How to Excel in Financial Modelling: Key Skills and Tools

According to a Deloitte survey, 85% of companies that implement comprehensive financial analysis tools report improved decision-making capabilities. Financial models provide a clearer understanding of potential outcomes and risks. Businesses that use advanced financial modelling techniques improve their forecast accuracy by up to 30% compared to those relying on traditional methods. Accurate forecasts enable better strategic planning and resource allocation. Companies using financial modelling to streamline their budgeting and forecasting processes can reduce operational costs to a great extent. Enhanced efficiency in financial planning leads to cost savings and better financial control. Financial modelling is a crucial aspect of decision-making for businesses across various industries. It involves creating a representation of a company's financial situation using mathematical models and forecasting techniques. Let us learn more about financial modelling and analysis in today’s blog:

What is Financial Modelling?

Financial modelling is a highly valued skill in financial analysis that aims to integrate accounting, finance, and business metrics to project a company’s future performance. Essentially, a financial model is a spreadsheet—usually created in Microsoft Excel—that predicts a business's financial future. This prediction is typically based on the company’s past performance and future assumptions. Building a financial model involves preparing an income statement, balance sheet, cash flow statement, and additional schedules, which are collectively known as a three-statement model. Financial modelling is used for decision-making and performing financial analysis, whether inside or outside of the company.

Financial modelling and valuation is the process of determining the worth of a business, asset, or investment. Financial models are essential tools in this process, as they provide the necessary data and projections to assess value accurately. Different financial modelling and valuation methods are used depending on the context, such as Discounted Cash Flow (DCF) analysis, Comparable Company Analysis, or Precedent Transactions. By using financial modelling and valuation, analysts can estimate the fair value of an asset or company and make informed investment decisions.

Key decisions made using financial models include:

• Raising Capital: Whether through debt or equity.
• Making Acquisitions: For businesses or assets.
• Organic Growth: Expanding the business by opening new stores or entering new markets.
• Selling or Divesting: Disposing of assets or business units.
• Budgeting and Forecasting: Planning for future financial years.
• Capital Allocation: Determining which projects should be prioritised for investment.
• Valuing a Business: Assessing the worth of a company.
• Financial Statement Analysis/Ratio Analysis: Evaluating financial health and performance.
• Management Accounting: Assisting in internal financial decision-making.

Types of Financial Models

We have listed some of the most common financial models used by investment bankers, research analysts, private equity professionals, and other corporate finance experts:

Three-Statement Model

The three-statement model integrates the income statement, balance sheet, and cash flow statement into a unified spreadsheet. Each statement is dynamically linked using Excel formulas, allowing changes in assumptions to impact the entire model. This foundational model requires proficiency in accounting, finance, and Excel, providing a comprehensive view of a company's financial performance.

Discounted Cash Flow (DCF) Model

The DCF model builds upon the three-statement model by evaluating a company based on the Net Present Value (NPV) of its future cash flows. It adjusts these cash flows and discounts them back to present value using the Weighted Average Cost of Capital (WACC). This model is crucial for valuing investments and is widely used in equity research and capital markets.

Merger Model (M&A)

The M&A model assesses the impact of mergers or acquisitions, focusing on pro forma acquisition or dilution. It typically involves separate tabs for each company, which are consolidated to reflect the merged entity. This advanced model incorporates deal synergies, terms, and sensitivity analysis, making it essential for investment banking and corporate development.

Initial Public Offering (IPO) Model

The IPO model values a company preparing to go public by combining comparable company analysis with assumptions about investor pricing. It includes an "IPO discount" to facilitate favourable trading in the secondary market. This model helps determine the initial offering price and ensure successful market performance.

Leveraged Buyout (LBO) Model

The LBO model is used for transactions involving substantial debt, incorporating complex debt schedules and cash flow waterfalls. It focuses on the company’s capital structure and leverage, assessing how these factors impact equity returns. This model is intricate and commonly used in private equity and investment banking.

Sum of the Parts Model

The sum of the parts model values a company by aggregating multiple DCF models for its business units and other components. It calculates the Net Asset Value by summing individual unit values and subtracting liabilities. This model provides a comprehensive valuation by considering various business segments and assets.

Consolidation Model

The consolidation model combines multiple business units into a single financial model, with each unit having its own tab. A consolidation tab aggregates the financials from all units, offering a unified view of the company’s overall performance. This model is useful for managing and analysing consolidated financial data.

Budget Model

The budget model is used by financial planning and analysis (FP&A) professionals to create budgets for future periods. It focuses on monthly or quarterly figures and emphasises the income statement to plan expenses and revenue. This model is crucial for financial forecasting and planning.

What is Financial Analysis?

Financial analysis involves examining a company's financial data to evaluate its performance and gather insights for informed decision-making. By conducting financial analysis, businesses can assess economic trends, create long-term strategies, establish financial policies, and identify optimal investment opportunities. This analysis can be done internally or externally, benefiting both internal stakeholders and investors. There are two primary techniques used in financial analysis:

• Fundamental Analysis: This method relies on ratios derived from a company’s financial statements. It helps analysts determine the intrinsic value of a security by evaluating the company's data. The goal is to compare the security's intrinsic value with its current market price to identify whether it is undervalued or overvalued.
• Technical Analysis: This technique focuses on statistical trends and price movements rather than determining the security's value. Technical analysis accepts the current price of a security and studies its price trends to understand market sentiment and identify patterns.

Why is Financial Analysis Important?

Financial analysis is crucial because it helps answer significant questions about a company's financial health and viability. It determines whether an entity is stable, liquid, solvent, and profitable enough to be considered a favourable investment opportunity. Additionally, financial analysis plays a key role in setting financial policies, developing business plans, identifying investment opportunities, and evaluating economic trends. By providing insights into a company’s creditworthiness, ability to generate wealth, and overall profitability, financial analysis enables stakeholders to make informed decisions. It also allows business leaders to assess the effectiveness of operations and identify areas for improvement. A key component of financial analysis is financial data analysis, which involves the detailed examination of a company’s financial data to uncover patterns, trends, and insights. This analysis is significant as it transforms raw financial data into actionable intelligence, helping businesses to forecast future performance, assess risks, and optimise financial strategies. Therefore, financial data analysis effectively allows companies to stay competitive, make evidence-based decisions, and respond swiftly to market changes.

Overview of Financial Statement Analysis

Financial statement analysis involves reviewing a company's financial statements to support decision-making. External stakeholders use this analysis to gauge the overall health of the organisation and assess its financial performance and business value. Internal stakeholders use it as a tool to monitor and manage the company’s finances. The financial statements contain critical data on various aspects of the business, which can be analysed based on past, current, and projected performance. Financial Statement Analysis (FSA) can also be described as the process of identifying a firm's financial strengths and weaknesses by establishing relationships between items on the balance sheet and the profit and loss account.

Types of Financial Statements

Companies use three main financial statements— the balance sheet, income statement, and cash flow statement— to manage their operations and provide transparency to stakeholders. These statements are interconnected and offer different perspectives on a company’s activities and performance.

• Balance Sheet: The balance sheet presents a company’s financial worth in terms of book value, divided into three parts: assets, liabilities, and shareholder equity. Short-term assets like cash and accounts receivable provide insights into operational efficiency; liabilities include expenses and debt; and shareholder equity reflects equity capital investments and retained earnings. The balance sheet must balance these elements, with assets and liabilities equalling shareholder equity, which is considered the company’s book value and an important performance metric.
• Income Statement: The income statement details the revenue earned against the expenses incurred to reveal the net profit or loss. It is divided into three parts: gross profit (revenue minus direct costs), operating profit (subtracting indirect expenses like marketing and depreciation), and net income (after deducting interest and taxes). Analysing the income statement typically involves calculating gross profit margin, operating profit margin, and net profit margin to understand where costs are high or low.
• Cash Flow Statement: The cash flow statement provides a summary of cash flows from operating, investing, and financing activities. Net income from the income statement is carried over to the cash flow statement as the top line item for operating activities. Investing activities involve firm-wide investments, while financing activities cover cash flows from debt and equity financing. The bottom line indicates the company’s available cash.

What is Financial Ratio Analysis?

Financial ratio analysis is a technique used to evaluate a company's financial health by examining its balance sheet and income statement. This method provides insights into the company’s liquidity, operational efficiency, and profitability. Rather than focusing on a single metric, financial ratio analysis involves analysing various financial data points to form a comprehensive view of the company's performance. It is a fundamental aspect of equity analysis and helps investors and business experts predict a company's financial stability and potential growth. These ratios can be used to track a company’s performance over time or to compare it with others in the same industry. For example, comparing the price per share to earnings per share yields the price-to-earnings (P/E) ratio, an essential metric for assessing a stock's value.

Types of Ratios for Financial Ratio Analysis

Financial ratios can be categorised into six main types, each providing different insights into a company's financial condition. Analysing ratios from each category offers a holistic view of the company and helps identify potential issues.

1. Liquidity Ratios: Liquidity ratios assess a company’s ability to meet short-term debt obligations using its current or quick assets. Examples include:

• Current ratio
• Quick ratio
• Working capital ratio

2. Solvency Ratios: Solvency ratios or financial leverage ratios, compare a company’s debt levels to its assets, equity, and earnings. These ratios help determine the company’s long-term viability by assessing its ability to repay long-term debt and interest. Examples include:

• Debt-to-equity ratio
• Debt-to-assets ratio
• Interest coverage ratio

3. Profitability Ratios: Profitability ratios indicate how effectively a company generates profit from its operations. Common examples are:

• Profit margin ratio
• Return on assets (ROA)
• Return on equity (ROE)
• Return on capital employed (ROCE)
• Gross margin ratio

4. Efficiency Ratios: Also known as activity ratios, efficiency ratios measure how well a company uses its assets and liabilities to generate sales and profits. Key efficiency ratios include:

• Turnover ratio
• Inventory turnover
• Days sales in inventory

5. Coverage Ratios: Coverage ratios evaluate a company’s ability to meet its debt-related obligations, such as interest payments. Examples include:

• Times interest earned ratio
• Debt-service coverage ratio

6. Market Prospect Ratios: Market prospect ratios are widely used in fundamental analysis to predict a company's earnings and future performance. These ratios include:

• Dividend yield
• Price-to-earnings (P/E) ratio
• Earnings per share (EPS)
• Dividend payout ratio

Financial Planning & Analysis: Definition & Step-by-step Process

Financial Planning & Analysis (FP&A) is a collection of activities including planning, forecasting, budgeting, and analytics that aid in guiding a company's significant business decisions and overall financial well-being. The FP&A process is a continuous cycle of collecting and analysing data. As businesses grow and enter new markets, especially during periods of market volatility and rapid change, this process becomes more intricate. This increased complexity requires more data collection and deeper analysis, which is why many large and midsize companies have established dedicated FP&A teams within their finance departments. Despite the growing complexity, the core financial planning & analysis process remains centred on four fundamental steps:

Data Collection, Consolidation, and Verification

The first step in the FP&A process involves gathering financial and operational data from various sources like ERP systems, data warehouses, and other business solutions. Additionally, external data such as demographic, economic, and market information may also be collected. Once the data is gathered, it must be consolidated, standardised, and verified. The accuracy of plans, forecasts, budgets, and analyses heavily relies on the quality of the data, making this step crucial. Given its time-consuming nature, many businesses are now using AI-powered tools to automate parts of this process.

Planning and Forecasting

In this step, FP&A analysts use the prepared data to create financial forecasts that project the company’s future performance and assess whether it is on the right path. These forecasts can include sales predictions, cash flow projections, and more. Financial models are also used to test various scenarios, simulate the impact of different variables, and determine the best course of action to achieve desired outcomes. Common financial planning methods include:

• Predictive Planning: This method involves creating models based on large datasets of past performance, which are then used to forecast future performance. When combined with AI and machine learning, predictive analytics significantly enhance planning tools.
• Driver-Based Planning: Analysts focus on identifying key business drivers and create plans that show how these drivers would be impacted by various factors.
• Multi-Scenario Planning: This method, increasingly popular among businesses, involves creating multiple plans based on assumptions about future events. Analysts anticipate potential outcomes and prepare responses for each scenario. These plans are used to achieve strategic goals, both short-term and long-term, such as revenue targets and net income objectives.

Budgeting

In the budgeting phase, FP&A professionals estimate the costs required to implement the corporate plan based on the revenue projections. They allocate budgeted expenses to each business unit or department, along with the expected revenue and cash flow they should generate. The corporate budget is typically created annually, with quarterly updates to account for changes in financial conditions. To manage volatile markets better, some companies have adopted continuous budgeting cycles, frequently updated with rolling forecasts and projections. Additionally, some organisations use zero-based budgeting, which continually evaluates the necessity of expenses to prevent overspending.

Performance Monitoring and Analytics

FP&A teams continually monitor financial performance metrics such as sales, expenses, profit, working capital, and cash flow. They analyse data and respond to ad hoc queries to provide decision support. By translating numbers into a narrative or data story, they help decision-makers understand situations and make informed choices.

Key Takeaways

Mastering financial modelling and analysis equips businesses with the tools to navigate complexities, drive growth, and maintain a competitive edge in a changing global market. Financial modelling not only refines budget forecasting but also supports critical decisions such as capital raising, acquisitions, and divestitures. By integrating accounting, finance, and business metrics, financial models provide a detailed representation of a company's financial situation, leading to more informed investment decisions and better financial control. Furthermore, the use of financial analysis techniques, including ratio analysis and performance monitoring, allows businesses to evaluate their financial health, identify areas for improvement, and optimise resource allocation. As we dive deeper into these practices, it becomes clear that their role in enhancing financial accuracy and strategic planning is indispensable for achieving long-term success.