Founding a company is one thing but seeing it grow is another.
You will need to learn to manage your capital resources carefully, and a key tool in doing that is a financial model of your business.
Financial modeling is too large a topic to cover in one post. To learn in detail how to create one consider attending a financial modelling in Excel course.
In this article we will explain why you need a financial model and how you go about creating one.
What Is a Financial Model?
A financial model represents a company’s operation in terms of numbers.
A good financial model allows executives to properly evaluate the current condition of the business and make future decisions.
A good financial model is grounded in reality and so depends on historical data and assumptions generated from looking at the business’s past performance.
Financial modeling is the art of uniting accounting, finance, and business metrics to come up with an abstract representation of a business. At a minimum a financial model will contain the following:
- Assumptions Sheet: This lays out all the assumptions that have gone into the model.
- Income Statement: Showing if the business is profitable or not.
- Cashflow Statement: Showing where the business is generating cash and where it’s investing cash.
- Balance Sheet: Showing the business’s asset and liability situation.
In addition financial models also often have charts which summarize the output visually.
Why Use Excel to Create a Financial Model
Financial modeling requires complex calculations that vary widely from business to business.
Every business has its environment, from operations and productions to payment terms, financing and supplier terms. Businesses differ from each other enormously.
A pre-built financial model would not be flexible enough to allow for all of these variations.
Microsoft Excel offers the level of flexibility required as it allows each model to be produced completely bespoke. Excel provides you with what is effectively a blank canvas.
Why You Need a Financial Model of Your Business
A good financial model is an important tool because:
- Financial models are used by executives in decision-making. They mean that different scenarios can be modeled and reviewed very quickly and simply.
- Financial models are also used to forecasting cash flows based on historic data and future assumptions and so ensure that appropriate financing is in place for the business. This article explains using financial models to manage uncertainty in business.
- Financial models serve as a financial presentation of your company and feed into presentations that are used by executives to attract investors and raise capital.
- Financial models are used to model the outcome of corporate transactions like mergers and acquisitions before they happen.
- These models are also helpful in comparing your business with other competitors. For example, benchmarking operating margins and other financial metrics.
5 Steps To Creating a Financial Model
Creating a financial model from scratch is a large piece of work.
Here is a step-by-step plan to creating one.
1. Gather historic data
A good financial model is ideally based on five years performance, and really needs to have three years as a minimum. After inputting the historical results into the model use them to calculate the financial ratios that you will need for your model.
2. Calculate ratios using historical data
With historical data, you should be able to calculate parameters like sales growth, gross margins, variable and fixed costs, inventory turnover, and other important parameters. A good financial model must include all the parameters that are crucial drivers of the business. These can be completely different between businesses.
3. Draw your assumptions for future
By reviewing the historic data and operating ratios you can anticipate future results. Start by projecting your assumptions in the form of sales growth, cash flows, capital expenditure, and other parameters.
When working on assumptions, you also must consider your industry overall and also the external environment.Most obviously are there any additional taxes that the government has announced that should also be included in your model.
The quality of a financial model depends on the quality of the assumptions that it contains so don’t rush this step.
4. Forecasting the data
In this stage you create your forecast income statement, balance sheet, and cashflow statement. The ratios and assumptions that you calculated in steps 2 and 3 will generate these figures for you.
5. Make charts and graphs
Most people visualize the key outputs from their model using charts and graphs. This is another area where Excel is great. It contains a huge number of charts which can be customized to make sure that the information is presented really clearly. This page has lots of detail about Excel charts.
Once you have a full financial model you can then look at more advanced areas like performing discounted cash flow (DCF) analysis, sensitivity analysis and stress testing.
What Level of Excel Skills do You Need?
To prepare a financial model in Excel, you need to have intermediate to advanced level knowledge of Excel. You also need to be organized and lay out your model clearly. Financial models tend to be large and span multiple worksheets so it is easy to get confused if you do not lay things out clearly.
Final Thoughts
A good financial modelling gives valuable visibility and insight into your business.
As an entrepreneur you may not have time to build one yourself but you definitely need to understand the process so that you can work with a model.
| SUM | Used for summing up different ranges also SUMIFS would be useful for conditional sum operations |
| AVERAGE | Used for calculating the averages, AVERAGEIFS is useful with conditional calculations |
| COUNT | To count the occurrences of values, COUNTIF is useful to check specific values |
| MIN & MAX | To find out the minimum and maximum values from the range of numbers |
| IF Function | To evaluate different criteria, nested IF is useful to evaluate complex criteria |
| Charts and Graphs | To visualize the important numbers for better communication and presentation |
| Formatting Features | Helps in giving a proper structure to the entire model like color coding for inputs and formulas, etc |
Conclusion
A financial model is indeed a great tool to understand ins and outs of the business in a better way. A great financial model will require a lot of efforts but once the model is ready, you would be at the advantage of making an informed decision rather than making guesses to improve your business.
Microsoft Excel provides you with all the necessary formulas and features that are required to make a great financial model. It makes a lot of sense to learn Excel to be able to make financial models that stand out from the rest. Keep Learning!