Making business plans is fraught with uncertainty. Developing strategic plans is the secret weapon for these unpredictable times. This is when financial simulations come into play. Strategic Financial models can not make the future more foreseeable, but they can assist you in deciding between several possibilities and preparing organizations to handle unexpected plot twists as they execute their plans.
What Is Strategic Financial Modeling and How Does It Work?
Financial modeling is the process of constructing a spreadsheet that contains a breakdown of a company’s expenses and earnings and may be used to analyze the effects of a future event or decision. It is most commonly used by financial analysts to examine and foresee how future occurrences/executive choices will affect an organization’s stock performance.
Strategic Financial Modeling – What Is It?
A financial model is a technique that estimates a corporation’s economic performance in the future and is integrated into spreadsheet software such as Microsoft Excel. The prediction is usually based on the company’s past performance and future expectations, and it necessitates the preparation of financial statements, balance sheets, cash flows, and supporting schedules.
More advanced models, like discounted cash flow analysis, leveraged buyout, mergers and acquisitions, and sensitivity analysis, can be created from there.The act of creating a national framework that shows where a company’s financial status will be at some point in the future is known as strategic financial modeling.
It is based on data acquired from financial accounts and market research in the actual world. A financial model, when done correctly, evaluates all aspects of a company’s financial performance and creates three statement models: income, balances, and cash flow. It accounts for changes in company activities using explicit, logical, and justifiable assumptions.
What Is The Purpose Of Strategic Financial Modeling?
Whether inside or outside the organization, the result of a financial model can be used for decision-making and financial analysis. Executives inside a company will use financial models to make choices about:
- Capitalization (debt and/or equity)
- Buying and selling enterprises and/or assets
- Organically growing the business
- Assets & business units are being sold or divested.
- Planning and budgeting
- Capital allocation
- Business valuation
- Management accounting
- Financial report analysis/ratio analysis
Financial Model Types
Financial models of many forms are used to help a company’s financial decision-making.
Model of Three Statements
This finance model determines a company’s financial performance using three basic statements. They are as follows:
- Profit and Loss Statement
- The Balance Sheet
- Statement of cash flows
Financial firms frequently utilize these financial models to assess the previous financial performances of their business borrowers.
Ratio Analysis or Comparable Company Analysis (CCA)
The CCA model is used to identify where a company stands in contrast to its competitors. An analyst uses this technique to identify a set of comparable organizations depending on their accounting and business profiles. This profile is studied by comparing the company’s size, top and bottom lines, and other characteristics. Financial statistics such as the PE Multiple, EV/EBITDA, and P/B ratios are employed in the comparison section of this model.
Model of Credit Rating
The Credit Rating Model concept is taken from the Three Statement Model and is intended to forecast data for three to five years. Many other characteristics are incorporated into this financial model, such as strength and quality assurance, collateral quality, future demand development, and the behavior of existing loan accounts.
Discounted Cash Flow Model
The DCF model comprises financial analysis related to future cash flow estimates and judgments. It is used to determine the worth or value of an organization. These financial models are commonly used by investors to determine the true value of a startup before investing funds in it.
Leveraged Buyout (LBO) Model
In terms of value analysis methods, this is identical to the DFC model. What distinguishes the two is that even the LBO approach considers loan funding while developing the financial model. When an acquirer business utilizes a significant level of debt financing to pay for the cost of acquisition, the LBO model is often used.
Here is a comprehensive guide to Financial Planning and Analysis
To Create a Financial Model, Who Should You Turn To?
A financial model is a tool that your company can use to help with strategic planning. The person who creates your financial model should be well-versed in accounting concepts and analysis of financial statements, as well as familiar with your sector. Building financial models are done by a variety of specialists. Investment banking, stock research, corporate strategy, FP&A, and accounting are the most popular job paths.
Strategic Financial Modeling Fundamentals
Financial modeling is a numerical representation of a business’s operations in the previous, present, and predicted future. Models like these are meant to use as decision-making aids. They can also be used by organization leaders to estimate the expenses and profitability of a particular project.
They are used by financial analysts to explain or predict the influence of occurrences on a company’s stock, ranging from internal elements such as a change in plan or biz model to outside factors such as changes in economic policy or legislation. Financial methods are used to calculate a company’s value or to compare companies to their industry peers.
They’re also utilized in strategy development to run simulations, assess the costs of new initiatives, set budgets, and allocate company resources. Discounted cash flow analysis, in-depth evaluation, and sensitivity analysis are examples of financial models.
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What is the Most Effective Way to Learn Strategic Financial Modeling?
Practice is the most essential technique to learn strategic financial modeling. To become an expert at constructing a strategic financial model, you’ll need experience and a lot of practice in strategic financial modeling. Reading equity study papers can be a good approach to practice because you can match your results to theirs.
Using a mature company’s past financials to develop a flat-line model for the future and estimate the value of the present value per share is one of the greatest ways to practice. This should be comparable to the present share price or equities research report target pricing.
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What are the Best Practices for Strategic Financial Modeling?
Excel Tips and Techniques
When creating a model in Excel, it’s critical to follow best practices.
- Use your mouse as little as possible or don’t use it at all. Use keyboard shortcuts wherever possible.
- Keep hard codes and inputs in blue font (formulas can stay black) • Keep formulas basic and break complex calculations down into parts • Keep in mind how to use the most essential Excel excel functions
- To query data, use INDEX and MATCH rather than VLOOKUP. • To create scenarios, use the CHOOSE function.
Arrangement
In a financial model, it’s important to recognize between inputs (assumptions) and outputs (calculations). Formatting standards, such as rendering inputs blue and equations black, are commonly used to accomplish this. Other conventions, such as coloring cells or using borders, can also be used.
Design and Arrangement of the Model
It’s vital to lay out a financial model clearly and straightforwardly. This usually means creating the whole model on a single worksheet and then grouping/chunking it into pieces.
From Top to Bottom, the Following Sections Should Be Included in a Financial Model:
- Drivers and assumptions
- Profit and loss statement
- Balance sheet
- Statement of Cash Flow
- Timetables to back up
- Valuation
- Analysis of sensitivity
- Graphs and charts
Guide to Strategic Financial Modeling – 10 Step Instructions
The process of financial modeling is iterative. You have to work on different portions before you can finally tie everything together. Here’s a step-by-step guide to help you figure out where to start and how to connect all the dots.
1. Preliminary Findings and Assumptions
Every financial model begins with an organization’s past/previous performances. You start by extracting three years of economic statements and entering them into Excel to create the financial model. Then you calculate things like sales growth rate, gross margins, indirect costs, fixed costs, AP dates, inventory days, and AP days, among other things, to reverse engineer the estimates for the historical period. From there, you can use hard codes to fill in the forecast period’s hypotheses.
2. Begin Your Income Statement
With the forecasting parameters in place, you can compute sales, COGS, gross margin, and operating expenses down to EBITDA at the top of the income statement. Calculating depreciation, amortization, interest, and taxes can be done later.
3. Begin Your Balance Sheet
You can begin filling up the balance sheet now that the top of the financial statements is complete. Begin by computing the revenue and COGS functions of receivables, as well as the AR days & inventory days’ assumptions. Fill in the accounts payable section, which is based on COGS & AP days.
4. Create the Supplementary Schedules
You must first develop a schedule for capital assets such as Real estate, Plant & Equipment, as well as debt and interest before you can finish the balance sheet and income statement. The PP&E schedule will add capital spending and deduct depreciation from the historical period. The debt schedule would also use data from the past to add debt rises and deduct repayments. The overall debt balance will be used to calculate interest.
5. Make a Profit and Loss Statement and a Balance Sheet
The income statement and balance sheet are completed with the data from the supporting schedules. Connect depreciation to the PP&E calendar and interest to the debt calendar on the income statement. You can then figure out your profits before taxes, taxes, & net income.
Connect the ending PP&E balance to the closing debit balance from the calendars on the balance sheet. Pulling forward last year’s ending balance, trying to add net income and capital raised, and deducting dividends or shares repurchased completes shareholder’s equity.
Also Read: Finance and Quantitative Modeling for Analysis
6. Create a Cash Flow Statement
After you’ve completed the balance sheet and income statement, you can use the reconciliation procedure to create the cash flow statement. To calculate cash from operations, start with net income, subtract depreciation, and account for fluctuations in non-cash working capital. Cash used for investments is a consequence of capital expenditures in the PP&E calendar, while cash used for financing is a result of the assumptions made regarding debt and equity financing.
7. Conduct a Discounted Cash Flow (DCF) Analysis
After you’ve finished the three-statement model, you may compute cash flow and make a business appraisal. At the firm’s cost of capital, the business’s cash flow is depreciated back to today.
8. Include Possibilities and Sensitivity Analysis
After you’ve finished with the DCF analysis & valuation portions, it’s time to add sensitivity analysis & scenarios to the model. The goal of this analysis is to see how many modifications in underlying assumptions will affect the company’s worth (or some other indicator). This is quite important for determining the investment risk or even for business planning (for example, would the company need to seek money if sales volume reduces by (x) percent?).
9. Create Graphs and Charts
The ability to communicate sets apart excellent financial analysts from competent ones. Charts and graphs are the most powerful way to display the findings of a financial model. Because most executives wouldn’t have the time or the patience to investigate the model’s inner workings, charts are far more useful.
10. Run the Model Through a Stress Test and an Audit
Your labor does not end after the model is completed. Then, to see if the model behaves as intended, start stress-testing extreme scenarios. It’s also crucial to use the auditing tools presented in our financial modeling fundamentals course to ensure that the data is valid and that all of the Excel formulas are functioning properly.
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What Happens After A Financial Model Is Created?
While financial modeling can make a buyer feel more confident in your growth plans, it is merely the first step. You’ll want to utilize your economic model to estimate your company’s current and forecast value to see if it fits your objectives. The next step is to identify areas in your firm where you can enhance or invest, and then create a strategic strategy to make it all happen.
Buyers want to know how exactly you came to meeting previous projections, what course of action you took while you diverged or exceeded projections, which representatives of the leadership team were central to the process, and how they would take your business to the next level, so keep track of everything that ends up going into this process.
Strategic planning efforts can be developed and improved using a financial model. It covers five topics: determining whether your company’s value is just where you would like it to be, revamping projected against actual results, identifying opportunities for better achievement, continuing to develop strategies to accomplish results, and aligning your current organizational structure with your business goals.
Why Should You Update Strategic Financial Models Regularly?
As time passes and situations change, it’s a foregone fact that your financial model will vary from what occurs. That’s why it’s so important to keep your financial models as well as overall strategy plan up to date. Any variations from the models must be taken into account, and corrective action must be done.
Commonly Asked Questions
Q1. What is the purpose of strategic financial modeling?
Financial models are used to predict a company’s value or to compare companies to their industry peers. They’re also utilized in strategic planning to run simulations, assess the costs of new initiatives, set budgets, and allocate company resources.
Q2. Is financial modeling challenging?
The nature of linkages between many financial variables, which eventually end in the financial accounts, is difficult to comprehend. Financial modeling, on the other hand, is regarded as one of the most difficult assignments in the financial world.
Q3. What exactly is a three-statement model?
A three-statement model combines the income, balance, and cash flow statements into a single fluidly integrated financial model. More enhanced accounting models, such as discounted cash flow models, are constructed on the foundation of 3 statement models.
Q4. What is Excel strategic financial modeling?
Financial modeling in Excel is a set of tools for creating expected financial statements that forecast a corporation’s economic performance in the future based on assumptions and previous data. Excel can be used by traders to do technical calculations and generate basic accounting ratios. Companies can use Excel to perform capital budgeting, risk analysis, and cash flow discounting. Excel is frequently used by options traders to perform Black-Scholes pricing.
Summary – Key Takeaways
- Financial modeling is the numerical representation of certain or all elements of a business’s activities.
- strategic modeling is used to estimate a company’s value or to compare companies to their industry peers.
- There are a variety of models that can create varied outcomes. The input and hypotheses that go into a model are only as effective as the model itself.
The act of creating a national framework that shows where a company’s financial status will be at some point in the future is known as strategic financial modeling. It is based on data acquired from financial accounts and market research in the actual world. A financial model, when done correctly, evaluates all aspects of a company’s financial performance and creates three statement models: income, balances, and cash flow. It accounts for changes in company activities using explicit, logical, and justifiable assumptions.
