What is Financial Modelling and How Do Analysts Use It?

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?
• How Does Financial Modelling Work?
• 10 Types of Financial Models
• Benefits of Financial Modelling
• Key Components of Financial Modelling
• Step-by-Step Process of Financial Modelling
• Real-Life Use Cases of Financial Modelling
• Who Builds Financial Models?
• Top 5 Financial Modelling Software
• Common Mistakes in Financial Modelling
• Best Practices for Financial Modelling
• How to Learn Financial Modelling

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.

How Does Financial Modelling Work?

Financial modelling is typically done by employees in financial planning and analysis (FP&A) or anyone with a solid understanding of accounting and finance. They start with the three-statement method, using the latest income statement, balance sheet, cash flow statement, and supporting schedules.

External analysts at investment banks, venture capital firms, private equity firms, or other stakeholders also develop models. They review a company’s financial performance and test assumptions based on key business drivers, which can be internal (sales, manufacturing capacity, inventory) or external (interest rates, unemployment, regulations).

Using these inputs, analysts forecast short-term (next quarter, fiscal year) or long-term (three to five years) financial performance. Short-term forecasts are generally more accurate because assumptions are easier to predict. Financial modelling builds a clear picture of a company’s performance, valuation, and the potential 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. 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.

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:

•  Complex Formulas: There are some complex mathematical formulas, such as statistical and probability distributions, which are hard to create, analyse, and maintain.
• 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.
• Incomplete Data Capture: Sometimes, data is hidden in operational or supply chain systems, resulting in incomplete data.
• 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!

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 for 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. 

What Is Financial Modelling? – FAQs