What is a Financial Model?

And how can you learn to build one through financial modeling courses?

By: Greg Ahuy

Date: August 1, 2021

A financial model is typically built in MS Excel to forecast a company’s operational and financial performance into the future. The forecast can be based on the company’s historical performance or it can purely be based on the set of assumptions that the modeler makes about the company’s future. So, the financial model is essentially an Excel spreadsheet, however, it is highly structured and dynamic, the cells are interrelated, and almost always, there are well-defined outputs of the financial model. Financial modeling is the process of creating financial models, often, in MS Excel.

What is the purpose of the financial model?

There are different types of financial models, depending on the purpose of why the financial model has been built in the first place. So, we may build the financial models to:

1. Make a decision about investment into a company – the purpose here is to see whether the company’s future performance warrants our investment, whether we will make an adequate return on our investment, and what happens if some of the assumptions made by the modeler are not true (sensitivity and scenario analysis);

2. Raise either equity or debt – similar to the decision to about investing in a company, raising capital is based on the future operational and financial performance of a company and whether the company will be able to attract the necessary equity or whether it has the necessary capacity to raise debt;

3. Value a business – we may value a business for different purposes, because we may want to sell a business, because we may want to invest in a business, or because we may want to assess the performance of a business. Regardless of the valuation’s purpose, we typically build financial models to perform the valuations. 

4. Acquire a business – we may build financial models to perform valuation analysis in more complex corporate transactions such as mergers & acquisitions (M&A), and leveraged buyouts (LBO) where we are interested in the performance of the company being acquired under assumptions of significant leverage, and if the company’s future performance merits the acquisition.

Who builds the financial models?

People who are involved in managing the finances of a company, typically, build or interact with financial models. These may be people inside the company, such as business development analysts, treasury specialists, and chief financial officers. Or, it may be outside consultants who help to raise the capital or who provide the capital to a company, such as investment banking analysts, management consultant associates, commercial banking officers, private equity, and hedge funds associates.

What are the different types of financial models?

Well, there are a variety of different financial models out there dependent on the models’ objectives. Here, we will provide a brief overview of the most common models that we may have to build working for a private or public company, or working for an investment or commercial bank. 

Financial models built in investment banking – DCF (discounted cash flow), M&A, and LBO models – when investment bankers help companies raise capital / or advise on various corporate / restructuring transactions. Dependent on the stage of the transaction, investment banking financial models can be quick & dirty models, or extensive models. 

Financial models built /used by commercial banks, investment funds, and companies’ corporate development divisions tend to be extensive models, typically based on the quarterly or monthly periodicity. The purpose of these models can be diverse: 

1 commercial banks are interested in the debt capacity of the company and the downside risks; 

2 investment funds are interested in equity returns (although depending on their investment whether it is equity or debt);

3 and corporate development may create models that serve all of the stakeholders, such as financial models for senior management, shareholders, commercial banks, investment funds, or investment bankers. 

How can you learn financial modeling?

The best way to learn financial modeling is to enroll in a financial modeling course that teaches you financial modeling skills. Note that financial modeling is a practical skill and therefore, it is important to select a course, where the instructor has experience with real-life transactions. This way you will learn the best practices applicable to modeling. 

There are differences in approaches to financial modeling depending on where you will be working. Models developed in corporate settings (corporate business development function) tend to be detailed and require flexibility. This is the opposite of the models that are typically developed in investment banking, where, mostly, lite financial models are typically developed that feed the pitch books and presentations to clients. It is recommended that you learn both, so you acquire the skills to develop the models based on the situation you find yourself in.

Look at the table below to see the differences between models when it comes to the purpose, users, level of detail, and flexibility. This table is based on the author’s experience in investment banking and project finance.

You can see from the table above that the type of financial model that you have to develop depends on the situation. While complex models may be required by all users, dictated by the situation, usually, for initial investment evaluation and even for fairness opinions that are prepared by investment banks, simple DCF models, sometimes with integrated 3-way financial statements may suffice. So, developing complex and flexible financial models for an idea pitch to the client is certainly overkill. Therefore, there is a benefit to learning to create simple DCF models.

On the other hand, for project finance transactions, where the financial model is used for investment evaluation and for the loan approval process purposes, the need for detail and flexibility is high. Project finance models are usually based on 20 + years of forecast periods and include detailed information about the cash inflows, cash outflows, sources, and uses of cash. Most of the project finance models are based on monthly periodicity, so you can imagine the level of detail that those models include. So, if you are planning to work in the infrastructure area, you have to learn how to develop detailed and flexible financial models.

Note that the more complex the model is, the higher the likelihood of errors in the model. This is because there are more links, more formulas, and more data in the model. Therefore, complex models tend to be carefully organized and planned, and this includes everything in the model, from the layout of the model to individual formulas. Complex models require a system, a set of rules, sometimes referred to as financial modeling best practices, on how to build the financial model, and usually, numerous error checks are an integral part of the complex models.