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Financial Modeling

Financial modeling involves building a mathematical representation of a financial situation to answer 'what if' questions and make projections. It requires modeling a company's income statement, balance sheet, and cash flow statement. The income statement shows revenue, expenses, and profit over a period of time. The balance sheet represents a company's financial position at a moment in time by listing assets, liabilities, and equity. The cash flow statement tracks cash inflows and outflows. Developing a complete financial model requires considering a company's financing, accounting for inventory, and showing how the financial statements relate.

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194 views3 pages

Financial Modeling

Financial modeling involves building a mathematical representation of a financial situation to answer 'what if' questions and make projections. It requires modeling a company's income statement, balance sheet, and cash flow statement. The income statement shows revenue, expenses, and profit over a period of time. The balance sheet represents a company's financial position at a moment in time by listing assets, liabilities, and equity. The cash flow statement tracks cash inflows and outflows. Developing a complete financial model requires considering a company's financing, accounting for inventory, and showing how the financial statements relate.

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josh.molina
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© Attribution Non-Commercial (BY-NC)
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FINANCIAL MODELING

WHAT IS FINANCIAL MODELING? Financial modeling is the task of building an abstract representation (a model) of a financial decision making situation. This is a mathematical model designed to represent (a simplified version of) the performance of a financial asset or a portfolio, of a business, a project, or any other investment.

IT IS DESIGNED TO REPRESENT IN MATHEMATICAL TERMS THE RELATIONSHIPS AMONG THE VARIABLES OF FINANCIAL PROBLEM SO THAT IT CAN BE USED TO ANSWER WHAT IF QUESTIONS OR MAKE PROJECTIONS.

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: 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. But it does not matter!

Practically these are the fundamental building blocks of analysis and you have to start thinking in these terms for the analysis 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 o Create logical modules for your model o Keep your P&L, Balance Sheet, cash flow statement, etc. separate o Even in P&L, keep the revenue generation separate from costs

THE BASICS OF FINANCIAL STATEMENTS You need to create ALL THREE of these statements to have a real financial model.

BALANCE SHEET
Balance sheets represent the financial state of the company at a specific moment in time. It is important to realize that the balance sheet of a company changes from day to day and moment to moment. It is usually prepared at a minimum of once per year. Companies operate on a fiscal year, which is usually 12 months and probably ends at the end of a quarter (March 31, June 30, September 30 or December 31). At the end of the fiscal year, companies hire accountants to prepare financial statements. The balance sheet is prepared as of the end of the fiscal year. It can take many months to prepare a balance sheet, so by the time it is prepared it is already out of date. The balance sheet has 3 basic components: ASSETS Stuff the company owns. LIABILITIES Amounts the company owes to lenders. EQUITY Amounts the company owes investors and profit that has accumulated. Q: So, how can we tell between assets and liabilities?

INCOME STATEMENTS
An Income Statement represents the companys profit or loss over a specific period of time. At the top of an income statement is the company's revenue, hence the Wall Street jargon of "top line" for revenue. In the middle of an income statement are the expenses of the company, both fixed and variable and any non-cash expenses (more on this later). At the bottom of an income statement expenses are subtracted from revenues and you get a profit figure, hence the Wall Street jargon of "bottom-line" for profit. The income statement has 3 parts: REVENUE Amounts you get from selling goods or services (aka income) EXPENSES Including non-cash charges such as depreciation. PROFIT a.k.a. net income Q: So, whats depreciation?

CASH FLOW STATEMENTS


The cash flow statement is the most difficult statement to understand but the easiest to calculate. The cash flow statement includes all cash that is coming into the company, whether it be from revenue or from bank borrowing1. It also shows all the ways cash has left the company, including expenses such as salaries and making investments such as buying real estate. The cash flow statement is, in some ways, a means of adjusting the income statement to reflect changes in the balance sheet.

There are 2 ways to represent the cash flow statements:


CASH FLOW #1

REVENUE Amounts you get from selling goods or services (aka income) EXPENSES Including non-cash charges such as depreciation. PROFIT a.k.a. net income
CASH FLOW #2

REVENUE Amounts you get from selling goods or services (aka income) EXPENSES Including non-cash charges such as depreciation. PROFIT a.k.a. net income

Most people only know how to model income. For example, "I will make computer chips for .50 cents each and sell them for .75 cents each." This is only the income and costs, not the whole story. You need to show how your company will finance itself, how it will account for important things like inventory and what your balance sheet looks like. TERMS

FASB The Financial Accounting Standards Board RESOURCES Wall Street Preparation Tests http://www.wallstreetprep.com/ Chandoo Financial Modeling Introduction http://chandoo.org/wp/2010/07/21/financial-modeling-introduction/

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