS being higher, the transaction is called “accretive” while the opposite scenario would be termed as “dilutive”.
Comparable Company Analysis
In this analysis we we compare the financial metrics of a company against similar firms in industry. It is based on an assumption that similar companies would have similar valuations multiples, such as EV/EBITDA, P/E, P/BV.
Credit Rating Model
As the name suggests, this model is mainly used by Credit analysts to assess the creditworthiness of the company. The model makes assumptions regarding the future earnings, cost and ebitda margins and assesses if the company will have the ability to pay interest and principle.
Financial Statements; Financial Management and Ratio Analysis; Valuation Methods
Excel, Written Communication, Analytical Ability Core Skills
Financial Statement Analysis, Building financial statements in Excel, Building Financial models Related Skills / Knowledge
Understanding of Financial markets like market structure, mutual funds, debt markets, credit appraisal and ratings etc.