Financial Modelling: Defined
Financial modelling is the process of creating a structured summary of a company’s expenses and earnings typically in a spreadsheet format to forecast future financial performance.
Common Uses of Financial Models
- Business Valuations
- Mergers & Acquisitions (M&A)
- Budgeting & Forecasting
- Strategic Planning
Assumptions or Drivers
These are the key inputs that drive the financial model. The accuracy of these assumptions heavily influences the reliability of the model "garbage in = garbage out."
Examples of common drivers:
- Revenue growth
- Cost margins
- Interest rates
Revenue Forecast
A projection of a company’s future sales, using approaches such as:
- Top-down: Starting with market size and estimating share
- Bottom-up: Building from individual products or customer segments
- Year-over-Year (YoY) Growth %
Cost of Goods Sold (COGS)
Direct costs involved in producing goods or services.
Formula:
Revenue – COGS = Gross Profit
Important for understanding production efficiency and calculating gross margin.
Gross Margin
Formula:
(Revenue – COGS) ÷ Revenue × 100
Indicates how efficiently a company produces goods.
Higher gross margin = better profitability
Operating Expenses (OpEx)
Costs not directly tied to production, such as:
- Salaries
- Rent
- Marketing
OpEx is deducted to calculate EBIT (Earnings Before Interest and Taxes).
EBITDA
Earnings Before Interest, Taxes, Depreciation, and Amortization
- A proxy for core operating performance
- Commonly used in valuation multiples
Depreciation & Amortization (D&A)
Non-cash expenses representing asset usage:
- Depreciation: Tangible assets (e.g., equipment)
- Amortization: Intangible assets (e.g., patents)
D&A impacts cash flow and tax calculations.
EBIT (Operating Income)
Earnings Before Interest and Taxes
Formula:
Revenue – Operating Expenses – D&A
Useful for assessing the profitability of core operations.
Net Income
Also known as the "bottom line."
Formula:
Revenue – All expenses
Key for calculating:
- Equity value
- Earnings Per Share (EPS)
- Forecasting performance
Free Cash Flow (FCF)
Cash available to investors after capital expenditures.
Formula:
FCF = EBIT × (1 – Tax rate) + D&A – CapEx – ΔWorking Capital
Essential for Discounted Cash Flow (DCF) models.
Capital Expenditure (CapEx)
Spending on long-term physical assets:
- Property
- Plant
- Equipment
CapEx is crucial for business growth and impacts both cash flow and depreciation.
Working Capital
Formula:
Current Assets – Current Liabilities
Measures short-term liquidity.
Changes in working capital affect cash flow projections.
Discount Rate (WACC)
Weighted Average Cost of Capital (WACC) is the rate used to discount future cash flows in DCF models.
Reflects the overall risk of the business and cost of capital.
Terminal Value
Estimates the business’s value beyond the forecast period.
Two common methods:
- Perpetuity Growth
- Exit Multiple
Often the largest component in a DCF model.
Sensitivity Analysis
Tests how changes in key assumptions affect outcomes.
Example:
What if revenue grows 5% instead of 10%?
Useful for understanding risk and key value drivers.
Scenario Analysis
Builds multiple versions of the model to assess potential outcomes:
- Base Case
- Best Case
- Worst Case
Helps prepare for uncertainty and make strategic decisions.
Circular References
Occurs when a formula refers back to itself.
Example: Interest depends on debt, which depends on interest.
Must be carefully managed using iterative calculations to ensure model stability.
Three-Statement Model
Integrates:
- Income Statement
- Balance Sheet
- Cash Flow Statement
Considered the gold standard in financial modelling due to its comprehensiveness.
Audit Trail
A well-structured model with traceable formulas and logic:
- Enhances transparency
- Increases model reliability
- Essential for professional standards
