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A Guide To Financial Modelling And Financial Model Building
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One clear fact for those who are planning to make career in investment banking or corporate finance is that they need to have expertize at Financial Modelling. However, most aspirants get confused about the term financial modelling and what a financial model exactly does?
One of the reasons behind this is that professional financial modelling rarely form part of any university curriculum. Further, less availability of quality financial modelling courses makes it more difficult.
Here is an attempt to elucidate what is Financial Modelling to help aspirants get clear idea of the term and its use.
The first question is "What is Financial Modelling?"
In simple terms, Financial Model is just a MS Excel Spread Sheet prepared to represent detailed financial of any company and the task of preparing these sheets is Financial Modelling. As an Equity Research Analyst, you job will be to analyze company’s financial statements to write a report on company's future prospects. You need to check out company's past performance and to come out with expectations of its financial performance in future. You can easily get answers to a number of your doubts and questions with the help of a financial model.
The components forming part of the analysis include - assumptions, income statement, balance sheet, cash flow statement, debt pay down schedule, depreciation schedule, amortization schedule, valuation and summary.
Why Financial Modelling is required?
1. With the help of it, an investment banker can find out a company's worth, its valuation and the stock price.
2. Bank finds out company's loan pay back capability and determines how company's cash flow look like
3. A CEO finds out company's product producing efficiency. This can be done by analyzing company's inventory turns, output ratios, return on capital etc.
4. An investor finds out expected Return on Equity (ROE) for the last investment.
5. Financial modelling helps a credit analyst understand company's probability of defaulting on loan.
From the above mentioned points, it can easily be inferred that in corporate finance industry, one needs to have good command at Financial Modelling and analysis irrespective of the role.
How to build a Financial Model?
To build a financial model, you need the below mentioned components:
With income statement analysis you can understand core business of the company and can get answer to the questions like:
• Is this business scalable?
• Required investment to scale the business?
• How long will it take the business to achieve profitability?
• Biggest costs?
• How do expenses increase with revenue?
• Where is the leverage in the business?
It helps find out financial soundness of the company and answers questions such as:
• Cash balance of the company
• Available working capital
• Type of most of the assets - tangible or intangible
• Net worth of the company
• Are there too many short-term liabilities coming up?
• Time to record inventories
Cash flow statement
As in a business everything is based on cash, the Cash Flow Statement is considered to be the most crucial financial statement to check out. Company's survival and investment in future to a large extent depends on timing of cash leaving and entering the company. It helps you find out:
• Monthly cash burn rate
• Percent of EBITDA in free cash flow
• Are new capital expenditures showed up in profits
With the help of Depreciation or Amortization schedule you get to know about:
• Various assets in the company
• Worth of each asset
• Bankruptcy value of the assets
• Non-cash expense in the company
Debt Paydown Schedule
This is an important component for large inventory based companies. It helps you get the answer of questions like:
• Amount of the debt the company has
• Interest being paid
• Per cent of profits paid for debt
• The time when company should refinance debt
Financial ratios are the summary overviews of other components and bring together information from different statements in one ratio. With the help of it you can find out profitability ratio and return on equity.
In most of the cases, the basic reason of building a model is to find a company's worth. With this you can get answer of questions like:
• Fair value of the company
• Stock price of the company
• Risk associated with the company as compare to the competitors
• How the company should raise capital - by debt or equity
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