Financial modelling is a critical skill for MBA students, particularly those who aspire to work in finance, investment, strategic planning, or any role that involves making informed business decisions. This article provides an overview of financial modelling, the skills required, areas of focus, relevant tools and technologies, and potential use cases.
Understanding Financial Modelling
A financial model is considered to be a spreadsheet forecast model of a company. Financial modelling is the process of creating a representation of a company's financial situation. It involves using mathematical models to predict the financial performance of a business based on a set of variables. Financial models are used for decision-making, financial analysis, business valuation, scenario planning, strategic planning, capital budgeting, and more.
Characteristics of a financial model
A model needs to be developed with the following attributes:
Financial Modelling as a discipline
Financial Modeling is a unique professional discipline. A financial model needs to serve as a powerful communication tool to clearly and effectively tell the story of a company to management and stakeholders. A financial model is a critical decision-making tool that allows users to make accurate and informed financial decisions about a company. A builder of financial models requires skills in accounting, finance, spreadsheets and overall business knowledge in order to effectively forecast a company’s financial statements into the future
Scenario Analysis
Flexibility in models is critical, as stakeholders typically like to know what the impacts of changing key drivers would do to the overall business under various scenarios (ie. Base Case, Best Case, Worst Case…). Key drivers are assumptions that are difficult to forecast, hard to control, and they materially affect the business. These can include:
An effective model should be able to switch between different operating cases, or scenarios, and these assumptions should dynamically flow through the model and ultimately through to the financial statements
Financial Statements
It is crucial for model builders to have a solid grasp of accounting fundamentals in order to understand the linkages between the various numbers on the financial statements. A financial model of a company will typically contain the following financial statements
A financial model of a company may also include other statements:
It is critical to understand the framework of each statement and connectivity to other sheets within the workbook. For a financial model of a company, the model should also include a number of schedules to calculate the values that will be required on the financial statements. The most common schedules to include in a model are:
Jobs that require financial modelling knowledge
Financial modelling is undeniably one of the most valuable and sought-after skills in the finance sector. It plays a pivotal role in a wide array of financial scenarios, such as evaluating a company for investment, advising on capital raising, assessing operational enhancements, and understanding a company's performance. This skill is crucial in making informed business decisions, and there are numerous careers that demand strong financial modelling knowledge and technical skills. Here are some of the key sectors where financial modelling is indispensable:
Accounting
Accounting and finance are closely intertwined, and there's a significant overlap in the skills required. A strong understanding of financial statements, their interrelationships, financial ratios, and key financial metrics is crucial in this field.
Corporate/Commercial Banking/Private Debt
Roles in corporate/commercial banking and private debt involve providing loans to projects and companies. Analysts and associates in this field need to create forecasts for the company to understand potential future cash flows. A robust understanding of financial modelling is vital in this space.
Corporate Development
Corporate development teams assist companies in acquiring other businesses for strategic reasons, such as expanding market share, achieving growth in a new market or product, or obtaining cost synergies through vertical supply chain integration. While strategic aspects are important, understanding the financial implications of the acquisition is equally crucial.
Equity Research (Sell-Side)
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Equity research groups are responsible for analyzing a specific sector in the stock market, typically covering 8-20 stocks within a given sector. They write equity research reports providing an opinion to public investors on the fair price of a stock, backed by projection models and sometimes DCF analysis.
Financial Planning and Analysis (FP&A)
FP&A roles involve planning, forecasting, budgeting, and analyzing a company's financials. Three-statement financial modelling skills are important and necessary for FP&A professionals to perform their analysis effectively.
Hedge Funds
Hedge funds manage pools of money on behalf of investors and buy or sell short marketable securities such as stocks. To understand the quantitative side of a company’s performance, analysts typically build forecast models including a DCF.
Investment Banking
Investment bankers advise companies on capital-raising, such as initial public offerings (IPOs), and mergers & acquisitions (M&A). During this advisory process, financial models are built to help value the companies, assess credit quality, and understand the impact of M&A.
Private Equity
In private equity, an LBO model is used to assess the equity investor returns of a potential deal (often done by analyzing the internal rate of return or IRR). An LBO model analyzes the free cash flow generated by a company to determine how much debt can be paid off during the lifetime of the deal.
Venture Capital
Venture capital funds invest in start-up or earlier stage companies that require financing to grow. To understand what the future revenue, expenses, and cash flow might look like and estimate valuation, Venture Capital investors create projection and DCF models.
Essential Knowledge and Skills
MBA students aiming to excel in financial modelling should possess the following knowledge and skills:
Areas of Focus
MBA students should focus on the following areas:
Tools and Technology
The most important tool for financial modelling is Microsoft Excel. It's essential to master advanced Excel functions, such as pivot tables, VLOOKUP, HLOOKUP, and macros. Additionally, learning programming languages like Python or R can be beneficial for more complex models. Familiarity with financial software like QuickBooks or statistical modelling tools like SAS, SPSS, MiniTAB etc. can also be advantageous.
Use Cases for Financial Modelling
Financial modelling can be applied to a variety of business problems, such as:
Courses and Certifications
Several courses and certifications can enhance your financial modelling skills:
To sum up: