What is Financial Modeling?

This video will provide you with an overview of financial modeling. This is a complex topic that cannot be grasped fully within just a few days. If you are looking to learn more about this subject however this video will help you out.

Video Transcript/Summary of What is Financial Modeling:

  1. A financial model looks at historical performance of a company and enables you to make reasonable and realistic assumptions on future growth for a company’s revenue, income, earnings, cash flow and so forth. Virtually every business decision can benefit from the use of a financial model but it is important to remember that the model is a guide, rather than simply the decision maker.
  2. The three components to an integrated financial model are the (i) Income Statement, which depicts net profit or net income, derived from revenue or sales – expenses – taxes (ii) the Balance Sheet which discloses assets, liabilities and owners equity (ALOE) and finally (iii) the Cash Flow Statement, highlighting cash from operations, financing and investing.
  3. Sales – Cost of Sales = Gross Profit. This gross profit divided by revenue gives us the gross margin. Once we subtract the operating expenses from the gross profit, we are left with the operating income. Operating income – taxes = net income.
  4. Earnings per share (EPS) is an important number for public companies and in particular, analysts on Wall Street and is simply the net income divided by the number of shares outstanding. Diluted EPS is generally a more accurate number and will typically be slightly lower than basic EPS.
  5. Current Liabilities on the Balance sheet are shorter term whilst Long term liabilities are longer term. Assets will equal the combined liabilities and equity.
  6. In the cash flow statement, adjustments are made to the net income figure to remove non-cash items such as depreciation. Most of these figures come from either the income statement or changes in the balance sheet. Adding up the operating, investing and financing cash flow figures, you get the cash at the end of the period.
  7. A good model should allow the easy review of operating income, ebitda, net income, cash from operations and debt coverage. As the modeller, you can decide to build a one-off model or a template model but you need to be able to understand financial statements, how they are interlinked, and how they are realistically projected. Your models should be built in Excel so you need to spend time learning about it.
  8. Keep the model as simple as possible and do not take the model results as gospel. There are many assumptions that are made so use it as a guide and reference point. Before creating the model, you need to consider the big picture and assumptions you believe appropriate to go into the model. Ensure the layout is consistent in terms of font and formatting. Only provide one input cell for any one variable.
  9. Avoid hard coding numbers into your model and break long formulas into small components. Use absolute references where you can and check the parameters on excel functions. Know the numbers well and use the Excel help function. Finally, save the file often as you build the model and consider saving different versions as back up.

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