Jul 14, 2014 7 Key Financial Drivers of Profit and Cash Flow Published on July 14, 2014 July 14, 2014. 17 Likes. 0 Comments. Guide to What is Financial Modeling. Here we discuss uses of financial models, financial modeling examples (DCF, LBO, M&A, SOTP, Comps, Transaction Model), prerequisites to learning financial modeling, how to build a financial model, financial modeling tips, and best practices. How might driver-based forecasting—an approach that bases financial forecasts on operational drivers—support your company's performance management needs? In the following Q&A—based on questions asked by participants during a live webcast on the topic—we discuss driver-based forecasting, the. The image shows the top 10 business drivers for the oil & gas industry for 2015. (See video below) Internal and external business driver. Examples of internal drivers are the staff and different departments within a business. Especially those that contribute to product sales, marketing, production, and development. A concern, which I come across in almost every financial modeling exercise leading to valuation, is how to estimate the revenue drivers of the company I am modeling for. This question is also raised every time I assign a company to my team of analysts and associates for modeling. In every classroom.
Financial Modeling Tutorials
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What is Financial Modeling?
Financial Modeling Definition –
Financial Modeling is an abstract numerical scenario of a real-world financial situation used to ascertain the future financial performance by making projections. The user can manipulate the inputs to maintain the quality of a financial model, which will result in accuracy and dependency one can have on the outputs.
- Financial modeling is either building a model from scratch or work on maintaining the existing model by implementing newly available data to it. As you can notice all the above financial situations are of a complex and volatile nature. A financial model helps the user to gain an in-depth understanding of all the components of the complex scenario.
- In Investment Banking, Financial Modeling is used to forecast potential future financial performance of a company by making relevant assumptions of how the firm or a specific project is expected to perform in the forthcoming years, for instance how much cash flow a project is expected to produce within 5 years from its initiation.
It is easily possible to work on individual different parts of the model without affecting the whole structure and avoiding any huge blunders. It is useful when the inputs are of a volatile nature and are subject to change with newly available data. So there is a certain flexibility one can have with the structure when working on Financial Modeling as long as they are accurate, of course!
Though it sounds complex, it can be learned by steady practice and the appropriate know how.
What is Financial Model used for?
Financial modeling can be done for various situations; for e.g. valuation of a company, valuation of an asset, pricing strategies, restructuring situations (merger & acquisition), etc.
Below are the areas in which Financial modeling is generally used for –
Who builds the Financial Models?
Financial Models are build by the following –
- Credit Analysts
- Risk Analysts
- Data Analysts
- Investors
- Management/Entrepreneurs
Majorly financial modeling is used for determining reasonable forecasts, prices for markets/products, asset or enterprise valuation (Discounted Cash Flow Analysis, Relative Valuation), share price of companies, synergies, effects of merger/acquisition on the companies, Leverage Buy-out (LBO), corporate finance models, option pricing, etc.
How can you learn Financial Modeling?
There are various ways in which you can learn financial modeling.
- Learn Financial Modeling in Excel (Basic) – This is a step by step tutorial on Financial Modeling. Here you will learn to prepare a financial model of Colgate.
- Financial Modeling Course (Advanced) – This is an advanced tutorial on Financial Modeling. You will learn sector modeling of Banking, Petrochemical, Real Estate, Capital Goods, Telecommunication and more.
Financial Modeling Examples
There are various financial modeling examples differing in type and complexity as the situation demands. Financial models are widely used for valuation, sensitivity analysis, and comparative analysis. There are other uses of financial modeling as well, like risk prediction, pricing strategy, effects of synergies, etc. Different examples of financial models cater to their own set of specialties, requirements, and users.
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M&A Modeling CourseLBO Modeling CourseValuation Modeling CourseFollowing are some of the Financial Modeling examples that are widely used in the Finance Industry:
Example #1 – Full Blown Three Statement Financial Modeling:
- This type of financial model represents the complete financial scenario of a company and projections. This is the most standard and in-depth form of a financial model.
- As the name suggests the model is a structure of all the three financial statements (Income Statement, Balance Sheet and Cash Flow Statement) of a company interlinked together.
- There are also schedules supporting the data. (Depreciation schedule, debt schedule, working capital calculation schedule, etc.).
- The interconnectivity of this model sets it apart, which allows the user to tweak the inputs wherever and whenever required which then immediately reflects the changes on the entire model.
- This feature helps us to get a thorough understanding of all the components in a model and its effects thereof.
- Important uses of this model are for forecasting and understanding trends with the given set of inputs.
- Historically the model can stretch back as long as the conception of the company and forecasts can stretch up to 2-3 years depending requirement.
Example #2 Discounted Cash Flow (DCF) Model:
Through this financial model template, you will learn Alibaba’s 3 statement forecasts, interlinkages, DCF Model – FCFF Model and Relative Valuation.
- The most widely used method of valuation in the finance industry is the Discounted Cash Flow analysis method which uses the concept of Time Value of Money.
- The concept working behind this method says that the value of the company is the net present value (NPV) of the sum of the future cash flows generated by the company discounted back today.
- The discounting of the projected future cash flows is done by the discounting factor. One rather important mechanic in this method is deriving the ‘discounting factor’. Even the slightest error in the calculation of discounting factor can lead to enormous amounts of change in the results obtained.
- Usually, the Weighted Average Cost of Capital (WACC) of a company is used as the discounting factor to discount the future cash flows.
- DCF helps to identify whether a company’s stock is undervalued or overvalued. This proves to be a rather important decision making factor in case of investment scenarios.
- In simplicity, it helps to determine the attractiveness of an investment opportunity. If the NPV of the sum of future cash flows is greater than its current value then the opportunity is profitable or else it is an unprofitable deal.
- The reliability of a DCF model is strong as it is calculated on the base of Free Cash Flow, thus eliminating all the factors of expenses and only focusing on the freely available cash to the company.
- As DCF involves the projection of future cash flows it is usually suited for working on financials of big organizations, where the growth rates and financials have a steady trend.
Example #3 Leveraged Buyout (LBO) Model:
- In a leveraged buyout deal a company acquires other company by using borrowed money (debt) to meet the acquisition costs. Then the cash flows from the assets and operations of the acquired company are used to pay off the debt and its charges.
- Hence, LBO is termed as a very hostile/aggressive way of acquisition as the target company is not taken under the sanctioning process of the deal.
- Usually cash-rich Private Equity firms are seen to be engaged in LBO’s. They acquire the company with a combination of Debt & Equity (where a majority is of debt, almost above 75%) and sell off after gaining substantial profit after few years (3-5 years)
- So the purpose of an LBO model is to determine the amount of profit that can be generated from such kind of a deal.
- As there are multiple ways a debt can be raised each having specific interest payments, these models have higher levels of complexity.
- Following are steps that goes into making a LBO model;
- Calculation of purchase price based on forward trading multiple on EBITDA
- Weightage of debt and equity funding for acquisition
- Building projected income statement and calculate EBITDA
- Calculation of cumulative FCF during the total tenure of LBO
- Calculating Ending exit values and Returns through IRR.
Example #4 Merger & Acquisition (M&A) model:
- The M&A model helps to figure out the effect of merger or acquisition on the earnings per share of the newly formed company after the completion of the restructuring and how it compares with the existing EPS.
- If the EPS increases altogether then the transaction is said to be “accretive”, and if the EPS decreases than the current EPS the transaction is said to be “dilutive”.
- The complexity of the model varies with the type and size of operations of the companies in question.
- These models are generally used by Investment Banking, corporate financing companies.
- Following are steps that go into making an M&A model;
- Valuing Target & Acquirer as standalone firms
- Valuing Target & Acquirer with synergies
- Working out an Initial offer for the target firm
- Determining combined firms ability to finance transaction
- Adjust cash/debt according to the ability to finance the transaction
- Calculating EPS by combining Net income and figuring out an accretive/dilutive situation.
Example #5 Sum-of-the-parts (SOTP) financial model:
- Valuing of huge conglomerates becomes difficult to value the company as a whole with one single valuation method.
- So, valuation for the different segments is carried out separately by suitable valuation methods for each segment.
- Once all the segments are valued separately, the sum of valuations are added together to get the valuation of the conglomerate as a whole.
- Hence, it is called “Sum-of-the-parts” valuation method.
- Usually, SOTP is suitable in the case of a spin-off, mergers, Equity carve-outs, etc.
Example #6 Comparative Company Analysis model:
- Analysts while working on a comparative valuation analysis of a company looking for other similar companies that are equal in terms of size, operations and basically the peer group companies.
- By looking at the numbers of its peers, we get a ballpark figure of the valuation of the company.
- It works on the assumption that similar companies will have similar EV/EBITDA and other valuation multiples.
- It is the most basic form of valuation done by analysts in their firms.
Example #7 – Comparable Transaction Analysis Model
Transaction multiples Model is a method where we look at the past Merger & Acquisition (M&A) transactions and value a comparable company using precedents. The steps involved are as follows –
- Step 1 – Identify the Transaction
- Step 2 – Identify the right transaction multiples
- Step 3 – Calculate the Transaction Multiple Valuation
Prerequisites to Learning Financial Modeling
Building a Financial model will only be fruitful when it is giving out results which are accurate and dependable. To achieve efficiency in preparing a model, one should have a required set of basic skills. Let’s see what those skills are:
#1 Understanding of Accounting Concepts:
Building a Financial model is a pure financial document which uses financial numbers from a company or market. There are certain accounting rules and concepts that are constant in the financial industry over the world, e.g. US GAAP, IFRS (International Financial Reporting Standards), etc. These rules help in maintaining the consistency of presentation of financial facts and events. Understanding these rules and concepts are of extreme importance to maintain accuracy and quality while preparing to build a financial model in excel.
Our main focus in Accounting is also to identify and predict the accounting malpractices by companies. These are normally hidden away. You can see the confessions in Satyam Fraud Case
#2 Excel Skills:
The basic financial modeling in excel where is where a model is prepared is an application like MS Excel. A Financial Model excel involves a wide range of complex calculations spread over multiple tabs which are interlinked to show their relationships with each other. Having an in-depth working knowledge of excel like formulas, keyboard shortcuts, presentation varieties, VBA Macros, etc. are a must while preparing a financial model excel. Keeping knowledge of these skills gives the analyst an edge in his working skills over others.
#3 Interlinking of Financial Model Statements:
A 3 statement financial modeling needs to be interlinked together. The interlinking allows key numbers in the model to flow from one statement to the other, thus completing the inter-relationship between them and showing us the complete picture of the financial situation of the company. Example of interlinking: 1) Net change in cash (from Cash Flow Statement) must be linked to Cash in Balance Sheet. 2) Net Income from Income statement should be linked to Retained Earnings in Statement of Stock Holder’s Equity.
#4 Forecast financial model:
The skill of forecasting financial modeling is important because usually, the purpose of a financial model excel is to arrive at an understanding of the future scenario of any financial situation. Forecasting is both an art and a science. Using the reasonable assumptions while predicting the numbers will give an analyst a close enough idea of how attractive the investment or company will be in the coming period. Good forecasting skills increase the dependability of a model.
#5 Presentation:
Financial modeling is full of minute details, numbers and complex formulas. A financial model is used by different groups like operational managers, management, clients. These people will not be able to decipher any meaning from the model if the model is looking messy and hard to understand. Hence, keeping the model simple in presentation and at the same time rich in details is of great importance.
How do you build a Financial Model:
Financial Modeling is easy as well as complex. If you look at the Financial Model you will find it complex, however, financial modeling a sum total of smaller and simple modules. The key here is to prepare each smaller modules and interconnect each other to prepare the final financial model.
Examples Of Financial Drivers
You can refer to this step by step guide on Financial Modeling in Excel for detailed learning.
You can see below various Financial Modeling Schedules / Modules –
Please note the following –
- The core modules are the Income Statement, Balance Sheet, and Cash Flows.
- The additional modules are the depreciation schedule, working capital schedule, intangibles schedule, shareholder’s equity schedule, other long-term items schedule, debt schedule etc.
- The additional schedules are linked to the core statements upon their completion
A full-scale financial modeling is a lengthy and complicated process and hence disastrous to go wrong. It is advisable to follow a planned path while working on a financial model in order to maintain accuracy and avoid getting confused and lost in it. Following are the logical steps to follow:
- Quick review of Company Financial Statements: A quick review of the company financial statements (10K, 10Q, Annual reports, etc.) will give the analyst an overview of the company, as in, the industry of the company, segments, history of the company, revenue drivers, capital structure, etc. This helps in planning the structure of financial modeling by setting a guide path, which can be referred to from time to time as we progress.
- Historical Numbers: Once a fair idea is generated about the company and the types of financial models to be prepared it is advisable to start with inputting Historical data. Past Financial Statements of the company can be found on the company website. Data from as long as conception of the company is available. Usually past 3 years data is added to the historical side which is called as actual numbers. Color code the cells, so that historical and formulas can be quickly identified separately.
- Ratios and Growth rates: Once the historical numbers are added the analyst can proceed with calculating the required Financial ratios (Gross Profit Ratio, Net Profit Ratio, etc.) and growth rates (YoY, QoQ, etc.). These ratios help in identifying a trend for high level strategizing and also forecasting.
- Forecasting: Next step after historical and ratios is implementing projections and forecasting. It is usually done for 3 to 5 years. Line items like Revenue are usually projected on Growth rates. Whereas cost items like COGS, R&D, Selling General & Admin exp. Etc. are projected on the base of revenue margin (% of sales). Analyst should be careful while making the assumptions and should consider the trends of market.
- Interlinking of Statements: For the model to reflect the flow from one statement to other, it is imperative that they should be linked together dynamically and accurately. If done correctly the model should balance out all the statements thus giving it a finalized outlook.
Tips for creating a seamless Financial Model:
Following are some tips for creating a seamless and dependable financial model:
- Planning & Outlining: Before you rush into putting the historical numbers and start with your model, always begin with planning the whole project outline. Decide a timeline, the extent of the years of historical numbers, projection years, read about the industry and the company. Do an in-depth run of the recent Annual report or the situation at hand. This helps in giving you a steady head start.
- Quality: As you proceed through the complex process of modeling, do not forget about maintaining quality of the same. At the start it may look an easy task, but once the model gets chunky and complicated it becomes difficult for an analyst to maintain their nerves about it. Be patient and work with confidence. Take breaks if required. There goes a saying that “Trash in-Trash out”. It means if you are putting the wrong data, you will get wrong results.
- Presentation: The amount of efforts you are putting in for financial modeling will only be fruitful when it can be used and understood by others easily. Color coding, font size, sectioning, names of line items, etc. are all included under presentation. These may sound very basic, but combined effects of all these makes an enormous difference in the lookout of the model.
- Assumptions: What we project in financial modeling is only as good as the assumptions we are basing it on. If the assumptions are awry and lacking reasonable base the projections will be useless considering the inaccuracy. Setting assumptions should have a realistic thinking and reasonability in it. It should go with the industry standards and general market scenario. They shouldn’t be too pessimistic or too optimistic.
- Accuracy Checks: As the model flows longer and longer, with multiple sections and parts, it becomes difficult for the analyst to keep a check on the accuracy of the whole. So, it is important to add Accuracy Checks wherever necessary and possible. It helps in keeping the modeling process under constant quality check and avoids huge blunders at the end.
Financial Modeling Best Practices
- Flexibility: Every financial model should be flexible in its scope and adaptable in every situation (as contingency is a natural part of any business or industry). Flexibility of a financial model depends on how easy it is to modify the model whenever and wherever it would be necessary.
- Appropriate: Financial models shouldn’t be cluttered with excessive details. While producing a financial model, the financial modeler always should understand what financial model is, i.e. a good representation of reality.
- Structure: The logical integrity of a financial model is of utter importance. As the author of the model may change, the structure should be rigorous and integrity should be kept at the forefront.
- Transparent: Financial modeling should be such and based on such formulas which can be easily understood by other financial modelers and non-modelers.
Example Financial Statement
COLGATE BALANCE SHEET HISTORICAL DATA
Also, note the color standards popularly used in Financial Modeling –
- Blue – Use this color for any constant that is used in the model.
- Black – Use Black color for any formulas used in the Financial Model
- Green – Green color is used for any cross-references from different sheets.
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Business Financial Statement Example
This has been a guide to What is Financial Modeling. Here we discuss uses of financial models, financial modeling examples (DCF, LBO, M&A, SOTP, Comps, Transaction Model), prerequisites to learning financial modeling, how to build a financial model, financial modeling tips and best practices. You can learn more about Financial Modeling from the following –
What Is a Financial Asset?
A financial asset is a liquid asset that gets its value from a contractual right or ownership claim. Cash, stocks, bonds, mutual funds, and bank deposits are all are examples of financial assets. Unlike land, property, commodities, or other tangible physical assets, financial assets do not necessarily have inherent physical worth or even a physical form. Rather, their value reflects factors of supply and demand in the marketplace in which they trade, as well as the degree of risk they carry.
Financial Asset
Understanding a Financial Asset
Most assets are categorized as either real, financial, or intangible. Real assets are physical assets that draw their value from substances or properties, such as precious metals, land, real estate, and commodities like soybeans, wheat, oil, and iron.
Intangible assets are the valuable property that is not physical in nature. They include patents, trademarks, and intellectual property.
Financial assets are in-between the other two assets. Financial assets may seem intangible—non-physical—with only the stated value on a piece of paper such as a dollar bill or a listing on a computer screen. What that paper or listing represents, though, is a claim of ownership of an entity, like a public company, or contractual rights to payments—say, the interest income from a bond. Financial assets derive their value from a contractual claim on an underlying asset.
This underlying asset may be either real or intangible. Commodities, for example, are the real, underlying assets that are pinned to such financial assets as commodity futures, contracts, or some exchange-traded funds (ETFs). Likewise, real estate is the real asset associated with shares of real estate investment trusts (REITs). REITS are financial assets and are publicly traded entities that own a portfolio of properties.
The Internal Revenue Service (IRS) requires businesses to report financial and real assets together as tangible assets for tax purposes. The grouping of tangible assets is separate from intangible assets.
key takeaways
- A financial asset is a liquid asset that represents—and derives value from—a claim of ownership of an entity or contractual rights to future payments from an entity.
- A financial asset's worth may be based on an underlying tangible or real asset, but market supply and demand influence its value as well.
- Stocks, bonds, cash, CDs, and bank deposits are examples of financial assets.
Common Types of Financial Assets
According to the commonly cited definition from the International Financial Reporting Standards (IFRS), financial assets include:
- Cash
- Equity instruments of an entity—for example a share certificate
- A contractual right to receive a financial asset from another entity—known as a receivable
- The contractual right to exchange financial assets or liabilities with another entity under favorable conditions
- A contract that will settle in an entity's own equity instruments
In addition to stocks and receivables, the above definition comprises financial derivatives, bonds, money market or other account holdings, and equity stakes. Many of these financial assets do not have a set monetary value until they are converted into cash, especially in the case of stocks where their value and price fluctuate.
Aside from cash, the more common types of financial assets that investors encounter are:
- Stocks are financial assets with no set ending or expiration date. An investor buying stocks becomes part owner of a company and shares in its profits and losses. Stocks may be held indefinitely or sold to other investors.
- Bonds are one way that companies or governments finance short-term projects. The bondholder is the lender, and the bonds state how much money is owed, the interest rate being paid, and the bond's maturity date.
- A certificate of deposit (CD) allows an investor to deposit an amount of money at a bank for a specified period with a guaranteed interest rate. A CD pays monthly interest and can typically be held between three months to five years depending on the contract.
Pros and Cons of Highly Liquid Financial Assets
The purest form of financial assets is cash and cash equivalents—checking accounts, savings accounts, and money market accounts. Liquid accounts are easily turned into funds for paying bills and covering financial emergencies or pressing demands.
Other varieties of financial assets might not be as liquid. Liquidity is the ability to change a financial asset into cash quickly. For stocks, it is the ability of an investor to buy or sell holdings from a ready market. Liquid markets are those where there are plenty of buyers and plenty of sellers and no extended lag-time in trying to execute a trade.
In the case of equities like stocks and bonds, an investor has to sell and wait for the settlement date to receive their money—usually two business days. Other financial assets have varying lengths of settlement.
Maintaining funds in liquid financial assets can result in greater preservation of capital. Money in bank checking, savings, and CD accounts are insured against loss of up to $250,000 by the Federal Deposit Insurance Corporation (FDIC)—the National Credit Union Administration (NCUA) for credit union accounts. If for some reason the bank fails, your account has dollar-for-dollar coverage up to $250,000. However, since FDIC covers each financial institution individually, an investor with brokered CDs totaling over $250,000 in one bank faces losses if the bank becomes insolvent.
Liquid assets like checking and savings accounts have a limited return on investment (ROI) capability. ROI is the profit you receive from an asset less the cost of owning that asset. In checking and savings accounts the ROI is minimal. They may provide modest interest income but, unlike equities, they offer little appreciation. Also, CDs and money market accounts restrict withdrawals for months or years. When interest rates fall, callable CDs are often called, and investors end up moving their money to potentially lower-income investments.
Pros
- Liquid financial assets convert into cash easily.
- Some financial assets have the ability to appreciate in value.
- The FDIC and NCUA insure accounts up to $250,000.
Cons
- Highly liquid financial assets have little appreciation
- Illiquid financial assets may be hard to convert to cash.
- The value of a financial asset is only as strong as the underlying entity.
Illiquid Assets Pros and Cons
The opposite of a liquid asset is an illiquid asset. Real estate and fine antiques are examples of illiquid financial assets. These items have value but cannot convert into cash quickly.
Another example of an illiquid financial asset are stocks that do not have a high volume of trading on the markets. Often these are investments like penny stocks or high-yield, speculative investments where there may not be a ready buyer when you are ready to sell.
Keeping too much money tied up in illiquid investments has drawbacks—even in ordinary situations. Doing so may result in an individual using a high-interest credit card to cover bills, increasing debt and negatively affecting retirement and other investment goals.
Real World Example of Financial Assets
Businesses, as well as individuals, hold financial assets. In the case of an investment or asset management company, the financial assets include the money in the portfolios firm handles for clients, called assets under management (AUM). For example, BlackRock Inc. is the largest investment manager in the U.S. and in the world, judging by its $6.5 trillion in AUM (as of March 31, 2019).
In the case of banks, financial assets include the worth of the outstanding loans it has made to customers. Capital One, the 10th largest bank in the U.S., reported $372,537,597 billion in total assets on its first quarter 2019 financial statement; of that, $247,090,748 billion were from real estate-secured, commercial, and industrial loans.