Key Skills Required to Become a Financial Modeller
Introduction: -
Financing Models Are Essential
An analytical finance model is a way to understand and predict an organization’s financial future. This means that a finance model is a structured and organized set of information (for example, in spreadsheet format) that can help forecast an organization’s future financial performance, based on current historical data, expected sales, and assumptions.
Companies use Financial Models to aid their decision processes about possible opportunities and investments (e.g. new product lines; mergers and acquisitions). The Financial Modeller creates a financial model based on the financial statements of the company to create projections and then analyzes multiple scenarios that would occur given each created projection (through the creation of multiple simulations). Example: How much additional revenue will be generated if we increase the production of electric vehicles? What will the operating costs be for such a change? What will the capital necessary to undertake these changes? And lastly, when do we expect our operations to generate any cash as a result of such investment?
In order to be a good Financial Modeller, you require a combination of key skills; technical, analytical, finance and marketing skills as well as communication skills. These specific skills will allow you to build accurate financial models which can assist in determining or influencing your future business actions.
Knowledge and Understanding of Accounting
Understanding accounting is crucial to building accurate financial models because the three main financial statements (the Income Statement, Balance Sheet and Cash Flow Statement) are the most important pieces of information used to build financial models. All three of the financial statements are linked together through the interaction of the various elements of sales/expenses/profits/liabilities/cash flow and all other accounts within a financial statement.
In order for financial models to be built accurately; the basis for the future financial performance of a company's financial position must be established using these three primary financial statements.
Example of How Financial Modelling Works in Practice
For example, if a financial modeller was assessing how to value an Apple Inc. iPhone, they would need to first establish the relationship of influencing sales to profitability, assets, liabilities and cash flows. Also, if the financial modeller is able to develop a financial model predicting an increase in sales, he/she should then determine the financial implications that result from an increase in accounts receivable because of increased sales (and subsequent collections) and the impact of requiring more inventory purchases to support increased sales volume. the increase in sales and increase in the operating cash flow required to fund those items.
Importance of Knowledge and Understanding of Accounting
The knowledge and understanding of accounting notions will assist the financial modeller with:
Ø Interpreting the past financial performance of the company based on historical data
Ø Preserving the integrity of the financial statements being used in the creation of financial models
Ø Eliminating errors in creating financial models
Without a thorough understanding of accounting principles, the financial models created by the financial modeller will ultimately be inaccurate and unreliable.
2. Advanced Microsoft Excel Proficiency
Financial Modelling has been carried out in Microsoft Excel for many years. A financial model requires an excel worksheet to provide the model with flexibility and dynamism — this requires a reasonably proficient user of excel.
Key Excel Functions
Ø VLOOKUP / XLOOKUP
Ø INDEX and MATCH
Ø IF Functions
Ø SUMIFS / COUNTIFS
Ø Pivot Tables
Ø Data Tables
Ø Conditional Formatting
A financial model in a real-world example would be how an investment bank develops a valuation methodology for a company like Amazon — to do this, they work out a forecast of revenue, operating margin, and free cash flow over a period of 5-10 years using a financial model in Microsoft Excel.
Revenue Forecast
Example revenue projection for a hypothetical company:
|
Year |
Revenue ($ Million) |
|
2024 |
500 |
|
2025 |
600 |
|
2026 |
720 |
|
2027 |
860 |
|
2028 |
1020 |
3. Evaluating Financial Statements
Evaluating (analyzing) the finances of a company is done by examining the company's financial statements. Through financial statement analysis, a reader can understand how accurate (successful) or healthy (financially) the finances of the company are.
1. Income Statement
An income statement shows the revenue (money earned by the company) and expenses (money spent by the company) for a given period of time to show if the company has a profit. At times, the income statement’s metric for a company's profits may be classified as gross profit, operating profit, or net profit.
A good example of a company that financial analysts might evaluate the ability of the company to produce profits or how the company has changed in terms of profit is Apple, Inc., which generates most of its revenue from three separate sources: iPhones, services, and other sources.
2. Balance Sheet Overview
The Balance Sheet describes the different asset categories a corporation possesses at a certain point in time in relation to both its liabilities and equity. The Balance Sheet allows a financial analyst to see what the company has vs what the company owes.
A corporation that can be looked at with regard to the types of assets it has as compared to both its liabilities and equity is Reliance Industries Limited because of its Refinery and Telecommunications operations.
3. Kazenski's Cash Flow Statement Analysis Amadi
The Cash Flow Statement shows how cash has flowed into and out of the company divided by the three components of cash flow (operating cash flow, investing cash flow, and financing cash flow).
When analyzing a business like Amazon, analysts generally look for both profitability and how much operating cash flow is generated for future expansion and investment.
Key Financial Ratios Commonly Used in Analysis
Profitability Ratios
The Profitability Ratios indicate the ability of a company to achieve Profit. For example, these Ratios include Net Profit Margin, Return on Equity (ROE), and Return on Assets (ROA).
Liquidity Ratios
The Liquidity Ratios provide an indication of a Company's ability to meet short-term financial obligations. Commonly used Liquidity Ratios include Current Ratio and Quick Ratio.
Leverage Ratios
Leverage Ratios measure a Company's Financial Risk by comparing Debt to Equity Capital. The Debt-to-Equity Ratio is the most commonly used Leverage Ratio.
Efficiency Ratios
The Efficiency Ratios measure how efficiently a company uses its assets to generate revenue. Examples of Efficiency Ratios are Inventory Turnover, Asset Turnover, etc.
4. Valuation Techniques
1. Use Discounted Cash Flow (DCF) Method
The DCF method derives its value through future cash flows. Future cash flows need to be discounted to their present date using a discount rate (WACC).
The reason behind using DCF is because money now is worth more than money in the future, therefore future cash flows will need to be adjusted for their present worth.
Example:
If an analyst were valuing Tesla, they may project cash flow for 10 years based on projected electric vehicle sales and then discount cash flow to come up with the company's present value.
Steps:
Ø Estimate future cash flows
Ø Decide on a Discount Rate (WACC)
Ø Calculate the present value of future cash flows
Ø Estimate Terminal Value
Ø Add all the present values to estimate the value of the company
2. Use Comparable Company Analysis (Trading Comparables)
The comparable company analysis will estimate the value of a company compared to other companies in the same industry. Analysts look for valuation multiples, such as P/E Ratio or EV/EBITDA, to come up with a proper valuation. For example, if an analyst was valuing Netflix, they may compare Netflix to Disney (another streaming company) to estimate an appropriate valuation multiple.
If industries with similar businesses sell for 20x earnings as examples, then the company in question will likely worth something similar.
3. Comparing Prior Transactions Method
Using this method of comparison is best done looking at companies that have been sold or merged in the past and then analyzing how much was paid for those select sample companies and valuing accordingly.
As an example of comparing something like e-commerce companies being sold, one could study the sale of Flipkart to Walmart to understand how this transaction was valued for both entities involved.
Since acquisitions frequently have some type of control premium associated with them, this analysis will typically produce higher values than other methods mentioned above.
4. Asset-Based Value Method
The method of asset valuation is a means of determining a company's value based on its net value of its assets minus liabilities.
Example of company value:
Company Value = Total Assets - Total Liabilities
This valuation method tends to work best for asset-heavy industries like manufacturing or real estate types of businesses.
For example, when analyzing Tata Motors, one would consider the value of their manufacturing plants, factory equipment, and other tangible assets.
5. Market Capitalization Method
The market capitalization method provides a simple valuation approach used with publicly traded companies.
Market Capitalization = Price/share x Total number of shares
So given that Apple has a share price of $180/share with 15 billion total shares outstanding, then their market capitalization is roughly $2.7 Trillion.
This method represents how the market currently views the company’s worth.
5. Forecasting and Assumption Building
Forecasting is one of the most important skills in financial modelling.
Financial modellers predict future business performance using assumptions such as:
Ø Revenue growth rate
Ø Cost structure
Ø Inflation rate
Ø Capital expenditure
Ø Working capital changes
Real-Life Example
When forecasting future sales for Netflix, analysts consider subscriber growth, pricing strategies, and content spending.
Forecasting Graph Example
Subscriber growth projection:
|
Year |
Subscribers (Millions) |
|
2024 |
260 |
|
2025 |
280 |
|
2026 |
305 |
|
2027 |
330 |
Such projections help investors evaluate company growth potential.
6. Knowledge of Business and Industry
It is essential that the financial model represents the real-life interaction of business and industry.
There are many different types of business and, as a result, there are also many different types of financial models.
Industries that would require a financial model include:
Ø Technology;
Ø Manufacturing;
Ø Banking;
Ø Real estate;
Ø SaaS companies.
Example: Tata Motors – A financial model based on Tata Motors would include the following factors:
Ø The demand for vehicles;
Ø The cost of raw materials;
Global supply chains and how that impacts the demand for vehicles.
Example: Microsoft – As opposed to Tata Motors, Microsoft uses a financial model focused more on:
Ø Sales based on software revenue;
Ø Sales based on subscriptions;
Ø Sales based on cloud growth.
Understanding the main drivers of an industry can help you improve the accuracy of your financial model.
7. Analysis and Interpretation of Data
Financial modellers will be required to work with/through multiple and large datasets to discover useful insights from those datasets.
Ø Tools Used to Analyze Data
Ø Excel;
Ø PowerBI;
Ø SQL;
Ø Python;
Example: For a financial analyst evaluating Uber, they would do the following to evaluate Uber's long-term profitability from a financial model perspective based on a financial model using major variables such as:
Ø The number of rides;
Ø Revenue per ride;
Ø The total cost of operational expenses.
Benefits Provided to Modellers
By incorporating data analysis experience into a financial model, a modeller will:
Ø Identify trends;
Ø Identify/respond to financial risks;
Ø Improve the accuracy of their financial forecast.
8. Attention to Detail
A financial model can contain thousands of calculations and multiple links between cells. Any minor error in a formula could result in a significant over- or under-valuation of the final financial model.
Example: A small error in the formula when creating a merger and acquisition model for Twitter may create an inaccurate valuation of Twitter.
Therefore, modellers should perform:
Ø Error checks;
Ø Audit of formulas;
Ø Validation of consistency.
9. Problem-Solving Skills
Financial models allow financial modellers to navigate an uncertain business environment.
Financial Modellers evaluate and recommend solutions to various business scenarios.
Scenario Analysis
Scenario analysis is often performed with regards to best-case, base-case, or worst-case scenarios when creating a financial model.
Example of a Real-World Scenario
When the COVID-19 pandemic occurred, many companies had to use their financial models to estimate the decline in revenue and forecast their liquidity requirements.
These forecasts and analyses allowed companies to develop plans to cope with disruptions in the economy.
10. Communication and Presentation Skills
Once the financial modeller completes his or her financial models, the financial modeller must communicate and present his or her conclusions to interested parties such as managers, investors, and other stakeholders.
In order to effectively communicate complex financial data, the financial modeller will use charts, dashboards, and reports to prepare a simple presentation of their findings.
Example: - As an example, a financial analyst may present the valuation of Alphabet Inc. in the future by using graphical representations, such as charts or dashboards, to explain the revenue forecast and to illustrate the opportunity for investors.
Key Skill Distribution
Typical importance of skills in financial modelling:
|
Skill |
Percentage Importance |
|
Excel & Technical Skills |
25% |
|
Accounting Knowledge |
20% |
|
Valuation Techniques |
15% |
|
Forecasting Skills |
15% |
|
Data Analysis |
10% |
|
Business Knowledge |
10% |
|
Communication Skills |
5% |
The Benefits of Knowing How to Make Financial Models
1. Lots of Career Options
If you know how to create a financial model, you can find a job in investment banking, consulting or corporate finance.
2. High Salaries
Financial modelling professionals are paid well — e.g. Goldman Sachs and JPMorgan Chase both pay their financial analysts very well.
3. Make Better Business Decisions
Being able to create financial models allows a company to make better strategic decisions.
4. Analyze Investments
Investors use financial models when evaluating a stock or investment opportunity.
5. Plan Strategically
Financial models are used by companies to develop budgets, prepare plans for expansion, and assess their projects.
Disadvantages and Challenges of Financial Modelling
1. Building an accurate financial model requires several advanced technical and accounting skills and experience working with a financial model; however, you will need to do additional research to find out what you will need to build a financial model successfully.
2. To create an accurate financial model requires a great deal of time because you must collect and analyze all the necessary data before you can build your financial model correctly.
3. Assumption Errors
Making errors in your assumption can result in inaccurate forecasts.
4. High-Pressure Work Environment
Financial models have a great deal of influence over multi-million-dollar business decisions, which means that there is a high level of responsibility when using or relying on these types of financial models.
Conclusion
A financial model is a valuable resource that investors, corporations, and other financial entities rely upon to review performance and determine future strategies. A financial modeler will possess technical talent, financial expertise, analytical capability, and effective communication skills to properly develop and utilize a financial model.
Accounting skills, Excel proficiency, Valuation techniques, Forecasting skills, and understanding of industries are essential to develop sound financial models.
Companies such as Apple, Tesla, and Amazon utilize financial models extensively to assess capital expenditures, project revenues, and evaluate strategies for future growth.
With an increasing emphasis on using data to drive business decisions, the global shortage of experienced financial modellers is likely to continue. Financial modellers who successfully develop the above equally use their knowledge in careers in investment banking, corporate finance, consulting, and entrepreneurial initiatives.
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