Beginner’s Guide to Financial Modeling

Businesses of all sizes regularly need to make critical decisions—decisions that could lead to the loss of a lot of money if things go wrong. Fortunately, financial modeling is available to help make these decisions a bit easier.

Whether businesses need to allocate their budget, sell some assets, or decide to merge with another company, financial modeling is a tool that enables companies to try and predict how the decision will affect their financial standing. 

Financial Modeling Basics

In essence, financial modeling is the method that companies use to summarize their expenses and their profits. This summary is then used to predict the potential financial impact of major business decisions. These models are typically completed in Excel. The process usually begins by gathering historical data regarding the company’s finances from the last several years; most professionals recommend that this step contain the data from the past three years at the minimum. Next, some assumptions are made regarding the company’s profit margins, ratios of expenses to revenue, and annual growth rates. These assumptions are also based on historical data to produce the most accurate results. 

Once these assumptions have been added to the model, a forecast can be built and the risk of the potential decision can be calculated. This is always done using the numbers that were discovered in the assumptions phase. Near the end of the process, a Discounted Cash Flow model is typically completed to determine the value of the company, as well as the potential added value given a particular decision. This model helps stakeholders decide whether to invest and how much to budget for a potential project. Analysts can also complete stress testing of their predictions at this time. For example, the 2008 recession is often used to test real estate developments to illustrate how the business would perform under extreme stress.

Pros and Cons of Financial Modeling

Financial modeling is becoming an increasingly common practice when businesses need to make crucial decisions. Therefore, it is important for anyone learning about this tool to understand its advantages as well as its limitations. 

One of the primary benefits of financial modeling is that it often leads to a more thorough understanding of the business. Creating a financial model requires various team members to provide input on things like potential upcoming changes to the business and current internal processes that need improvement. These discussions lead to a deeper awareness of how a business works and what main factors are driving its success. For similar reasons, financial modeling also helps businesses understand their finances better as well. Without financial modeling, some businesses expect there to be a direct correlation between expenses and revenues. Financial modeling can help businesses predict their cash flow at specific points in time. Knowing their precise worth helps provide more accurate information to investors and other stakeholders.

The process of financial modeling is not without its flaws. For starters, it is an incredibly time-consuming endeavor. A great deal of information must be gathered and a lot of different people have individual assignments to complete before all of the data is brought together. The model also requires repeated testing to ensure accuracy. Even still, financial modeling also has the potential to be inaccurate. This is expected to a certain extent; it is impossible to predict how interest rates will rise and fall over time. Financial modeling is best used when trying to predict events relatively near in the future; trying to predict events that may happen a long time from now will almost certainly be incorrect. Some factors cannot be integrated into a financial model. For example, if two companies are planning on a merger, the ability of employees to get along with each other cannot be accounted for. 

Careers That Use Financial Modeling

More often, companies and hiring managers are looking for employees who are familiar with financial modeling. To remain competitive in their industries, most businesses need to be able to organize raw data and use it to make recommendations about future decisions. Below are a few examples of careers that require knowledge of financial modeling. 

Investment bankers routinely develop financial models to advise companies through complex processes like mergers and acquisitions. Their clients range from large corporations and private firms to government agencies around the world. Investment bankers also utilize financial modeling to help raise capital and offer support with stock offerings. 

Equity research analysts spend a lot of their time analyzing companies within a specific industry. They compile their findings in reports and share this information with their clients, who will decide whether they’d like to invest based on what the analyst finds. Real estate developers also utilize financial modeling to determine whether a particular development is going to be profitable. 

Learn Financial Modeling with Career Centers

If you want to learn more, the financial modeling courses offered at Career Centers are an excellent place to start. If you’re looking for a minimal time commitment, you may want to check out the Advanced Excel for Financial Modeling class or the Stock Market Investing Fundamentals class. Both are less than ten hours long and provide a great deal of information suited for beginners in the field. Career Centers also offers a Financial Modeling Bootcamp. This course covers advanced Excel skills, basic accounting principles, and ends with the creation of your financial model to add to your portfolio. Finally, they have a Financial Analyst Training Program, an intensive five-day bootcamp that covers current industry trends and prepares you to start working as a financial analyst.