What are the four important Financial Modeling Techniques?

A good financial  model  should always be:-

Realistic based on reasonable and defensible assumptions and projections

Flexible and adaptable with dynamic working schedules (or modules)

Easy to follow, should not intimidate the reader

Wondering how can a model have these features. So lets learn some important financial modeling techniques and make a model flexible and easy to understand.

So let’s understand what financial modeling is,

A financial model represents the financial performance of a company for both past and future. Models being very cohesive it’s also advisable to build a financial model in excel. Knowledge of excel, knowledge of accounting and corporate finance, understanding the company’s operations are some of the skill sets required in an individual in order to build a model.

Financial modeling technique 1 – Historical data

Your assumption for the future years is based on your historical. So it is very important to gather the right data from the right source. While gathering data remember one thing you are an analyst not an auditor. So if the annual reports published by the company do not tally don’t panic and sit to tally them.

Financial modeling technique 2– Assumption

Financial models need to have clear and well defined assumptions which is Referred to as ‘drivers’ or ‘inputs’ these are based on a thorough understanding of the business

Assumptions should reflect business realities and expectations

In order to come up with an assumption analyzing the historical plays a vital role. To analyze the historicals one should do ratio analysis of the company financials and come up with answers to certain question like

Whether a certain ratio has declined or is growing

What are the reasons behind this declining or growing percentage

How would it affect future

The other criteria which one should consider while making an assumption are

No bias should get into the assumptions on the business

Clearly understand the expected changes in future performance

Understand Management expectations

Check out what other analysts think about the company

Note: Become a Financial Modeling Expert

Learn fundamental financial analysis of companies. Forecast future financials of business. Perform financial valuation to decide a buy/sell call on public company shares.

Financial modeling technique 3 – Color coding /Linkages

Formatting is very important in anything you prepare. In financial modeling color coding is one of the formatting which one needs to take care of.

Let’s consider an example and try to understand why color coding is so important.

You have prepared a financial model but the color of all the numbers are same and you are on leave. There is some very important news that has been published which would change the assumptions that you had made for that particular company and your colleague wants to come up the target price. In order to come up with a target price your colleague has to change certain things in the model. Since it has same color throughout your colleague is finding very difficult to find the right cell in which changes needs to done .

What  can be done to overcome this situation?

A right color coding would solve this problem. So there should always be different color coding for Historical inputs, formulas and linkages. This would help your colleague to understand the financial model and make the necessary changes in the right cell.

Financial Modeling Technique 4 – Circular reference

A circular reference is a series of references where the last object references the first, resulting in a closed loop.