Chapter 1
IN THIS CHAPTER
Exploring the who, what, and why of financial modeling
Investigating different types of models
The demand for financial modeling skills has increased exponentially in recent years and many job listings for finance positions now include “financial modeling” as a core skill. If you’re reading this book, you’ve probably already discovered how important this skill is, and you know that learning financial modeling will increase your employability in finance or financially focused fields.
In this chapter, I define financial modeling — what it is, who uses it, and why it matters. I also show you some examples of financial models. If you’re brand-new to financial modeling, this chapter is a very good place to start.
Before you dive into how to use Microsoft Excel to create financial models, you need to know what financial modeling is, who uses financial models, and why financial modeling matters. In this section, I fill you in.
When I teach a course on basic financial modeling, I always ask my students for their definitions of the term financial model. Most of them come up with long-winded descriptions using terms like forecast and cash flow and hypothetical outcomes. But I don’t think the definition needs to be that complicated. A financial model is a tool (typically built in Excel) that displays possible solutions to a real-world financial problem. And financial modeling is the task of creating a financial model.
You may have thought that a financial model was basically just an Excel spreadsheet, but as you know, not every spreadsheet is a financial model. People can and do use Excel for all kinds of purposes. So, what makes a financial model distinct from a garden-variety spreadsheet? In contrast to a basic spreadsheet, a financial model
More broadly, a financial model is a structure (usually in Excel) that contains inputs and outputs, and is flexible and dynamic.
Many types of people build and use financial models for different purposes and goals. Financial models are usually built to solve real-world problems, and there are as many different financial models as there are real-world problems to solve. Generally, anyone who uses Excel for the purpose of finance will at some point in his career build a financial model for himself or others to use; at the very least, he’ll use a model someone else created.
Bankers, particularly investment bankers, are heavy users of financial models. Due to the very nature of financial institutions, modeling is part of the culture of the company — the business’s core is built on financial models. Banks and financial institutions must comply with current regulatory restrictions, and the tools and controls in place are forever changing and adapting. Because of the risk associated with lending and other financial activities, these institutions have very complex financial modeling systems in place to ensure that the risk is managed effectively. Anyone working in the banking industry should have at least a working knowledge of spreadsheets and financial models.
Outside the banking industry, accountants are big users of financial models. Bankers are often evaluating other companies for credit risk and other measures. An accountant’s models, however, are often more inward looking, focusing on internal operations reporting and analysis, project evaluation, pricing, and profitability.
A financial model is designed to depict a real-life situation in numbers in order to help people make better financial decisions.
Wherever there are financial problems or situations in the real world that need solving, analyzing, or translating into a numerical format, financial models help. Sometimes it’s just an idea or a concept that needs to be converted into a business case or feasibility proposal. A skilled financial modeler can put substance to the idea by augmenting the details enough to get a working model upon which decisions can be made, investor funds can be gained, or staff can be hired.
For example, financial models can help investors decide which project to put their money into, an executive track which marketing campaigns have the highest return on investment, or a factory production manager decide whether to purchase a new piece of machinery.
When you then consider the benefits that a financial model can bring, it’s difficult not to get carried away thinking of the application potential of a financial model! When you understand the principles of financial models, you can begin to look at the most common scenarios in which a model would be implemented.
There are a variety of categories of financial models:
Modelers generally specialize in one or two of these model categories. You’ll see some overlap between each type of model category, but most models can be classified as one model type.
In this section, I show you some examples of scenarios and places in which these categories of financial models can come in handy, along with the functions and characteristics of each.
Loans and the associated debt repayments are an important part of project finance models, because these projects are normally long term, and lenders need to know whether the project is able to produce enough cash to service the debt. Metrics such as debt service cover ratio (DSCR) are included in the model and can be used as a measure of risk of the project, which may affect the interest rate offered by the lender. At the beginning of the project, the DSCR and other metrics are agreed upon between the lender and borrower such that the ratio must not go below a certain number.
The input to a pricing model is the price, and the output is the profitability. To create a pricing model, an income statement (or profit-and-loss statement) of the business or product should be created first, based on the current price or a price that has been input as a placeholder. At a very high level:
Of course, this kind of model can be very complex and involve many different tabs and calculations, or it can be quite simple, on a single page. When this structure model is in place, the modeler can perform sensitivity analysis on the price entered using a goal seek (see Chapter 7) or a data table (see Chapter 8).
Not every financial model needs to contain all three types of financial statements, but many of them do, and those that do are known as integrated financial statement models. You may also hear them referred to as “three-way financial models.” The three types of financial statements included in an integrated financial statement model are the following:
From a financial modeling perspective, it’s very important that when an integrated financial statement model is built, the financial statements are linked together properly so that if one statement changes, the others change as well. For an example of how to build an integrated financial statement model, turn to Chapter 12.
Building valuation models requires a specialized knowledge of valuation theory (using the different techniques of valuing an asset), as well as modeling skills. If you’re a casual financial modeler, you probably won’t be required to create from scratch a fully functioning valuation model. But you should at least have an idea of what types of valuation financial models are out there.
Here are three common types of valuation financial models you may encounter:
Because they look historically at what occurred in the past, some people argue that reporting models are not really financial models at all, but I disagree. The principles, layout, and design that are used to create a reporting model are identical to other financial models. Just because they contain historical rather than projected numbers doesn’t mean they should be categorized any differently.
In fact, reporting models are often used to create actual versus budget reports, which often include forecasts and rolling forecasts, which in turn are driven by assumptions and other drivers. Reporting models often start out as a simple income statement report, but end up being transformed into fully integrated financial statement models, pricing models, project finance models, or valuation models.
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