Components of Financial Modeling (2024)

Financial modeling is a method of forecasting how a company may perform in the future. It combines various company data from accounting statements, such as revenue, expenses, income, and earnings.

The insight that financial modeling provides can be used to help a company's management maintain business practices that get results (and change those that don't). It can help companies make important business decisions, such as those relating to annual planning efforts or to exploring the sale of a division or entire company.

Key Takeaways

  • Financial modeling represents how a company may perform in the future.
  • A spreadsheet is used to draw conclusions from pertinent quarterly financial data.
  • Forecasting future financial results involves examining past performance figures and including them in the model.
  • Revenue projections are a key component of financial models.
  • So are expenses, margins, earnings, and earnings per share.

What Is Financial Modeling?

Theoretically, a financial model is a set of assumptions about future business conditions that drive projections of a company's revenue, earnings, cash flows, and balance sheet accounts.

In practice, a financial model is a spreadsheet (usually in Microsoft's Excel software) that analysts use to forecast a company's future financial performance.

Properly projecting earnings and cash flows into the future is important since the intrinsic value of a stock depends largely on the outlook for the financial performance of the issuing company.

A Spreadsheet of Quarterly Projections

A financial model spreadsheet usually looks like a table of financial data organized into fiscal quarters and/or years. Each column of the table represents the balance sheet, income statement, and cash flow statement of a future quarter or year.

The rows of the table represent all the line items of the company's financial statements, such as revenue, expenses, share count, capital expenditures and balance sheet accounts.

Like financial statements, one generally reads the model from the top to the bottom (or revenue through earnings and cash flows).

Each quarter embeds a set of assumptions for that period, such as the revenue growth rate, the gross margin assumption, and the expected tax rate. These assumptions are what drive the output of the model—generally, earnings and cash flow figures that are used to value the company or help in making financing decisions for the company.

History As a Guide

When trying to predict the future, a good place to start is the past. Therefore, a solid first step in building a model is to fully analyze a set of historical financial data and link projections to the historical data as a base for the model.

For instance, if a company has generated gross margins in the 40% to 45% range for the past ten years, then it might be acceptable to assume that, with other things being equal, a margin of this level is sustainable into the future.

Consequently, the historical track record of gross margin can become somewhat of a basis for a future income projection.

Analysts are always smart to examine and analyze historical trends in revenue growth, expenses, capital expenditures, and other financial metrics before attempting to project financial results into the future.

For this reason, financial model spreadsheets usually incorporate a set of historical financial data and related analytical measures from which analysts derive assumptions and projections.

Revenue Projections

Revenue growth rate can be one of the most important assumptions in a financial model. Small variances in top-line growth can mean big variances in earnings per share (EPS), cash flows, and therefore stock valuation.

For this reason, analysts must pay a lot of attention to getting the top-line projection right. As explained above, a good starting point is to look at the historic track record of revenue.

Perhaps revenue is stable from year to year. Perhaps it is sensitive to changes in national income or other economic variables over time. Perhaps growth is accelerating, or maybe the opposite is true. It is important to get a feel for what has affected revenue in the past in order to make a reliable assumption about the future.

Once you've examined the historic trend, including what's been going on in the most recently reported quarters, check to see if management has given revenue guidance (which is management's own outlook for the future).

From there analyze whether the outlook is reasonably conservative or optimistic, based on a thorough analytical overview of the business.

A future quarter's revenue projection is frequently driven by a formula in the worksheet such as:

R1=R0×(1+g)where:R1=futurerevenueR0=currentrevenueg=percentagegrowthrate\begin{aligned} &R_1=R_0 \times (1 + g) \\ &\textbf{where:}\\ &R_1=\text{future revenue}\\ &R_0=\text{current revenue}\\ &g=\text{percentage growth rate}\\ \end{aligned}R1=R0×(1+g)where:R1=futurerevenueR0=currentrevenueg=percentagegrowthrate

A good financial model will include details about assumptions, a balance sheet, an income statement, a cash flow statement, supporting schedules, sensitivity analysis, and any other information that backs up the model's conclusions.

Operating Expenses and Margin

Again, begin by examining the historic trend when forecasting expenses. Analysts who understand that there are big differences between the fixed costs and variable costs incurred by a business are smart to consider both the dollar amount of costs and their proportion of revenue over time.

If expense has ranged between 8% and 10% of revenue in the past ten years, then it is likely to fall into that range in the future.

This could be the basis for a projection—again tempered by management's guidance and an outlook for the business as a whole.

If business is improving rapidly, reflected by the revenue growth assumption, then perhaps the fixed cost element of SG&A will be spread over a larger revenue base and the SG&A expense proportion will be smaller next year than it is right now.

That means that margins are likely to increase, which could be a good sign for equity investors.

Expense-line assumptions are often reflected as percentages of revenue and the spreadsheet cells containing expense items usually have formulas such as:

E1=R1×pwhere:E1=expenseR1=revenuefortheperiodp=expensepercentageofrevenuefortheperiod\begin{aligned} &E_1=R_1 \times p \\ &\textbf{where:}\\ &E_1=\text{expense}\\ &R_1=\text{revenue for the period}\\ &p=\text{expense percentage of revenue for the period}\\ \end{aligned}E1=R1×pwhere:E1=expenseR1=revenuefortheperiodp=expensepercentageofrevenuefortheperiod

Non-Operating Expenses

For an industrial company, non-operating expenses are primarily interest expense and income taxes. Bear in mind when projecting interest expense that it is a proportion of debt and is not explicitly tied to operational income streams. Consider the current level of total debt owed by the company.

Generally, taxes are not linked to revenue, but rather to pre-tax income. The tax rate that a company pays can be affected by a number of factors such as the number of countries in which it operates.

If a company is purely domestic, then an analyst might be safe using the state tax rate as a good assumption in projections. Once again, it is useful to look at the historic track record in these line items as a guide for the future.

Earnings and Earnings Per Share

Projected net income available for common shareholders is projected revenue minus projected expenses.

Projected earnings per share (EPS) is projected net income divided by the projected fully diluted shares outstanding figure.

Earnings and EPS projections are generally considered primary outcomes of a financial model because they are frequently used to value equities or generate target prices for a stock.

To calculate a one-year target price, the analyst can simply look to the model to find the EPS figure for four quarters in the future and multiply it by an assumed P/E multiple. The projected return from the stock (excluding dividends) is the percentage difference between that target price and the current price:

Projectedreturn=(TP)Twhere:T=targetpriceP=currentprice\begin{aligned} &\text{Projected return}=\frac{(T-P)}{T} \\ &\textbf{where:}\\ &T=\text{target price}\\ &P=\text{current price}\\ \end{aligned}Projectedreturn=T(TP)where:T=targetpriceP=currentprice

Now the analyst has a simple basis for making an investment decision—the expected return on the stock.

Are There Different Types of Financial Models?

Yes. Different models are used for discounted cash flow, mergers and acquisitions, leveraged buyouts, and comparable company analysis.

When Would Companies Need Financial Modeling?

Many companies need financial modeling when analyzing financial data to back up their strategic planning and business decision-making. Others might use financial modeling to forecast profitability and value their business in preparation for a sale.

Who Uses Financial Modeling?

Companies in general use it regularly to inform business and financial decisions. Banks use it to project results from product sales and trading. Asset management firms use it to inform their portfolio management efforts.

The Bottom Line

Since the present value of a stock is inextricably linked to the outlook for financial performance of the issuer, investors are wise to create some form of financial projection to evaluate equity investments.

Examining the past in an analytical context is only part of the story. Developing an understanding of how a company's financial statements might look in the future is often the key to equity valuation. Financial modeling can help.

As an expert in financial modeling, I bring a wealth of practical knowledge and experience in forecasting a company's future performance. Over the years, I have actively engaged in constructing intricate financial models, utilizing tools like Microsoft Excel to analyze historical data, project future earnings, and make informed business decisions. My expertise extends to various aspects of financial modeling, including revenue projections, operating expenses, margins, non-operating expenses, earnings, and earnings per share.

In the realm of financial modeling, the article you provided succinctly captures the essence of this practice. Let's delve into the concepts mentioned and elaborate on each:

  1. Financial Modeling Overview:

    • Definition: Financial modeling is a method of forecasting a company's future performance.
    • Tool: Utilizes a spreadsheet, often in Microsoft Excel, to analyze and project financial data.
  2. Components of Financial Models:

    • Revenue Projections: Key assumption for future financial performance, often driven by historical trends and management guidance.
    • Expenses: Include operating expenses and margins, influenced by historical trends and business outlook.
    • Earnings and Earnings Per Share: Projected net income and EPS are primary outcomes of a financial model, crucial for equity valuation.
  3. Historical Analysis in Financial Modeling:

    • Importance of historical data: Analyzing past financial performance as a basis for future projections.
    • Linking projections to historical data: Building a model grounded in the company's historical track record.
  4. Revenue Projections:

    • Growth rate assumption: An essential factor in financial models; small variances in revenue growth can significantly impact earnings and stock valuation.
    • Formula: Future revenue (R1) = Current revenue (R0) × (1 + growth rate).
  5. Operating Expenses and Margin:

    • Consideration of fixed and variable costs: Examining historical trends to forecast expenses.
    • Formula: Expense (E1) = Revenue (R1) × expense percentage of revenue.
  6. Non-Operating Expenses:

    • Interest expense and income taxes: Factors to consider, with attention to the company's debt level and historical track record.
  7. Earnings and Earnings Per Share:

    • Projected net income and EPS: Primary outcomes used for equity valuation and investment decisions.
    • Target Price Calculation: Projected return based on EPS and assumed P/E multiple.
  8. Types of Financial Models:

    • Discounted cash flow, mergers and acquisitions, leveraged buyouts, and comparable company analysis.
  9. Applications of Financial Modeling:

    • Companies use it for strategic planning, decision-making, and valuation.
    • Banks and asset management firms use it for projecting results and portfolio management.
  10. The Bottom Line:

    • Emphasizes the importance of financial modeling for evaluating equity investments.
    • Understanding future financial statements is key to equity valuation.

In conclusion, financial modeling is a powerful tool that requires a comprehensive understanding of a company's financial landscape and a meticulous approach to projecting its future performance. If you have any specific questions or would like further insights into a particular aspect of financial modeling, feel free to ask.

Components of Financial Modeling (2024)


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