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What is Financial Modeling?

Posted on December 19, 2011 by survivalware

Definition of Financial Modeling


Wikipedia defines financial modeling as the task of building an abstract representation (a model) of a financial decision making situation. I prefer a more inclusive definition: financial modeling is the task of building a financial model, or the process of using a financial model for financial decision making and analysis. I would agree that a financial model is an abstract representation of a financial decision making situation. By abstract representation, we really mean a mathematical model, and to be practical, a computer based mathematical model. The model usually represents an ongoing business, or a project that requires investment. Financial models are not limited to profit making entities. Non-profits, governments, personal finances all can be represented by financial models.

What is Financial Modeling used for?


Financial modeling is used to do historical analysis of a companys performance, and to do projections of its financial perfo rmance into the future. Project finance is another area that lends itself to financial models. A project (such as a real estate investment, or a new factory) can be analyzed using a financial model. It does not have to be complete business. Financial Modeling is not just for the accountant or financial consultant, who are called upon to develop financial projections, but also for business owners and managers. With improved user interfaces and heavy use of graphics, it is now feasible for nontechnical people to use a financial model to test options and make decisions based on the projected impact on profits and cash flow.

How does a financial model work?


Some financial models are black boxes with their logic hidden or poorly understood by the users of the model. Most spreadsheet models fall into this category, because the time it takes to find and understand the relevant formulas is daunting for most users. However, the more you understand about how a financial model works, the more confident you can be in using its results. In the next four blog posts, Im going to explain how financial models work for each of the four main kinds of financial models: 1. Transaction based models 2. Discounted Cash Flow models 3. Financial Statement models 4. Consolidation Models But first (you can skip this part)..

My Introduction to Financial Modeling


Financial modeling is my passion. I was introduced to it 35 years ago when I went to work for a company called Comshare, which sold computer timesharing services to corporate customers. We targeted financial analysts, controllers, and CFOs who were frustrated at having to go through their IT departments for management reports and analysis. Some things never change. Back then a new class of higher level software deemed third generation was all the rage. (The first generation was assembly language, second generation was general purpose programming languages such as Fortran and Cobol. Who knows what generation we are in now!) Part of this new wave of software was the genre known as the financial modeling language. These languages let you construct financial models using English like statements instead of obscure lines of code. Today, some of us old timers consider spreadsheets with their obscure cell formulas to be a step backward, at least when it comes to constructing financial models that are maintainable and understandable. In the first 3 or 4 years after getting a degree in Industrial and Operations Engineering (a fake engineer as my wife likes to refer to it), I bounced around from job to job trying to find my niche. When I interviewed for the job in ComsharesArlington,Va.sales office, I told them up front my goal was to start my own company. (Good boy correct answer, shows initiative). I started in the Fall of 1977 as a customer support representative. I learned FCS, the financial modeling language sold by Comshare that was growing by gangbusters in the late 70s. Some of the other popular financial modeling languages at the time were Prophit II and IFPS. As I settled in, I thought I had died and gone to heaven. It seemed the perfect confluence of interest and passion for me: computers, business, and customer support. (Some say it is a character defect, but I genuinely enjoy helping people). One of our customers back then was the Marriott Corporation who used financial models to do cash flow projections for hotel projects. They had a great formula for growth. They would find investors to put up the money to build a hotel, and then take a management fee for running it and including it in the Marriott network. Marriott had a dynamic young Treasurer at the time named Al Checchi, who pushed for financial discipline and fact based analysis. Financial modeling was a great tool for crunching the numbers and analyzing the returns to both Marriott as well as the investors.

Another customer was the First American Bank ofMaryland. They used a financial model for overall corporate planning. They put in assumptions about interest rates, average loan balances and deposits by category and by branch and computed a complete income statement and balance sheet for each branch and the consolidated bank. The model had to handle the simultaneous equation involved in computing the banks cash position each month. In banking, since cash is also inventory, they have accounts called Fed Funds Purchased or Fed Funds sold depending on whether or not they needed to borrow from the Fed. I could never remember which account meant you had excess funds. I seem to remember it was counterintuitive. The financial model sorted it all out. Yet another customer was Fairchild Industries, a Fortune 500 aircraft manufacturer and NASA contractor. They had several independent divisions, and used financial modeling to consolidate the financial reports on a monthly basis, and to prepare budgets. In addition to helping the customers learn the modeling language and developing models for them, I worked with Comshares sales representatives to go out and find new customers. Ill never forget a sales call we made at McCormick, the spice company inHunt Valley,Md. They asked if FCS could interface with their General Ledger (i.e. accounting software) that ran on their mainframe computer. My answer (with a straight face) was yes, of course it interfaces. You print out the financial reports from the general ledger, and type in the numbers on the computer terminal. I seem to remember that we did not get the business. That was the state of the art of automated interfaces at the time. The disadvantage of financial modeling back then was something we referred to as the ouch point. Computer timesharing was priced based on usage. In Comshares case, there was a charge for the length of time you were logged on to the computer, plus some measure of CPU seconds. These charges included a fee to go to the software company that developed the financial modeling language. Since financial models gave the finance department freedom from the internal IT department, things got done quickly, and usage soared. The ouch point occurred when the monthly timesharing bill was big enough to be noticed by senior management. Any IT manager worth his pocket protector would try to use the expense as an excuse to bring the application in-house, and the renegade users back onto the IT reservation. This was a pre-cursor to the Personal Computer vs. Mainframe battles soon to come. Comshare made a big mistake and promoted me to branch technical manager in early 1979. All of a sudden I had all the headaches of being a manager, but not much difference in the amount of pay. I figured if I was going to put up with the BS, I may as well do it on my own. So I put in my notice, and to make it a smooth transition, I wound down my involvement from 5 to 4 to 3 to 2 days a week in the waning months of 1979, and was fully on my own by January, 1980. This was just in time for the steepest recession since World War II, the 2 Oil Price shock, and a prime rate that peaked just shy of 20%. Timing has never been my forte. The company I started was called Ferox Microsystems, Inc. Ferox was short for ferrous oxide. Iron oxide. Rust. My name is Rusty. So yeah it was my ego trip: I wanted to get my name into the company without sounding like a one man band. My original plan was to develop small business accounting software or something else simple enough to fit on the Apple II computer I had bought that summer. With a second mortgage, a working wife, and no kids I had about a 6 month horizon to make it work. To make a long story short, I found that the Apple computer was much more powerful than I anticipated, especially when they released Apple Pascal, a programming language that allowed you to write programs that were bigger than the computers memory. It did all the swapping for you behind the scenes. At the same time I had some consulting customers who were reaching their ouch points and pushed me to find a lower cost way to do financial modeling. The result was RCS The Micromodeler, a financial modeling language that ran on the Apple II computer, and sold for $1,500 a pop in mid 1980. RCS was short for Rustys Computer System. Entrepreneurial ego knows no bounds. A year or so later I sold the North American rights to a book publisher, who renamed the product DSS/Finance or DSS/F for short. Yet another example of my proclivity for poor timing, or just plain poor judgment. Fast forward to 2002, and I decided to start Luhring SurvivalWare, Inc. to adapt big company financial modeling technology to small company cash flow problems. I had gone through some roller coaster years with Ferox, and wanted to help other entrepreneurs avoid some of the mistakes I had made. By this time, I had shed the second mortgage, my wife was working part-time, and we had 4 kids, the first of which had started college. My original thought was to focus on detailed cash planning to help entrepreneurs survive a cash crisis but I quickly found this market segment not particularly receptive to parting with their scarce, hard-earned cash. SurvivalWare has evolved quite a bit since those humble beginnings to include the full range of financial modeling power to do financial statement projections, consolidations, and benchmarking analysis.
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Model:
Three words that occur very regularly in research texts are concept, theory and model. It is often assumed that everyone knows what these words mean and what the differences between them are. These are usually false premises. The terms will be defined and briefly discussed. As in most situations there are a number of possible definitions for each word. Concept Simply, a concept is an abstract notion or idea, something that isnt concrete. "A word or set of words that expresses a general idea concerning the nature of something or the relations between things, often providing a category for the classification of phenomena." Theodorson & Theodorson 1969 In other words a concept is an abstract summary of characteristics that we see as having something in common. Concepts are created by people for the purpose of communication and efficiency. A concept has no set meaning and it is up to us to define what we mean by the concept. But if concepts have no set meaning then anyone can define a concept in any way that they wish. But if everyone can define the concept in any way they like the concept becomes worthless; unless there is agreement on the meaning communication is impossible. A concept therefore has to be defined, but in such a way that it has a degree of acceptance. Experts in the field usually propose such definitions. As a researcher you would be expected to: review this range of definitions, and

decide on which you are going to use. Theory A very loose meaning of the word is: That part of the study of a subject which is not practical. For example, teaching theory is often contrasted with teaching practice. More substantial definitions of a theory are: "A theory is a set of interrelated principles and definitions that present a systematic view of phenomena by specifying relationships among variables with the purpose of explaining natural phenomena." Kerlinger 1986 "Any set of hypotheses or principles linked by logical or mathematical arguments which is advanced to explain an area of empirical reality of type of phenomenon." Jary & Jary 1995 In effect a theory includes a set of basic assumptions and axioms as the foundation and the body of the theory is composed of logically interrelated, empirically verifiable propositions. Let us look at one of these theories in more detail. Motivation theories fall into two main groups content theories and process theories. Content theories of motivation, such as Maslows hierarchy of needs and Herzbergs two factor theory of motivation, focus on what motivates people.

Process theories, such as Expectancy theory and Equity theory, place more emphasis on how people become motivated. If we look at one of these theories, Maslow is based on a set of assumptions and links a number of variables (physiological, security social, self-esteem and self-satisfaction) to explain motivation. (Torrington and Hall, 1995) Concepts are generally regarded as being at a lower level of abstraction than a theory but a necessary part of any theory, since theories are formed from concepts. Model Lucey (1991) defines a model of "any simplified abstract of reality ". For example we are all familiar with scale models of aircraft, cars, ships, housing estates, etc. These simplified versions of the real thing are called physical or iconic models. They are based directly on the representation of the phenomenon being studied and look like the object. An extension of the physical model is the analogue model. These models are physical in form but do not have the same appearance as the object being investigated. The circular movement of the hands of a wristwatch is an analogue of the behaviour of time. However there are other types of models. Symbolic models are based on logic, and inter-relationships between concepts are usually expressed mathematically or algebraically. They are concerned with quantification. Mathematical (algebraic) equations are symbolic models. For instance a simple mathematical model is: Profit = Revenue minus Total Cost or P = R TC There are many such symbolic models in the fields of economics, finance, statistics, science and engineering. One approach to the analysis of such models is to represent the model on a spreadsheet and conduct sensitivity analysis. A conceptual model is composed of a pattern of interrelated concepts but not expressed in mathematical form and primarily not concerned with quantification. Diagrams, such as maps, graphs, charts, balance sheets, circuit diagrams, and flowcharts, are often used to represent such models. Models may be very simple or very complex. Since the world we observe cannot be observed in totality, each model reflects only a limited aspect of the total world. No single model, or combination of models, reveals the truth of the structure of reality. Each model reveals and orders reality from a particular perspective. In practice concepts and especially theories are often referred to as models. Other words associated with concepts theories and models are law, empirical and variable. A law is a precise statement of a relationship among facts that has been repeatedly corroborated by scientific investigation and is generally accepted as accurate by experts in the field. Laws are generally derived from a theory. A law is frequently referred to as a universal and predictive statement. It is universal in the sense that the stated relationship is held always to occur under the specified conditions, although the conditions may be predicted to follow. Empirical means based on experience, observation or experimentation. Empiricism is the belief that all human knowledge is derived from experience as opposed to, for example, idealism, rationalism and naturalism.

A variable is a characteristic or attitude that changes or varies. More exactly, it is any measurable characteristic which can assume varying or different values in successive individuals cases. In the mathematical sense it is a quantity that may take any one of a specified set of values, for example, height. A wider use of the term variable includes mathematically non-measurable characteristics such as gender and religion. It is usual, when comparisons are made between two variables or there is a relationship between two variables, to term one the dependent variable and the other the independent variable. The independent variable is the variable that is changed or manipulated. As a consequence of this change there will be a resulting change in the other variable dependent variable. For example, research may be conducted into the intensity of lighting in a room in order to observe the effect on productivity levels of workers. The independent variable is the intensity of lighting and the dependent variable is the level of production.

Financial Modelling Financial modeling is creating a complete program/ structure, which helps you in coming to a decision regarding investment in a project/ company. Now this could be on a simple piece of paper or in excel. [h=3]Person responsible for Financial Modeling[/h]Anybody dealing with any decision related to money. If you are involved in financial decision making/ planning related to large corporate, then you would definitely need financial modelling day in and day out. Financial modeling is a mandatory activity for investment bankers, bankers, project finance persons, equity research folks. [h=3]Steps In Building A Financial Model[/h][h=3]The following steps are taken while constructing a financial model:[/h]

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Data collection Back of the envelope calculations Structured approach to thinking Once the basic numbers seem reasonable (they make business sense and seem to be true as well), you have to dig deeper! This is where you need a complete financial model. And the first real step to doing that is to think of a structure of analysis. Thankfully finance has some basic theories in place and you can rely on them to proceed: Deciding on a Layout Now when you start to put this plan in excel, the starting point is deciding on a layout for your financial model. Usually the following questions need to be answered: How much information/ data would your model have? If its going to be large, then it might make sense to break the model in multiple sheets What kind of assumptions would your model make? For better readability, we would try to keep assumptions in a different heading than the calculations and the final conclusion Different fonts/ formatting for assumptions and other parts might enhance readability as well Create logical modules for your model Keep your P&L, Balance Sheet, cash flow statement, etc. separate Even in P&L, keep the revenue generation separate from costs So financial Modelling helps in taking decisions related to investments in the Promising projects. inancial modeling is creating a complete program, which helps you in coming to a decision regarding investment in a company or a project. Financial modeling is a mandatory activity for investment bankers, project finance persons,and peple researching in equity

It involves the following process:

Data collection Back of the envelope calculations Structured approach to thinking Deciding on a Layout

Two important points for financial modelling are : Cash is the king The more cash is generated (from the operations of the business) the better is the business Money today is better than money tomorrow technically this can be called Time value of money.

Model: Lucey (1991) defines a model of "any simplified abstract of reality ". A representation of a system that allows for investigation of the properties of the system and, in some cases, prediction of future outcomes.

Models are divided into three classes on the basis of their degree of abstraction (1) Iconic model: least abstract, physical, 'look-alike' model, such as a model airplane or train. (2) Analogous model: more abstract but having some resemblance to what it represents, such as a chart, graph, map, network diagram. (3) Symbolic model: most-abstract model with no resemblance but only an approximation to what it represents, such as a mathematical equation or formula, financial statement, language, and set of accounts. There are many such symbolic models in the fields of economics, finance, statistics, science and engineering. One approach to the analysis of such models is to represent the model on a spreadsheet and conduct sensitivity analysis.

Financial Modelling: Financial Modelling is an abstract representation of Financial decision making situation. To be more specific, Financial Modelling refers to the process of building a structure that integrates the Balance Sheet, Income Statement, Cash Flow Statement and supporting schedules to enable decision making in areas like, Business Planning and Forecasting, Equity Valuation, Credit Analysis/Appraisal, Merger/acquisition analysis, Project Appraisal etc.