Question

list the various elements of financial modeling.

Answer 1

While developing a financial model, it is important for the analyst to follow the following elements:

Working on the requirements:

->It is essential for the analyst to know the purpose of the financial modeling, i.e., the use of it whether in project performance forecast, acquisition synergies or any other objective.

-> The next objective is to know the target audience for whom the modeling is being done

-> The list of questions or decisions that should be inferred from the results of modeling

Working with historical results and the assumptions:

->Deciding on the scope is very important as it will help to provide better results. Before carrying out the modeling one should decide on the number of years for which financial statements need to be considered and the number of years for which they should be projected/ forecasted.

-> Now, reverse engineering the assumptions, the analysts need to calculate certain parameters such as the revenue growth rate, Variable and fixed costs, turnover ratios etc.

Developing the structure:

->Financial models generally have three structural elements: Input, Processing, Output

-> A perfect structure should be able to segregate all these three elements

Building the financial statements and valuation:

-> While projecting, one should start with the income statement, followed by balance sheet and then calculate the parameters accordingly

-> One needs to create a schedule for capital assets, debts, and interests before completing the balance sheet and the income statement

   >> Capital assets schedule needs to pull from historical periods, add back the expenditures and subtract the depreciation

    >> Interest schedule will depend on the average debt balance

   >> Debt schedule also needs to pull from historical periods , add back the additions in debt and then subtract the debt Payment

->The next step involves the building of the cash flow statement

-> After the cash flows have been generated, the analyst is required to carry out the valuation of the business/firm

The three important modules:

->Output: This is the first template with time period being on the horizontal axis and the outputs in the rows.

-> Logic for the output: The analyst needs to mention the logic behind deriving the outputs. Using various iterations and using the suitable input, the logic should be developed.

-> Testing is the third most important module which if not carried out can cause errors resulting in wrong outputs

Sensitivity and scenario analysis:

->This is done to understand the key risks and the dependency of the output variables on the input variables. Presenting the sensitivity analysis is another important step in order to complete the modeling. By changing the underlying assumptions one can find out the variations in the output.

Stress Testing:

->Once the model has been build, the final step is to carry out the stress test. It involves testing extreme scenarios i.e., the boundary condition inputs to check whether the model is behaving as expected.