5 min read · May 22, 2019
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In a nutshell, financial modeling is a numerical scenario of a real world financial situation used to ascertain the future financial performance by making projections. The objective is to combine accounting, finance and business metrics to create a representation of a business, forecasted into the future.
Financial models are essential decision making tools. It allows the decision makers to test out scenarios, observe outcomes and help make important decisions.
A good financial model should be well-structured with a solid layout. It should be simple, accurate and easy to follow with all the drivers and assumptions clearly laid out.
Start by asking yourself- Why are you building a financial model? If you’re looking to fundraise and are building it for potential investors focus on highlighting the profitability of the business to convince them that you are worth their time, effort and money.
You can start by thoroughly grasping the factors that drive your business and quantifying them- gather data about the market size, growth of the said market, competition, preferences of customers, etc
Proceed to collect historical financial information, calculate the various ratios/metrics relevant to the business such as margins, growth rates, etc, study the environment and competition and make logical assumptions about the future.You can do so following either of the two approaches:
1) Top-Down Approach: You can start by estimating your total addressable market, and based on the market share and various other segments like product, geography, customers etc, work to calculate your projected revenue.
2) Bottom-Down Approach: Focus on the most basic factors that drive your business and work your way up to make sound assumptions about the projected revenues.
The essence of a good financial model lies in its assumptions about the future performance of the business. You can broadly segregate these assumptions into Revenue, Cost assumptions and Balance Sheet assumptions.
Revenue assumptions are basically the expectations for the business’ sales growth, Cost assumptions will include projections of various operating expenses — salaries, office rent, legal costs related to company registration, and others essential to sustain the business. and Balance Sheet Assumptions address debtor days, creditor days, etc which gives an idea of the working capital cycle.
Once you’re through with making assumptions move on to the three financial statements — Income statement,Balance Sheet & Cash-flow Statement.
Income Statement- Income statement essentially conveys details about the profitability of the business, efficiency of the management, if the company is performing at par with its peers, etc. The income statement primarily focuses on –revenues and expenses. It keeps an account of how net revenue transforms or will transform into net earnings in the future.
Balance sheet: The balance sheet is a snapshot of a company’s financial health. It reports a company’s assets, liabilities and shareholder’s equity at a moment in time. The balance sheet is broadly divided into two sections. the company’s assets and the company’s liabilities and shareholder’s equity. The general subsections under the assets side are — Current assets (Cash and cash equivalents, account receivables and inventory) and Non-Current Assets (Plant, property and Equipment and intangible assets) and under Liabilities are — Current Liabilities (Accounts Payable, current debt, current portion of long term debt), Non-current Liabilities and Shareholder’s Equity
The balance sheet talks about the company’s liquidity, leverage, efficiency and rate of return through various ratios and metrics
Cash-flow statements: Cash flow statements depict the financial health of the company. It summarizes the amount of cash and cash equivalents entering and leaving the company. The main components of the cash flow statement are: Cash from operating activities, Cash from investing activities, Cash from financing activities. It is essential for assessing company’s liquidity, flexibility and overall financial performance
How The Three Financial Statements Are Linked Together?
● Net income from the income statement links to the balance sheet and cash flow statement
● Depreciation is calculated using the PP&E in the balance sheet, subtracted in the Income Statement and added back in the Cashflow from operating activities. Capex is deducted in the Cashflow from investing activities and the same amount is added in the PP&E of the balance sheet.
● Debt/Loans in the balance sheet is used to calculate interest expenses for the income statement.
● Cash flow from operations is calculated using changes in the working capital which comes from the balance sheet.
● The sum of the last period’s closing cash plus this periods cash from operations, investing, and financing is the closing cash balance on the balance sheet
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