What Is Financial Modelling?

Intro

Did you notice the two “l”s I used in the title for the word "modelling"? Before diving into this topic, let's address the elephant in the room: the spelling! While North America leans towards “modeling” with a single “l”, the rest of the world adds another. Regardless of your preference, I just think life's too short to debate spellings.

Defining Financial Modelling

At its core, a typical financial model represents a forecast of a company’s future financial performance. However, many of these key terms - "forecast", "company" - can be debated and redefined based on context. For example, if you build a personal budgeting model for you and your family, you’ve built yourself a nice little financial model. I doubt it has a balance sheet with Retained Earnings, and it’s got nothing to do with a company. Many would argue (quite aggressively!) that it’s not a “real” financial model. I would disagree.

Roderick McKinley, a modelling whiz and good friend of Full Stack, aptly described a financial model as "any set of calculations used to represent value-flows over time." You may find this definition frustratingly vague. I think it’s appropriately broad to cover the many variations of a financial model that exist in reality.

What Constitutes a Financial Model?

Many people associate financial models with three core financial statements, but it’s not as straight forward at that. The content and complexity depend on the industry, the questions being addressed, and the user's objective. There are many finance professionals out there who build lots of financial models. Many of them will never build a full three statement model in their lives.

The Modelling Purist’s Perspective

For a modelling purist - those who have dedicated their careers to financial modelling - the definition is more precise. These experts often expect forward-looking models inclusive of an Income Statement, Balance Sheet, and a Cash Flow Statement. 

I understand why the purests have this narrow view of a financial model, but I push back against it whenever I can. I believe there’s far more value to be gained by making thousands of up-and-coming modellers feel like they’re part of the community, doing good work that can be thought of as financial modelling, as early as possible. That’s a topic for another blog though...

The purest's models are driver-based, structured, and mostly crafted in Microsoft Excel. However, as the digital landscape evolves, other tools are gaining traction. If you've never flirted with the idea of venturing beyond Excel for your modelling work, I'd suggest you have a quick look at companies like Equals, Brixx, Visyond and Squirrel365 - to name just a few.

Different Types of Financial Models

Here’s how you’ll see model types generally listed:

1. Three Statement Models: This is the most common setup for financial forecasting. It interlinks the income statement, balance sheet, and cash flow statement. It provides a holistic view of a company's financial performance and position over time.

2. Discounted Cash Flow (DCF) Models: Used primarily for valuation, this model estimates the value of an investment based on its expected future cash flows, discounted back to their present value. It helps determine the potential return on an investment.

3. Budget Models: This model is typically used by businesses to forecast income and expenditure for the upcoming year, helping them set future financial targets and allocate resources.

4. Forecasting Models: Extending beyond a budget, forecasting models predict the company's financial position for the coming years, based on certain assumptions and scenarios.

5. Mergers & Acquisitions (M&A) Models: Used in evaluating the financial profiles of two merging companies. It helps in understanding potential synergies, financing structures, and determining whether the merger is beneficial.

6. Leveraged Buyout (LBO) Model: This model is designed for buyout transactions financed with significant amounts of debt. It assesses the potential return on equity for a buyout and helps in structuring the deal.

7. Option Pricing Model: Used to calculate the theoretical value of options, these models, like the Black-Scholes model, consider various factors such as the current stock price, option strike price, volatility, and time until expiration.

8. Comparative Company Analysis (CCA) Models: A method used to value a company by comparing it to other similar companies, based on metrics like Price-to-Earnings or Price-to-Sales ratios.

9. Project Finance Models: Designed for long-term infrastructure projects, this model predicts the project's feasibility by analyzing its potential cash flows and profitability.

10. Real Estate Financial Models: Tailored for the real estate industry, these models forecast the return on investment for real estate developments or acquisitions.

11. Scenario & Sensitivity Analysis Models: Though not standalone models, these analyses are vital components in various financial models. They test how changes in key assumptions impact the model's outcomes.

12. Consolidation Models: Used by companies with multiple subsidiaries or business units, it aggregates information from various entities to produce consolidated financial statements.

Each of these models serves its unique purpose and is chosen based on the specific financial question that needs answering. The complexity and details of the model will vary accordingly. I have some issues with this general list. Firstly, Three Statement Models (1 on the list) are often the fundamental structure behind many of the other entries on the list. Scenario & Sensitivity Analysis Models (11 on the list) are often a component of almost all of the other entries on the list. This can become a bit confusing, but overall the breakdown does a pretty good job of covering the most common types of corporate financial models.

I think models should also be categorised in a few other ways:

1. Purpose and Longevity - Ranging from single-use models like project finance transaction models, to financial operations models for ongoing business management (what you’d need after a project finance transaction is complete and the assets actually have to be built and managed!).

2. Output - Such as deterministic models that give a fixed outcome or stochastic models which provide a range of outcomes based on probabilities.

3. Software - While Excel reigns supreme, emerging tools like those I mentioned above are starting to provide stiff competition.

What Questions Can a Financial Model Answer?

Financial models help answer crucial business questions. The exact list is almost exhaustive, but here are some of the most common questions models will be used to answer:

- Is this acquisition worth it?

- How should we allocate our capital?

- What's the expected profit and cash flow?

- How has the company performed versus expectations?

- What price should we submit for this work?

- Can we meet our obligations?

The Contents of a Financial Model

Though the structure varies, a traditional three-statement model - following some form of best practice guidelines - usually includes:

- Control, Input, Calculation, and Output worksheets

- Clear colour coding for easy navigation

- A clear, consistent and well-structured design methodology

Wrapping Up

Just remember that financial models are tools. Just like a map helps you find your way, these models help people make better choices. But it's important not to get too caught up in tiny details and lose sight of the bigger picture. Modellers need to always remember the key questions they're trying to answer, and constantly think about the materiality and relevance what they're choosing to focus on. So, if you're ever working with or on a financial model, remember to step back once in a while and make sure you're still on the right track. It's all about getting useful answers, not just getting lost in the numbers.

Mastering Financial Modelling

If you aim to master Excel and financial modelling, consider joining the Full Stack Modeller community. Not only does our membership provide you with award-winning training content on financial modelling, but it also delves into Excel proficiency, data visualisation, analytics, and communication skills. 

We help transform individuals, and teams of finance professionals who join us in private cohorts throughout the year. We tailor our team training approach to suit the specific needs of each team, with a mix of on-demand and live training used to add the most value possible.