Financial Modelling, Working Model with Examples

What is Financial Modelling?

Financial Modelling refers to the structure of creating a proper representation of an organisation’s financial performance. It is primarily a mathematical model built in spreadsheets to include a company’s revenues, expenses, profits, losses, cash flow, balance sheet, etc. 

It is used to predict the future performance of the company based on certain assumptions and historical data available. It provides a structured way for the bankers to evaluate a company’s value and make informed investment decisions. Some of the common uses of financial modelling are listed below:

• Valuation of companies: Bankers use models to estimate the fair value of firms during mergers, acquisitions, or fundraising.

• Credit analysis: Models help evaluate whether a borrower can repay loans.

• Investment decisions: Portfolio managers and analysts rely on models to forecast returns.

• Scenario analysis: Bankers can test the impact of best-case, worst-case, and base-case scenarios on profitability and risk.

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How Financial Modelling Works?

The working of the financial models is dependent on the combination of historical data of financial statements, assumptions with regards to the future, and formulas to forecast the future outcomes. The process for the bankers involves the steps mentioned below:

• Collecting Data: The foundation of any model is accurate data. Bankers collect information from a company’s income statement, balance sheet, and cash flow statement. It also includes industry and economic data.

• Building Assumptions: Every model is based on assumptions. For example, a banker may assume that sales will grow by 10% annually or that interest rates will rise by 1%. These assumptions are crucial because they directly affect the model’s outcomes.

• Creating the Structure: The financial model is structured in spreadsheets, usually Excel. The three main statements income statement, balance sheet, and cash flow statement—are linked together. This ensures that changes in one area automatically reflect in others.

• Forecasting Performance: Based on historical trends and assumptions, bankers project future revenues, expenses, and profits. These forecasts help in understanding whether a company will remain profitable, generate cash, and sustain growth.

• Running Scenarios: Bankers rarely rely on a single forecast. They create multiple scenarios optimistic, pessimistic, and realistic to test how different situations affect the company’s performance.

• Drawing Insights: Finally, the results are analysed to provide actionable insights. For example, a banker may conclude that a company can handle a new loan, but only if interest rates remain stable.

Examples of Financial Modelling

The importance and working of Financial Modelling can be understood by the following example:

Let’s assume that a company approaches a bank for a business loan of INR 50 Crore. As a banker, you need to decide whether the loan is safe or not and can the loan can impact the company’s ability to repay. The steps to be followed by the Banker in such a situation is summarised below:

1. Gather Historical Data: You collect the company’s last three years of financial statements. The company has stable revenues of ₹200 crore annually, a net profit margin of 8%, and manageable debt.

2. Build Assumptions: You assume the company’s sales will grow by 12% per year, interest on the loan will be 10%, and operating costs will rise by 6% annually.

3. Create the Model: In Excel, you build a financial model linking the income statement, balance sheet, and cash flow statement. You include the new loan in liabilities and add interest expenses.

4. Forecast Future Performance: The model projects revenues, profits, and cash flows for the next five years. It shows that the company’s profits will increase steadily and cash flows will remain positive.

5. Test Scenarios: You create a worst-case scenario where sales only grow by 5%. In this case, the company’s profits shrink, but cash flow remains just enough to service debt.

6. Make the Decision: The model demonstrates that under most conditions, the company can repay the loan. Based on this analysis, you may recommend approval with certain safeguards, such as collateral or covenants.

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How Can You Learn Financial Modelling?

Those bankers who are looking to improve their career prospects and strengthen their expertise should learn everything about financial modelling. This skill can be developed by learning thoroughly over a period of time. Learning will involve becoming familiar with several software programs and spreadsheets. Bankers looking to learn financial modelling can check the table provided below for more information: