How to build a financial model (with definition and tips)
By Indeed Editorial Team
Updated 9 September 2022
Published 29 April 2022
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
A financial model is a tool used to forecast the performance of a business. Financial models are a critical part of knowing the value and potential of any business, and managers can use their company's financial model to aid decision-making. A company's financial model usually incorporates data including past performance, assumptions about the future and cash flow information. If you're interested in a finance career, you may benefit from learning how to construct a financial model. In this article, we explore how to build a financial model, what one is and tips for building one.
What is a financial model?
A financial model is a tool built using spreadsheet software that includes known information, such as the past performance of a company, and is used to forecast unknown information relating to the future performance of a company. Financial models are important because they tell us important information relating to the operations and financial health of a company or organisation. Managers and executives use financial models to inform decision-making, particularly when making decisions that impact the long-term finances of a company.
Financial models are also useful when bidding for funding, raising capital or budgeting for the future. It takes years to become an expert in financial modelling because there are so many calculations and estimates that go into each financial model, each of which can have a significant impact on the accuracy of the final model.
How to build a financial model
Most people use spreadsheet software like Microsoft Excel to build financial models, so having a good understanding of Excel is important, but it's also important to have excellent knowledge of financial terms and reporting before creating a financial model. Follow the steps below to find out how to build a financial model for any company or organisation:
1. Input the business's historical results
The first step when creating any financial model is to input the historical performance data of the business and make assumptions about what this means for the future. Include financial statements for the past three years in your financial model and use these to reverse engineer predictions by calculating gross margins, revenue growth rate and costs. You can then fill in assumptions for the coming years using this data.
2. Start creating an income statement
Once your forecasts are in place, you can start your income statement. This includes revenue, cost of goods sold (COGS), gross profit, operating expenses and other data. Calculate depreciation, interest, taxes and other costs later to finish the income statement. Set up Excel functions to assist you in calculating final figures once you've inputted the data.
3. Fill in the balance sheet
Once you've created the top of the income statement, you can start to fill in the balance sheet. This involves calculating accounts receivable and inventory, which you can do using data from the income statement, including COGS and revenue. The balance sheet also includes data on accounts payable, which you can complete at this stage too.
4. Create supporting schedules
Before you can finish the business's income statement, it's important to build supporting schedules that include data on debt and interest plus any capital assets, such as machinery and equipment the company owns. Pull assets from the data you've logged on the historical period and add capital expenditures while deducting depreciation on the property, plant and equipment (PP&E) schedule. Include debt in the same way, calculating additional interest based on the size and terms of the debt.
5. Complete the income statement and balance sheet
At this stage, you have enough data to complete the income statement and the balance sheet in your financial model. Include both depreciation of assets and interest on debt in your income statement by linking the income statement to the relevant sections of your supporting schedules. Make sure to calculate shareholder's equity too, which you can do by following this formula:
Shareholder's equity = previous year's closing balance + net income + capital raised - dividends and shares repurchased
6. Build a cash flow statement
The next step is to build a cash flow statement using the reconciliation method. This involves adding net income and back depreciation before adjusting for changes in non-cash working capital. This statement tells you more about a company's cash flow or the money that regularly moves in and out of the business.
7. Test and use the financial model
This completes the financial model, but there are extra steps that modellers can take to gain more information about a company's financial situation. A discounted cash flow analysis can offer important information on the value of a company, while a sensitivity analysis can help modellers to understand how accurate their model may be. Stress testing and auditing against extreme scenarios is another way to test a financial model's accuracy and reliability.
What is a financial model used for?
Financial models are important because they tell stakeholders important information about the value and performance of a company. A company's financial model is useful to professionals both within and outside of a company who may want to know more about that company's performance. Executives use financial models to make decisions relating to:
raising capital and funds
budgeting and forecasting
selling or divesting assets
valuing a business
growing a business
What are the benefits of building a financial model?
Building a financial model is necessary for businesses that want to gain a better understanding of the financial health of their organisation or share this information with third parties and stakeholders. Some of the key benefits of building a financial model are:
It helps you understand a business in more depth: A financial model is the best way to understand a business's finances and how they might change in the future. Some businesses might look financially healthy at first, but a financial model can reveal a downward trajectory.
It can help you identify where to add funds: Financial models can help business professionals to identify which aspects of a business need more funding. For example, cash flow statements can help managers to understand how much cash a business has available and make informed decisions about how to allocate it.
Tips on building a financial model
If you're planning to build a financial model, it's important to follow financial modelling best practices to ensure your model is accurate and your methods are efficient. Follow the tips below to help you build an effective financial model:
Learn how to use spreadsheet software efficiently
An important aspect of building a financial model is knowing how to use spreadsheet software, like Microsoft Excel, properly. Taking a course in Microsoft Excel, which teaches you how to use Excel shortcuts and functions, can help you with this. Create a financial model much more quickly by using keyboard shortcuts and employing expert Excel skills, such as using "INDEX" and "MATCH" functions instead of "VLOOKUP" to query data. Excel shortcuts can help you both improve the quality of your financial model and complete it more efficiently.
Proofread all your numbers
If you proofread all the figures you input into your financial model as you create it, it can save you a lot of time and stress in the future. If there are mistakes in your model but you don't know where they are, pinpointing these mistakes later could mean re-checking your entire model from the start. Always proofread each figure you enter before you move on to the next one to minimise mistakes and speed up the modelling process.
Consider the design and layout of your model
It's important to format your financial model properly and clearly, so it's easy to access the data your model displays. This means clearly distinguishing between inputs, which are 'known' data, and outputs, which are 'assumed' data. Many people choose to do this by inputting inputs in blue and formulas in black. It's also important to structure your financial model in an easy-to-follow order, usually starting with assumptions and an income statement and finishing with graphs and analysis.
Please note that none of the companies mentioned in this article are affiliated with Indeed.
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