Financial Modeling Process

The financial modeling process is a step-by-step approach that starts with populating the historical financial data in an excel sheet, performing financial analysis, making assumptions and forecasting, and finally assessing risk by performing sensitivity analysis and stress testing.

Keeping the expenses and earnings properly arranged in the spreadsheet helps firms and their professional get a clear picture of the cash going out and moving in the business. As a result, making a decision and tracking the effect of that decision on the business become much easier.

• The financial modeling process follows a systematic approach, commencing with inputting historical financial data into an Excel sheet. Subsequently, it involves economic analysis, assumption formulation, and forecasting and concludes with sensitivity analysis and stress testing to assess risk.
• The process entails seven sequential steps: entering historical financial data, assessing past performance, gathering assumptions for future forecasts, evaluating potential risks to the organization, conducting sensitivity analysis, and finally, stress testing the predictions.
• It's crucial to recognize that assumptions significantly impact predictions. Analysts should delve into the patterns and underlying causes after identifying them to comprehend better the dynamics influencing the outcomes.

The financial modeling process helps keeping the businesses’ earnings and expenses figures clearly readable. Based on the same, the financial performance is assessed, and companies can predict the stock value and its performance in accordance with the same.

The spreadsheet not only allows the executives keep track of the inflow and outflows but also serves to be the informative data leading to decision-making. The implementations of today can be assessed, depending on various parameters, in future for results. If the strategies adopted by the businesses seem to work, they continue with the same. Else, they get an idea that they need to change strategies to improve figures.

In addition, these figures help in the valuation of the firms and also allow them to have a clear comparison with the competitors in the market. However, to make this modeling process effective, it is important to follow few steps in a proper sequence.

The financial modeling process involves the following steps to ensure effectiveness. Let us look into these steps in details below:

1. The entry of Historical Financial Data
2. Analysis of Historical Performance
3. Gathering of Assumptions for Forecasting
4. Forecast the Three Statement Model
5. Future Business Risk Assessment
6. Performance of Sensitivity Analysis
7. Stress Testing of the Forecast

#1 - Entry of Historical Financial Data

Any financial model starts with the entry of historical financial statements. The analyst then inputs the historical information into an excel spreadsheet, which marks the start of financial modeling. Generally, analysts prefer the latest 3 to 5 years of historical data as it provides a fair bit of insight into the company's business trend in the recent past. The analyst should be cautious while capturing the historical data from the three financial statements and the corresponding schedules. Any mistake in this step can potentially deteriorate the quality of the end model.

#2 - Analysis of Historical Performance

In this step, the analyst must apply all their knowledge of accounting and finance. Each line item of the historical income statement, balance sheet and cash flow statement should be analyzed to draw meaningful insights and identify trends. For instance, growing revenue, declining profitability, deteriorating capital structure etc.

It is important to note that this analysis will strongly influence the assumptions for forecasting. Once the trend has been identified, the analyst should try and understand the underlying factors driving the trend. For instance, the revenue has been growing due to volume growth; the profitability has been declining in the last three years owing to a surge in raw material prices; capital structure has deteriorated on the back of debt-laden capex plan etc.

#3 - Gathering of Assumptions for Forecasting

Next, the analyst has to build the assumptions for the forecast. The first method to draw assumptions is using the available historical information and their trends to project future performance. For instance, forecast the revenue growth as an average of the historical revenue growth in the last three years, project the gross margin as an average of the historical period, etc. This method is useful in the case of stable companies.

On the other hand, some analysts prefer to use forecast assumptions based on the current market scenario. This approach is more relevant in the case of companies operating in a cyclical industry, or the entity has a limited track record. Nevertheless, the assumptions for some of the line items in the balance sheet, such as debt and CAPEX, should be drawn from the guidance provided by the company to build a reliable model.

#4 - Forecast the Financial Statements using the Assumptions

Once the assumption is decided, it is time to build the future income statement and balance sheet based on the assumptions. After that, the cash flow statement is linked to the income statement and balance sheet to capture the cash movement in the forecasted period. At the end of this step, there are two basic checks –

• The value of the total asset should match with the summation of total liabilities and shareholder’s equity
• The cash balance at the end of the cash flow statement should be equal to the cash balance in the balance sheet

#5 - Future Business Risk Assessment

Next, the analyst should create a summary of the output of the final financial model. The output is usually customized as per the requirement of the end-user. Nevertheless, the analyst must provide their opinion on how the business is expected to behave in the upcoming years based on the financial model. For instance, the analyst can comment that the company will be able to grow sustainably and service its debt obligations without any real risks in the near to medium term.

#6 - Performance of Sensitivity Analysis

This step aims to determine at what point the performance of the company will start to decline and to what extent. In this step, the analyst must build scenarios into the model to perform sensitivity analysis. In other words, the resilience of the business model will be tested based on scenarios. This step is beneficial as it helps assess variation in performance in case of an unanticipated event.

#7 - Stress Testing of the Forecast

Here the analyst assumes the worst-case (extreme) scenario based on some unfortunate event during a specific period, say a decade. For instance, the recession of 2008-09 is used for stress testing the forecasting models of US-based companies. This step is also crucial as it helps understand how a company will behave in such an extreme scenario and whether it can sustain itself.

Let us consider the following instance to understand the concept better:

Company A, given its consistent growth from a start-up to a full-fledged business in a couple of years, decides to track its sales growth and also compare itself with its own performance every year. Hence, it decides to follow a financial modeling process.

To achieve this, it lists down how to segregate the cells in the spreadsheet. It dedicates cell A to record the sales figures of the previous year, cell B for the sales figures of the current year, and cell C to find the average sales with respect to the sales figures A and B.

For cell C to work, the company professionals incorporate a formula – (A-B)/A. Hence, for every value of cell C, the spreadsheet carries out the respective average calculation. When the entries were made, company A observed an increase in its figures and hence it decided to go public given the progress it has been making over the past few years. This format becomes a standard one for the company and is likely to help it record the figures every year, enabling them to study the drop or rise in the sales figures.

Following this financial modeling process step-by-step and then preparing a spreadsheet is, of course, a time consuming affair, but once the standard format is prepared, entering, organizing, and managing data becomes easier. However, there are financial modeling templates available to save one’s time. It offers an in-built format to store, and use data from.

No matter which format one uses, manual or system-built, the organized data is of great importance. Let us have a quick look at some of them below:

• It helps give a clear picture of expenses and earnings a business has.
• Knowing the difference helps businesses assess the real position of the business. In turn, the firms also know how the stock performance would be.
• The figures become a ready reference for investors, who many have a look at it to decide whether making investments in the assets would be fruitful.
• The businesses, through this spreadsheet or template information, get to know how effective the strategies implemented for business growth have been. If they are found working well, the firms continue with the same. Else, they modify the strategies for better results.
• As the businesses learn about the expenses, they may make smart asset allocation and cost management decisions, accordingly.

This has been a guide to what is Financial Modeling Process. Here, we explain the concept along with the process steps, example, and importance. You can learn more about it from the following articles –

• Financial Modeling Software
• Financial Modeling Benefits
• Financial Modeling Interview Q&A
• Financial Forecasting