Financial modelling is a strategic tool for predicting opportunities and risks. Companies can foresee challenges, improve efficiency, and encourage growth by creating a comprehensive financial model. Financial models help businesses predict future performance, determine risk factors, and make strategic decisions.
In this blog, we will help you understand the financial modelling meaning, its types, benefits, and provide a guide on how to build effective financial models that drive business value.
Table of Contents
What is Financial Modelling?
Financial modelling is the process of preparing a company’s financial statements and forecasts in a spreadsheet that can be used to estimate the impact of an upcoming plan or decision. Company executives use financial models extensively. Financial analysts most often use it to assess and predict how a company’s stock performance might be affected by future events or executive decisions.
In simpler terms, individuals or organisations can make strategic decisions by quantitatively analysing different factors of their finances. Financial modelling enables stakeholders to understand the possible results of their choices and to plan accordingly by predicting future cash flows and evaluating investment opportunities.
The prediction is based on the past company performance and assumptions about the future, requiring the creation of a cash flow statement, an income statement, a balance sheet, and supporting schedules.
What Is Financial Modelling Used for?
A financial model can provide various types of results that cover a wide range of uses. The financial models enable leaders to make important decisions about a company’s strategy, such as the following:
1. Mergers & Acquisitions: Using financial modelling, a company can determine the valuation of a business they are looking to acquire. It also helps in knowing how much a potential buyer should offer and seller should accept.
2. Securing Funding: Financial modelling shows a clear picture of a company’s financial well-being and an estimation of valuation in the future. This helps in understanding how much capital a company can raise and how much it is going to cost.
3. Distributing Capital: First, a company needs to determine which investments are a priority before spending. For example, the company could invest in assets that appreciate, or long-term assets that depreciate over time, depending on the requirement.
4. Impact of Earnings Guidance: A publicly traded company can offer guidance that includes projected income and earnings per share for the next quarter during quarterly investor conference calls. This guidance can have a significant impact on the stock price of the company, depending on the company’s projections and its ability to achieve goals.
5. Annual Budgeting and Forecasting: A company’s yearly plans depend on financial modelling, integrating cross-functional strategies, such as marketing, R&D, sales, and manufacturing. These decide the budget priorities for the coming fiscal year.
6. Risk Management: Financial modelling can help company leaders understand which aspects may present significant risk to the company, like what kind of decline in sales volume could lead to running out of cash and having to file for insolvency.
How Does Financial Modelling Work?
Typically, financial modelling is done by employees who specialise in financial planning and analysis (FP&A) or have a solid understanding of accounting and finance principles. These experts start with the three-statement method, which includes the most recent income statement, balance sheet, and cash flow statement, as well as supporting schedules of a company.
However, financial modelling is not limited to internal teams; external analysts at investment banks, venture capital firms, private equity firms, or other entities having a financial interest in the company’s valuation and prospects also develop models. So, how do these analysts work? They start with a company’s financial performance and check assumptions based on key business drivers, factors that shape or influence the future income or expenditures. These drivers can be internal (anticipated sales, manufacturing capacity, inventory, or backlog of orders) or external (interest rates, the unemployment rate, or a new government regulation).
Using these inputs, analysts forecast the company’s financial situation over the short term (next quarter, this fiscal year) or long term (typically three to five years). Generally, short-term forecasts are more accurate than long-term forecasts because drivers and assumptions are easier to predict near term. Financial modelling aims to build a clear picture of the company’s financial performance and valuation, along with the value of projects and investments.
10 Types of Financial Models
The following are the best 10 types of financial models widely used in analysing and gathering data from current financial statements.
1. A 3 Statement Financial Model
A 3 statement financial model comprises a company’s income statement, cash flow statement, and balance sheet. A company’s financial outcomes and position over a given period are shown in a holistic and adaptive approach by this model. Also, most of the other financial models are built upon it. Users of this model are corporate finance teams, FP&A professionals, and financial analysts.
2. Discounted Cash Flow (DCF) Model
The Discounted Cash Flow (DCF) model determines the true worth of a business, investment, or project by discounting its projected future cash flows to the present value using a discount rate (usually WACC). The approach relies on the principle that a rupee today is worth more than a rupee in the future, due to factors like risk, inflation, etc. Users of this model are investment bankers, equity research analysts, and valuation specialists.
3. Merger Model (M&A)
The model estimates the financial results of mergers and acquisitions, considering cash flows and valuations of both companies. Using this model, investors and analysts decide whether a merger & acquisition makes financial sense or not. Users of this model are private equity analysts, M&A bankers, and corporate development teams.
4. Leveraged Buyout (LBO) Model
An LBO includes purchasing a company using debt, and an LBO model evaluates whether the company would be a good target for a leveraged buyout, or LBO. It needs to assess the total value of an LBO acquisition and also the liquidity and cash flow timing to evaluate the company’s ability to meet debt payments and other cash obligations. Users of this model are private equity firms, buy-side analysts, and investment bankers.
5. Initial Public Offering (IPO) Model
The model determines the proper value of a company’s shares when it goes public. It helps investors and underwriters determine the offering price of the shares by considering the company’s financials, growth prospects, and market conditions. Users of this model are investment banks and corporate finance teams.
6. Sum of the Parts Model
The sum of the parts model is constructed by combining several DCF models. It estimates a company’s total value by valuing its business segments separately and then summing those values. Users of this model are investment bankers, equity research analysts, corporate strategy teams, and private equity firms.
7. Consolidation Model
The Consolidation Model merges the financial statements of a parent company with those of its subsidiaries into a single set of statements. Publicly traded companies or companies with major ownership stakes in other entities use this model to prepare tax filings, financial reports, and regulatory compliance. This model works by determining the subsidiaries over which the parent company has control. Users of this model are corporate finance, group CFOs, and consolidation teams.
8. Budget Model
A budget model helps in calculating the future incomes and expenditures, providing a foundation for financial planning by forecasting the financial requirements of a company. Users of this model are corporate finance & FP&A Teams, CFOs & Controllers, department heads, and SME business owners
9. Forecasting Model
A forecasting model predicts future financial results based on past data and trend analysis of a company. The model helps businesses make better financial decisions by providing insights into possible outcomes. Users of this model are FP&A Analysts and Managers, CFOs, Startups & Founders, and Private Equity or Venture Capital.
10. Option Pricing Model
The model of option pricing specifies the true value of options, which gives the holder the right to purchase or sell an asset. It considers the price of assets, volatility, and the risk-free rate of interest. This model is used by traders and investors to find fair value and make trading decisions. Users of this model are traders, quants, and risk managers.
Benefits of Financial Modelling
A large corporation or company simply cannot operate effectively without strong financial modelling. Here are the top benefits business management gets:
1. Investment Insights: Financial modelling provides a clear picture of a company’s financial health and prospects, which helps businesses raise capital from equity investors and banks. It also lets management know the amount of capital they can raise and at what cost.
2. Risk Management Planning: Using modelling, founders or top management can determine potential risks and take steps to avoid or deal with them.
3. Determining Growth Opportunities: With the help of financial modelling, top management can determine opportunities for growth and make the right decisions about where to invest.
4. Financial Stakeholder Analysis: Shareholders and lenders can get information like future stock dividends, cash positions, valuation of the company, etc., through financial modelling.
5. Budget and Resource Management: Modelling helps management create budgets, allocate resources and personnel, and evaluate projects each year, distributing more budget to areas with higher ROI.
Key Components of Financial Modelling
Financial modelling brings together various aspects to create a comprehensive representation of a company’s financial position. These components include:
1. Past Financial Data
A financial model is based on the foundation of historical data, as it provides performance trends over time, helping in the identification of trends and patterns to establish a baseline for future predictions. Usually covering the past 3–5 years of the balance sheet, cash flow statement, and income statement (profit and loss).
2. Assumptions
The financial models rely heavily on assumptions, which predict future conditions. These assumptions drive the projections and help explore different scenarios. It includes assumptions such as cost margins, tax rates, revenue growth rate, working capital assumptions, and capital expenditure (CapEx), etc.
3. Valuation Calculations
It determines the company’s true market value. Financial models built for valuation purposes are Discounted Cash Flow (DCF), Comparable Company Analysis, Terminal Value, and WACC (Weighted Average Cost of Capital).
4. Financial Statements
The main outcomes of financial modelling include balance sheets, cash flow statements, and income statements, which are linked, reflecting the financial situation of the company.
5. Three-Statement Integration
It also ensures that the balance sheet, cash flow statement, and income statement are interconnected. Examples of key links are depreciation flows from the income statement into both the balance sheet and cash flow, and working capital changes impact both the cash flow and balance sheet. This is done to keep consistency and accuracy throughout the financial model.
6. Supporting Schedules
Alongside the main financial statements, supporting schedules help break down difficult calculations into manageable parts, increasing the model’s precision. The detailed sub-models that support the main statements are the CapEx schedule, the depreciation schedule, the working capital schedule, and the debt schedule.
Step-by-Step Process of Financial Modelling
The process of financial modelling involves several steps, which differ depending on the model type you want to develop and its intent. Here are some of the steps on how to build a financial model:
Step 1: Define Business Requirement and Objectives
Understand the business model of the company, its industry, and key revenue or cost drivers. Get to the purpose of the model; it could be budgeting, valuation, forecasting, M&A, etc.
Step 2: Compile and Process Historical Data
Gather financial statements of the past 3–5 years. To ensure consistency and reliability, clean, structure, and format the data.
Step 3: Create Key Assumptions
You can create an assumptions sheet that includes inputs like depreciation, revenue growth rates, operating margins, tax rates, CapEx, and changes in working capital, derived from historical data, trends, or market research.
Step 4: Forecast Financial Performance
Create a financial model using the income statement, balance sheet, and cash flow statement, and ensure it is fully integrated. You can use your assumptions to create dynamic, formula-driven forecasts (normally for 3–10 years).
Step 5: Add Supporting Schedules
You can create comprehensive schedules for capital expenditures, depreciation and amortisation, working capital, and debt & interest. These schedules support proper integration and forecasting.
Step 6: Analyse Financial Scenarios & Outcomes (if needed)
If needed, you can add DCF valuation, LBO models, or comps. Also, to test different business cases and assumptions, perform sensitivity and scenario analysis.
Step 7: Review, Test, and Present the Model
Check the entire sheet for balancing issues, formula errors, and logical consistency. For easy interpretation, you can create a clean dashboard or summary output. At last, for user clarity, finalise colour coding, formatting, and documentation.
Real-Life Use Cases of Financial Modelling
1. Mergers & Acquisitions (M&A)
Suppose a company wants to buy out a rival company. They can use an M&A model to thoroughly evaluate whether the deal is financially beneficial. The model evaluates purchase price, synergies, integration impact, and financing structure.
2. Initial Public Offering (IPO)
A fast-growing company plans to go public. They must use a valuation model to calculate IPO pricing. The model prepares a 5-year forecast to show future earnings potential and also helps investors and underwriters estimate value and risk.
3. Corporate Budgeting and Forecasting
When an FMCG company plans its annual budget, it should build a 3-statement model to forecast expenses, income, and profits. It sets departmental budgets, cost targets, and cash flow expectations.
Who Builds Financial Models?
Various experts within a company can develop a financial model depending on the end goal and their specific skill set. Some examples include:
1. Investment Bankers
To study and estimate the profitability and risks of IPOs, M&As, and other corporate transactions, investment bankers build financial models.
2. Equity Research Analysts
Equity analysts calculate the financial performance and future opportunities of companies and provide investment advice.
3. Management Consultants
The financial models are built by consultants from the ground up to analyse and evaluate the effect of strategic decisions, such as launching new products or entering new markets.
4. Entrepreneurs and Start-up Founders
When launching a new product or seeking funding, founders often build financial models to show the potential profitability and financial health of their companies to investors.
5. Educators and Researchers
In finance, educators and researchers often develop financial models for the purpose of teaching or researching markets, investment strategies, and economic trends.
Top 5 Financial Modelling Software
Here are the top 5 financial modelling software available:
1. Microsoft Excel
Microsoft Excel has an easy-to-use grid format and a wide range of formulas, making it the most popular choice for financial modelling work. It makes tasks simple, like data entry, number crunching, graphs, and even complex modelling.
2. Anaplan
Anaplan enables companies to create accurate financial projections in real-time with its connected planning platform. The platform is designed to adjust quickly, helping finance teams respond proactively to ever-changing business situations. Its model-building capabilities, combined with granular data analysis, allow for in-depth scenario planning.
3. Cube
Cube is one of the popular tools for building flexible, data-backed forecasting models in one system. Cube helps to get straight to the solutions that drive better business performance by merging data sources, automating repetitive work, and showing real-time performance.
4. Quantrix Modeler
Quantrix Modeler is an advanced financial modelling platform that addresses the restrictions and risks built into traditional spreadsheets. Key features of Quantrix are its multi-dimensional modelling, separation of data, logic, and presentation.
5. Finmark
Finmark helps startups and businesses to build, handle and update financial models easily. It assists with cash flow, budgeting, and runway predictions to guide careful spending.
How to Choose the Right Financial Model
Choosing the right financial model depends on your business objective, the type of analysis required, and the nature of the financial data. Here’s a practical guide to help you make the right choice:
Step 1: Determine Your Objective
Start by finding the main purpose of your financial model. Ask yourself: Are you building the model to value a company, raise capital, forecast cash flow, prepare a budget, or analyse a potential acquisition? The objective determines the structure and type of model you’ll use. For example, a DCF model is ideal for valuation, while a 3 statement financial model works best for internal planning and performance analysis.
Step 2: Understand the Business Type and Complexity
Every business has different revenue drivers, cost structures, and financial complexities. Before choosing a model, understand how the business operates, how it earns money, and what key metrics matter. A SaaS company may require a subscription-based revenue forecast, while a manufacturing firm might need detailed CapEx and inventory modelling. Your model should reflect the realities of the business it represents.
Step 3: Assess the Available Data
Your model is only as good as the data behind it. Review whether you have access to historical financials, operational KPIs, and industry benchmarks. If data is limited, it’s better to go with a simple forecast or bottom-up estimate. If you have rich and reliable data, you can build a more detailed and dynamic model with multiple assumptions and scenarios.
Step 4: Match the Model Type to the Use Case
Once you know the goal and data availability, select the model type that fits. For company valuation, use a Discounted Cash Flow (DCF) or comparable company analysis. For private equity deals, use an LBO model. For internal planning and performance tracking, use a budgeting or forecasting model. Always choose the model that best helps you answer your core business question.
Step 5: Determine the time horizon
Decide the time frame you’re planning for, short-term (monthly/quarterly), medium-term (1-3 years), or long-term (5-10 years). A rolling forecast might be needed for ongoing operations, while a long-term projection is better for investor decks or strategic decisions. Choose a model that accommodates the required timeline and reporting frequency.
Step 6: Think About the Audience
Tailor your model to the users. Investors prefer high-level summaries, return metrics, and scenario analysis. Internal stakeholders like department heads or CFOs may need detailed cost breakdowns, operational inputs, and dashboards. The more user-friendly and tailored your model is, the more effective it becomes for decision-making.
Step 7: Balance Complexity with Usability
Avoid making the model more complicated than it needs to be. A good financial model should be easy to follow, audit, and update. Use consistent formulas, clear formatting, and keep inputs, calculations, and outputs well-organised. Choose a model that delivers accurate insights without overwhelming the user.
Common Mistakes in Financial Modelling
While building a financial model, individuals and organisations can make some mistakes. Here are some of the most common mistakes:
1. Complex Formulas: There are some complex mathematical formulas, such as statistical and probability distributions, which are hard to create, analyse, and maintain.
2. Manual Updates: Often, numbers are exported into a spreadsheet at a fixed time and must be manually updated daily to maintain a model’s accuracy.
3. Incomplete Data Capture: Sometimes, data is hidden in operational or supply chain systems resulting in incomplete data.
4. Overcomplicating the Model: Financial models can become complex and hard to understand, so it is important to ensure clarity for investors and stakeholders who are unfamiliar with day-to-day operations.
Best Practices for Financial Modelling
Best practices for financial modelling can differ depending on the industry or company. Here are the best practices to consider when building your models.
1. Maintain a Clear and Transparent Approach
You need to make the calculations and logic easy to understand. For that, break formulas down into simple, logical, easy-to-follow calculations, and avoid hiding any rows, columns, or sheets.
2. Separate Inputs, Processing, and Outputs
You can separate input cells and format them so they are identifiable. And locate inputs in their cells, and do not include constants hardwired within a formula. Further, keep inputs, calculations, and outputs separate from each other.
3. Maintain a Consistent Layout
Introduce consistent cell and sheet formatting to improve user comprehension. Do not forget to include a format key to explain formats to model users and apply formatting consistently throughout the model.
4. Use Clear and Consistent Labelling
Make sure every row has an accurate and useful label. For better clarity, name each sheet clearly and consistently, and identify the units of every line item.
5. Use a Consistent Formula Pattern
Ensure logic is always in one consistent place in each row and prevent copying over mid-row formula changes. It makes reviewing or testing future maintenance easier and safer. You can use the same formula for Actuals and Forecast periods in the same row.
6. Minimise Potential Risk in Outputs
Avoid circular references and volatile functions such as INDIRECT & OFFSET, as they introduce a high risk of error, are difficult to check, and reduce calculation speed. Also, make sure outputs are free from logic issues and the model does not contain logic errors, including # #DIV/0! and #NUM!
7. Conduct Regular Error Checks
Frequently use error checks throughout the model to check that it is internally consistent and produces logical outputs. Further, link all error checks to a central location that instantly alerts the model user on every sheet if an error occurs.
How to Learn Financial Modelling
Practice makes perfect, and perfection matters in financial modelling. Typically, it takes years to become a master at building financial models. You can read equity research reports, as they give you something to compare your results to. You can take a large company’s historical financials, create a model for the future, calculate the net present value (NPV) per share, and compare your predictions to current share prices or the target prices in equity research reports.
To build a solid foundation of relevant concepts and skills in financial modelling, you can take a professional financial analytics course. Typically, the financial modelling course fees in India range between Rs. 12,000 – Rs. 50,000, depending upon the provider, format of the course, and other facilities.
Conclusion
In conclusion, having in-depth knowledge of what is financial modelling is an essential tool for companies, helping in strategic planning, decision-making, and risk management. You can start your journey by accessing the best financial modelling courses free with certificates, as the demand for financial modelling experts is rapidly increasing. So, whether you are a financial analyst, business owner, or investor, mastering financial modelling can improve your ability to make strategic and informed decisions.
Explore the key differences between the Cash Flow Statement and Fund Flow Statement in financial analysis.
What Is Financial Modelling? – FAQs
Q1: Is Excel enough for financial modelling?
Excel is the top choice for financial modelling because of its ability to manage complex models, large datasets, and advanced automation. With built-in functions, pivot tables, data validation tools, charts, and VBA macros, you can build anything from simple forecasts to complex 3-statement, DCF, or LBO models. You can refer to financial modeling examples to compare different software.
Q2: Do I need a finance background for financial modelling?
No. While having a finance background is a plus, many successful modellers come from engineering, science, or even the humanities. What matters is comfort with Excel, basic accounting logic, and business intuition.
Q3: What are the top certifications for learning financial modelling?
Certified Financial Modeling & Valuation Analyst (FMVA) from CFI, Financial Modeling Course from IIM Skills, and NSE financial modelling course called the Certification in Online Program on Financial Modelling & Valuation are among the best financial modelling courses available in India.
Q4: Can I learn financial modelling online?
Yes, you can start learning financial modelling online through platforms like Coursera, UpGrad, Udemy financial modelling course, etc. Also, there are several free financial modeling courses online, which you can choose to learn more about financial modelling.
Q5: What jobs can I get with financial modelling skills?
These are a few financial modelling jobs available in the market; investment banking, equity research, financial planning & analysis, private equity, finance consultant, credit consultant, corporate finance, hedge funds, and more.
Q6: What is financial modelling and valuation?
Financial modeling and valuation is the process of building a financial model that shows a company or project’s financial performance.