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Introduction to Financial Modeling Basics

A financial model represents the financial performance of a company. It represents the financial performance for both the past and future.

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Let’s go through this financial modeling basics tutorial and try to stop to take these vague decisions and unnecessarily increasing our risk. Let’s learn financial modeling basics and think and make a decision in a more structured way. To get in-depth knowledge of preparing a financial model through a video tutorial, please go through Financial Modeling Training.

What are the Financial Modeling basics? Historical and Assumption

Historical input data should always be taken from the right source. While making financial modeling basics assumptions for the forecasted year, historical data is one of the input criteria that must be considered.

The assumption is referred to as “drivers.”

The other criteria which one should consider while making an assumption are

No bias should get into the assumptions of the business

Clearly, understand the expected changes in future performance

Understand Management expectations

Check out what other financial modeling analysts think about the company

Color Coding

Color coding is one of the essential formatting factors in financial Modeling basic. This is done so that a person who has never seen your model can quickly know whether a particular financial data is historical input data, calculations, or linkages.

Financial Modeling Basics, One Formatting Tip Preparation of Financial Modeling Basics

To prepare a financial model, the first thing is to understand the company on which the person is preparing the model. The person should also have a thorough knowledge of the industry and its competitors to which his company belongs.

To analyze a company, one should not only check the company’s annual report but also read the transcript, conference calls, and presentations published by the company.

Compilation of Historical

One should compile the past five years of historical data while preparing a financial model.

While compiling, please keep specific points in mind:-

You are an “Analyst,” not an “Auditor.” So if the historical data available in the company’s annual report does not compile, don’t panic and sit to tally the financials. Just take the financials as they are.

It would be best to refer to the latest annual report for the historical data. In other words, if your historical year starts from 2008 till 2012 and you are compiling the data for the year 2011, then you need to pick up the figures from the 2011- 2012 annual report, which is the latest one and not from 2010-2011 as the new annual report contains the revised figures.

A financial model should always contain key financial terms like gross profit, EBITDA, EBIT, net profit, etc. If you cannot find these terms in the annual report, you need to prepare your financial model and record the items accordingly.

This is how the format of an income statement should appear

Financial Modeling Basics, BASE Equation

Certain items need to be added and subtracted to calculate the ending balance for this financial year.

Let’s understand this base equation in detail.

For Fixed Asset

To find out the ending fixed asset, we need to have an opening fixed asset, capital expenditure, Depreciation, and the sale of the asset. Let’s understand what amount needs to be added or subtracted to find the ending fixed asset.

Equation

Items

Description

B (Beginning) Beginning fixed asset This is the fixed asset that is carried forward from last year

A (Addition) Capital expenditure This is the extra asset you bought this financial year

S (Subtraction) Depreciation/ sale of the asset Depreciation is an expense you must deduct Since the assets are sold in this financial year, that amount must be deducted.

E (Ending) Ending fixed asset This fixed asset amount is generated after adding and subtracting all the necessary items in this financial year and will be carried forward in the next year.

Shareholders equity

Similarly,

Equation

Items

B (Beginning) Beginning shareholders fund

A (Addition) Net income / Issuance of equity

S (Subtraction) Repurchase of equity / Dividend paid

E (Ending) Ending equity balance

For long-term Debt

Equation

Items

B (Beginning) Beginning long-term Debt

A (Addition) Issuance of debt

S (Subtraction) Repayment of Debt

E (Ending) Ending debt balance

Income statement

An income statement is a financial statement that measures the company’s financial performance over a specific accounting period. It summarizes how the business incurs its revenues and expenses through operating and non-operating activities.

Let’s see how we can project the income statement

Net sales Calculation Calculation of Direct cost and selling and admin cost

One can calculate the direct cost, selling, and admin cost as a percentage of sales. Calculate the historical, then take up an average and find the forecasted figures.

Depreciation

It can be calculated as a percentage of fixed assets.

Interest expense

It can calculate by multiplying the interest expense rate and the average closing debt balance.

Income tax

One can calculate the tax rate using historical and the same rate in the future.

Profit

This is calculated by deducting expenses from the revenue

Balance sheet Fixed asset, long-term debt, shareholder’s fund

These items must be calculated using the Base equation and linked to the balance sheet.

Goodwill

Goodwill is not amortized, so it must be kept constant in the future.

Cash

The cash item must be linked to the ending cash balance from the cash flow statement.

Current assets and current liabilities

These items need to be calculated in the working capital schedule. Now let’s understand the working capital schedule in detail.

Working capital schedule

Accounts receivable

Calculate the accounts receivable in days for the historical using the ratio 365*Average debtor divided by net sales. The past historical data assumes the number of days for the forecasted years.

Inventory

Calculate the inventory in days for the historical using the ratio 365*Average inventory divided by net COGS. The past historical data assumes the number of days for the forecasted years.

Current liabilities

Accounts payable

Calculate the accounts receivable in days for the historical using the ratio 365*Average payable divided by net purchases. The past historical data assumes the number of days for the forecasted years.

Other current liability

One can calculate the other current liability for the historical as a percentage of the COGS, and then you can take an average and assume for the future.

After completing this working capital schedule, link it to the balance sheet.

Cash Flow Statement

Cash flow statements assess the amount, timing, and predictability of cash inflows and outflows and are used as the basis for budgeting and business planning.

It answers the questions:

Where the money came (will it come) from?

Where it went (will it go)?

The accounting data is usually presented in three main sections:

Operating activities ( sales of goods or services),

Investing activities (sale or purchase of an asset, for example), and

Financing activities (borrowings or sale of common stock, for example).

Whatever changes you have incurred in the amount of the item in the income statement or the balance sheet in the financial year will be recorded in the cash flow statement according to that item’s cash inflows and outflows.