Financial modeling is the process by which a firm constructs a financial representation of some or all aspects of the firm or given security. The model is usually characterized by performing calculations and makes recommendations based on that information. The model may also summarize particular events for the end user and provide direction regarding possible actions or alternatives. Financial modeling is a general term that means different things to different users, where the reference usually relates either to accounting and corporate finance applications or to quantitative finance applications.
An integrated financial model will normally contain 3- 5 years of historical income statement and balance sheet information, with approximately the same line items as the available historical financial statements of the business to be analyzed. It’s the task of building an abstract representation of a financial decision making situation. This is a mathematical representation model designed to represent the performance of a financial asset or a portfolio, of a business, a project or any other asset.
Steps involved in building a financial model
Financial models can be constructed in many ways, either by the use of computer software or with a pen or paper. However what matters the most is the underlying logic that encompasses the model rather than the kind of user interface used. Financial modeling is a mandatory activity for investment bankers, bankers, project finance persons and equity research folks. Formally there are 7 steps in building a financial model, they are:
Data collection- this is where the real front end banker works. He goes to the client, collects the data like revenue, growth, investments, need for money, etc.
Back of the envelope calculations- bankers would sanitize their thoughts and try to figure out, if the business makes any sense. Usually you need business knowledge for this.
Structured approach to thinking- once the basic numbers seem reasonable, you have to dig deeper. This is where you need a complete financial model and the first step is to think of a structure of analysis.
Cash is the king- the more the cash is generated the better the business is.
Money today is better than money tomorrow- technically this can be called Time value of money.
Deciding on a layout- now you start putting plan into a model and the starting point is deciding on a layout for your financial model. The following questions needs to be answered, the amount of information your model will have, the kind of assumptions your model will make and creating logical modules for your model.