A financial model is a tool that is used to understand a company's performance through years (or other time frames) and help forecast the financial performances into the future. A typical financial model is created in MS-Excel, however on a small scale it is completely possible to do it manually. The process of creating such a model is called Financial Modelling.
Income Statement, Balance Sheet and Cash Flow Statement are integral for a well devised financial model. Financial Modelling is extensively used by company executives, portfolio managers, financial analysts, investors etc. for understanding company performance. Raising capital, Budgeting, Valuation, Investments are just few of the fields which require an extensive encounter with financial models.
2. Income Statement
3. Cost of Goods (COGS)
4. Cash Flow
5. Operational Expenditures (OPEX)
6. Capital Expenditures (CAPEX)
7. Balance Sheet
8. Working Capital
A small-scale financial model- Suppose a firm has accounted for sales of two consecutive years T1 and T2 as 50(S1) and 75(S2), respectively. In order to find the projected sales for T3 we simply find the growth rate between T1 and T2. This can be done by finding the difference in sales (S2-S1), 25 and dividing the result by the base year sales i.e. S1, 50. The growth rate here is 25/50 i.e. 0.5. For projected we multiply this growth factor to the current year sales and add the result to the sales of current year. (75*0.5) + 75 is the projected sales for year T3, which is 112.5.
This approach becomes the foundation stone for creating extensive and advanced financial models with predictions into 10 year (or more), sensitivity to external factors (inflation, interest rate, competition), debt obligations etc.
When the economy goes erratic and standard rules of financial analysis no longer apply for forecasting, mere regression and growth prediction will not provide a credible study. During challenging times like COVID-19, financial modeling may provide a safe haven due to its dynamic nature. Financial Models can include sensitivity in order to incorporate the effects of lockdown, demand crunch production halt, inventory depreciation etc. Moreover, corporate needs to have a dynamic mechanism to gauge the likely impact of the market turbulence on their fortunes and thus arises the need for financial modelling.
Although while creating or reading a financial model we should always remember that, like any other model, this model is only as good as its inputs and assumptions. Being a tool, which relies completely on historical data, it should be taken into account that there is always a probability of failure in prediction. Due diligence is highly recommended while creating and using such models.
Post COVID-19, the demand for people with financial modelling skills is likely to increase. Existing corporate models and business ethics will evolve to incorporate a large-scale risk, like a pandemic. To materialize this risk adherence, corporations will look for highly sensitive and dynamic financial models that help them retain their resources and minimize the losses during worst case scenarios, like COVID-19. It is an undeniable fact that the jobs will be scarce after the reopening of our economy and the worldwide unemployment rate will rise to its highest it has been in decades. The competition in the market will be fiercer than usual and ‘Darwinian' competition will prevail. Only the best and the strongest will stand their grounds and remain employed. For a stronger profile in such turbulent times Financial Modelling will definitely prove handy. Financial Modeling is a key tool to establish a successful career in the field of Financial Modeling.
If we look into career options and growth opportunities surrounding financial modelling, we should understand that it is the most widely used tool in investment banking (portfolio management, stock selection etc.), equity research (acquisitions & mergers, fundamental analysis etc.), corporate development (valuation, comparison etc.), financial planning & analysis (FP&A), and accounting (transaction advisory, due diligence etc.).
The scope of financial modelling applications is very broad as models are used for a wide range of decision making, including those related to mergers, acquisitions, capital raising, internal planning, budgeting, forecasting, investments, and valuation. The scope is further increased when you start looking at ad-hoc analysis, including sensitivity analysis, scenario analysis, capital projects, return on investment and IRR. The activities are typically performed by professionals in private equity, investment banking, corporate development, equity research, and financial planning & analysis (FP&A).
Following firms have extensive use of financial modelling-
• Global Firms
• Boutique Firms
• Financial Services
• Domestic Brokerages
• Asset Management
• Private Equity
• Domestic Majors
• Other Corporates
Ans- The skillset is more important than a certification as most of the recruiters will check for either experience/exposure to financial modelling or will opt for a time-based test to check for the skillset. However, keeping a certification will only emphasise the credibility. There are many courses available online for financial modelling
Ans- Financial models are usually built on MS-Excel, therefore, good command of MS-Excel is a must. Along with this learner should also hold knowledge on creating balance sheets, P/L accounts etc.
Ans- As a skill financial modelling can be learned by students of various disciplines, from B.Com., CA, CFA, MBA to B.Tech. Having a finance or a commerce sure helps but it doesn't mean it's a requirement.
Ans- Yes, definitely. Most of the start-ups and even businesses in their early stages opt to outsource finance analysis and forecast. After COVID-19 a lot many of other firms will also opt for freelancers in order to cut the cost of operations.
Ans- The answer is research; every firm has its own dependence on different and unique external factors. Through a holistic research you have to find the link of dependency for example, Zomato will be more concerned about reach of internet but Land Rover will be more concerned about the changes in oil prices.
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Author: Paritosh Joshi
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