Financial modeling means creating an abstract form of a financial decision of an organization. The decision can be regarding a cost of project, financial planning, discounted cash flow, capital budgeting. Normally financial modeling is done by MBA or financial Analysts. Financial modeling is used in investment, banking, financing, accounting, construction and real estate’s sectors etc.
Financial model helps in solving the problems of “what if”. For example what would be my income after tax if my income increases by Rs.15, 000? The quality of solving the problem of what if with so much ease makes it different from the simple spreadsheet and VBA.
In the most simplest words we can say that financial model’s main objective is derive the dependable variable value from the independent variable value .Independent variable can be external or internal variables.
Financial models are normally prepared for 3-5 years periods .Financial model can have many or less steps as per the requirement of project handled. But normally financial modeling includes following kind of steps normally.
1. Setting objectives:
Setting objectives is the main criteria of creating a financial model. Because if objective is not clear or vague, it will ultimately affect the other stages.. What are the real expectations from the project and how it will help in expansion or useful for the organization. How realistic the model should be. More definite and structure model will be more better.
2. Data Collection:
Data collection include the data collection from external viz a viz internal resources. E.g. A Company wants to set a factory. The data can include availability of power supply, rules regarding power supply according to govt. norms, limit of credit which can be availed by the banks, quality of human resources, financial ability of the organization, maximum loss which can be borne in the initial stages if any, updating in technology etc.
Make a list of all these variable in tabular or graphical form in excel or VBA.
3. Project Development:
In this stage many assumptions are made regarding project. Once an assumption is made, it shouldn’t used again for the whole financial model. The main critical point is to decide who will use the data and how often? Because if the model is to be made for others then it should such setting inclusive so that no one can change the data unnecessarily. Because once a data value changed it will change the structure of whole model.
4. Designing of Model:
As computers can’t think, so the financial model is needed to be prepared in a way that supports the logics and facts. For solving complex problems a detail should be made on paper. It should also be decided that the whole financial model will be made on one single spreadsheet or should be distributed on many spreadsheets.
The necessary reports need to be produced to summarize the whole financial model.
Group all assumptions at one place. Complicated macros should be avoided to the extent possible.
Once it is designed fully, it should be tested whether it really cover everything and objectives. Is it free from all bugs? There is no standard approach to debug the model but still all precautionary measure should be taken. Checking model’s output by hand calculations or excel can be useful in testing the model.
Once a model is created the same should be protected from accidental or unauthorized changes e.g. clustering the input cells can be a good option to hide the data.
After clearing all stages the model should be documented in writing or physical form with details, flow charts, diagrams and figures, so that the creator or user can recall the data and even change it effectively if needed.
Financial modeling is not an easy task. It takes a lot of time and efforts to create it. And if it’s not documented properly, the creator may have to waste a lot of time in understanding the model. Financial modeling is a vital tool and is almost essential for equity stock researchers and other financial prospects.