Steps for Building a Financial Model

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27 Sept 2022

Process of Creating a Financial Modelling

There is a broad framework in financial analysis that needs to be followed in order to create working financial models. This requires a specific step-by-step approach to create a financial model. In this article, I'll work you through the major steps to be observed.

1. Historical Financial Data

Historical data are data that contains the company's past performance from the previous years. These past statements often reveal hidden trends in recent times and provide insights into the future.

Input at least 3-5 years of historical information for the business. For start-up companies with no past information available. In this case, data from a comparable company or industry can be used for the financial model.

2. Analysis of Historical Performance

In this step, calculations of historical ratios/ metrics for the business such as margins, growth rate, assets turnover ratio, inventory. the analyst must apply all their knowledge of accounting and finance try and understand the underlying factors driving the trend.

The purpose of a financial model is to accurately forecast the revenues and the expenses which may occur in the future, understanding the key parameters which influence the business is of vital importance. These parameters may be input or output of the prices of the commodities, fluctuations in currency rates, government laws and regulations.

3. Gathering of Assumptions for Forecasting

This step you build the ratios and metrics into the future by making assumptions about the future margins, growth rates, asset turnover and inventory changes will be going forward for the forecast.

4. Forecast the Financial Statements using the Assumptions

Build the future income statement and balance sheet based on the assumptions decided on. After that, the cash flow statement is linked to the income statement and balance sheet to capture the cash movement in the forecasted period.

5. Valuation

The company is then valued by using the DCF analysis - (Discounted Cashflow Analysis).
DCF analysis is simply a forecast of a company's unlevered free cash flow discounted back to today's value- NPV.

6. Sensitivity & Scenario Analysis

This step aims to determine at what point the performance of the company will start to decline and to what extent. The resilience of the business model will be tested based on different scenarios. This step is beneficial as it helps assess variation in performance in case of an unanticipated event. The reality is that the future is highly uncertain, and decision-makers should be provided with several scenarios. For instance, the best-case scenario, the worst-case scenario.

Preparing financial models are extremely complex task. These steps provide a broad guideline to accomplish the task. As an financial analyst, you should be cautious during this stages of getting the historical data from the three financial statements and the corresponding schedules, any mistake potentially deteriorate the quality of the end model.