Financial Modeling is a step-by-step procedure to mathematical represent the financial situation of a company. Lets take a brief example which would make this complex-seeming process your piece of cake. Suppose you saw the stock of the company and its current price is 100$ but your friend believe that the stock is overvalued and should be valued at 90$ but you believe that it should be valued at 110$ . What causes this difference in opinions? These are mere their opinions. But imagine a chart in front of you – yes, you got it right- a colorful one .
So, whenever you are able to give your decision on basis of past trends about a company along with a solid reason , none can reject your decision. That’s the reason why learning financial modeling becomes important. Not only at individual level, but it is one of the in-demand skills . So, basically, you are quantifying your views and concluding it to take a decision for a company.
USES
- Valuation
- Advising Merger and Acquisition
- Leverage Buyout ( Debt- based acquisition)
- Raising Funds
If you are not able to understand the above terms , don’t take it as a disaster. Lets take another example to simplify one of the above terms so as to relieve you that it is not worth leaving this field unexplored. So, there is a small retail shop which is earning quite well and a big retailer noticed it and wants to purchase it. So, at what price should it be purchased?
To decide this price we calculate valuation of a company. Valuation helps to estimate market value of that business on the basis of how it has been performing in the past few years and its future earning potential. And on this basis, the sale value of that retail business would be decided.
STEPS OF FINANCIAL MODELING
Here is the 6-step simple procedure to make financial models if you are a beginner and desire to explore this field furthur:-
(i) Knowing the purpose ( Why do you want to do it? )
In this step, you need to identify the objective of this analysis. It can be done to while investing in a company, during merger and acquisition, for financial analysis and planning or whether it is the matter to buy the entire company.
(ii) Conducting research
This could go a little technical as you need to start your research with company’s interim and financial reports. Then you need to go through investor presentations, concalls and industry reports. It would be an add-on if you have Equity research reports issued by the banks. You can also pay an amount and take an interview from the management. It can be a little challenging in the case of private company as information is not publicly available.
(iii) Identify the key-drivers of that industry
-For retailers it could be: sales per store, number of stores, cost per product sold, and average value preorder.
-For hotels: number of hotels / rooms, occupancy rates, tariffs
-For Food and Beverages: units sold, average price, cost per unit
–Pharmaceuticals: Number of patients, research and development and sales, future patents
–User Based(eg. Netflix): number of active users, cancellation rates, retention rate and monthly subscription fee
(iv) Gather information on peer companies (competitors)
To take a decision about your business, you must also be aware what your competitors are doing. So, a “Fairness Opinion” document is prepared to quickly analyze whether your numbers are making sense. Suppose in the industry the growth rate is 5% but you are quoting it to be 20% then it doesn’t seems reliable.
(v) Build your analysis
Till this stage, you would have collected all the required data. Here you will be projecting/ forecasting the revenues and expenses of next year on basis of past trends. While doing valuation, sometimes, you need a lot of outside data where you may require to do a lot of adjustments. While in the case of acquisitions, you may be performing Scenario Analysis.
(vi) Presentation of analysis
You will be displaying the results in the format of PPT slides, Word docs, Excel, or oral presentation. This information is used by bankers, portfolio managers, Venture Capitalist partners, or by interviewers.
This was an introduction to financial modeling to help know what it actually is. Now, if you feel like it is something really interesting, go for it and learn it without any hesitation since it is the first step towards one of the high paying field- investment banking .
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Great insights. Waiting for more such content.