Financial modeling is a critical skill in the finance world, particularly for those working in investment banking and related fields. To put it simply, financial modeling involves creating representations of a business’s financial performance to help professionals analyze data, and predict future outcomes.
In this beginner-friendly guide, we will explain the basics of financial modeling, various types of financial models, the importance of Microsoft Excel in Financial Modeling, its applications, best practices and tips for developing your financial modeling skills.
Understanding Financial Modeling with a Real Life Example
Financial modeling is like creating a virtual version of a business to understand how it works and how it might perform in the future. It’s like playing with numbers and making predictions based on the information you have about a company or investment.
A real life example – Imagine you want to open a lemonade stand. You’ll need to know how much money you’ll make by selling lemonade, how much it’ll cost to buy lemons, sugar, and cups, and how much profit you’ll have left after paying for all these things.
Financial modeling helps you create a “what-if” scenario using numbers and calculations to predict how well your lemonade stand will do.
So if you’re making a financial model of a Lemonade shop, you will analyse ‘What‘ will be the future Profit of the firm ‘if‘ the cost of lemons (or other factors leading to profit) are increased or decreased.
Finance professionals and investment bankers use financial modeling to help them make decisions about investments (Businesses) and understand how different factors can impact a business’s success. It’s like a crystal ball that uses math and logic to see into the future of a company or investment.
Scope of Financial Modeling
Financial modeling has a broad scope, with applications across various industries and job roles. Understanding the wide range of uses for financial models can help aspiring finance professionals realize the value of this skillset. Here are some key areas where financial modeling is applied and used:
- Valuation: Financial models are used to estimate the value of businesses, investments, or assets. This is particularly important in mergers and acquisitions, where investment bankers use models to determine a fair price for a transaction.
- Capital Budgeting: Companies use financial models to analyze potential investments, such as new projects or expansions, to determine their expected return on investment (ROI) and make informed decisions about allocating resources.
- Financial Planning and Forecasting: Financial models help organizations create budgets, forecast revenues and expenses, and develop long-term financial plans. Corporate finance professionals often use financial models to support strategic decision-making and assess the financial viability of various initiatives.
- Risk Management: Financial modeling allows professionals to analyze the potential risks associated with investments, business decisions, or market conditions. By identifying and quantifying risks, organizations can develop strategies to mitigate or manage them effectively.
- Investment Analysis: Portfolio managers and financial analysts use financial models to assess the performance of investments, such as stocks or bonds, and make informed decisions about buying, selling, or holding assets.
- Project Finance: Financial models play a crucial role in evaluating the financial feasibility of large infrastructure or industrial projects, helping project sponsors and lenders make decisions about financing and risk-sharing arrangements.
- Performance Measurement: Financial models are used to assess the performance of business units, teams, or individuals within an organization, helping management identify areas for improvement and align incentives with performance goals.
Financial Modeling Jobs and Salaries
Financial modeling skills are highly sought after by the recruiters in the finance world. The professionals with expertise in this area can find rewarding career opportunities in core finance. Here’s an overview of some common job roles related to financial modeling and their respective salary ranges:
- Investment Banking Analyst: Investment banking analysts create financial models to support transactions like mergers and acquisitions, and capital raising. Salary for these entry-level roles typically ranges from $60,000 to $100,000 per year, plus bonuses.
- Financial Analyst: Financial analysts use models to evaluate companies, industries, or investment opportunities for organizations such as banks, asset management firms, or corporations. Salaries for financial analysts vary based on experience and employer, typically ranging from $45,000 to $85,000 per year.
- Equity Research Analyst: These professionals analyze stocks and create financial models to forecast future performance and make investment recommendations. Salary of an Equity research analyst usually ranges from $60,000 to $120,000 per year, depending on experience and the size of the employer.
- Portfolio Manager: Portfolio managers oversee investment portfolios and use financial models to make investment decisions. Salaries for portfolio managers vary widely based on the size of the portfolio that they manage and experience level, ranging from $70,000 to over $200,000 per year, plus bonuses.
- Corporate Finance Manager: Corporate finance managers create financial models to support strategic planning, budgeting, and forecasting within a company. Salaries for corporate finance managers typically range from $80,000 to $150,000 per year, depending on the size of the company and the individual’s experience.
Also, just a disclaimer – The salaries given above can vary based on factors like location, years of experience, and the specific industry or employer.
Uses of Financial Modeling
- Financial Analysis: Financial models help professionals evaluate a company’s financial performance by examining financial reports, comparing numbers, and identifying trends.
- Forecasting: Models help predict future financial performance by using historical data, industry trends, and various assumptions.
- Decision-Making: Financial modeling helps professionals make informed choices about investments, allocating resources, and strategic planning by providing insights into potential outcomes and risks.
Who makes a financial model?
Financial models are created by various professionals in the finance world who need to make informed decisions, analyze performance, or predict future outcomes. Some of these professionals include:
- Investment Bankers: Investment bankers use financial models to value companies, analyze potential investments, and help clients make decisions about mergers, acquisitions, or raising capital.
- Financial Analysts: Financial analysts create models to evaluate the financial health of companies, assess investment opportunities, and provide recommendations to businesses or investors.
- Portfolio Managers: Portfolio managers use financial models to evaluate and manage investments, ensuring that their clients’ portfolios are well-balanced and meet their financial goals.
- Corporate Finance Professionals: Professionals working in corporate finance, such as CFOs and financial managers, create financial models to support strategic planning, budgeting, forecasting, and decision-making within a company.
- Consultants: Financial consultants and advisors use models to help clients understand their financial situation, explore various scenarios, and make informed decisions about investments, business plans, or financial strategies.
- Entrepreneurs and Business Owners: Entrepreneurs and business owners may create financial models to evaluate the potential success of their business ideas, plan for growth, and secure funding from investors or lenders.
The professionals mentioned above often have a strong background in finance, accounting, or economics and possess expertise in using tools like Microsoft Excel to build and analyze financial models.
Developing financial modeling skills can open up career opportunities in various fields and help professionals make data-driven decisions in their work.
Types of Financial Models
Discounted Cash Flow (DCF) Model
The DCF model is used to figure out how much an investment is worth today, based on the money it will make in the future. This helps in deciding whether an investment is worthwhile.
Leveraged Buyout (LBO) Model
The LBO model is used to analyze the potential purchase of a company using mostly borrowed money. This helps in understanding whether the investment can generate enough returns for investors.
Mergers and Acquisitions (M&A) Model
The M&A model is used to evaluate the financial impact of joining two companies or one company acquiring another. This helps in understanding the benefits and drawbacks of such deals.
Other Financial Models
- Valuation Models: These models, such as the comparable company analysis (CCA) and precedent transaction analysis (PTA), are used to value businesses, assets, or investments.
- Budgeting Models: These models help companies create budgets, plan expenses, and monitor financial performance.
For a detailed guide on all major types of financial model, refer to this blog – Top 9 Types of Financial Models
Microsoft Excel in Financial Modeling
- Importance of Excel: Microsoft Excel is a widely used tool for financial modeling due to its versatility, functionality, and ease of use. It allows finance professionals to build, modify, and analyze models efficiently.
- Essential Excel Functions: Some key functions used in financial modeling include VLOOKUP, HLOOKUP, INDEX, MATCH, SUMIFS, and various financial functions such as NPV, IRR, and PMT.
- Use Case: Building a DCF model by predicting cash flows and calculating present value of the business. Designing an LBO model with debt repayment schedules and potential returns for investors.
Developing Financial Modeling Skills
- Recommended Resources: Online courses, workshops, and books can help you learn financial modeling in a simplified manner. Some popular resources include Quintedge, Coursera, LinkedIn Learning.
- Practical application: Practice and apply your financial modeling skills in real-world scenarios to improve your proficiency and stay updated on industry trends.
- Networking and Professional Organizations: Join finance-related professional Telegram or Whatsapp groups, and network with fellow professionals on Linkedin to enhance your learning and open up new opportunities.
Frequently Asked Questions
Typically, a financial modeling fresher can expect a starting salary of 4-5 lakhs.
Financial modeling certification takes 6-8 weeks to complete