Do you want to master financial modelling? It’s a highly sought-after and must-have skill if you want to work in some finance careers like investment banking and private equity. As the name suggests, financial modelling is all about creating a digital and simplified representation of a company's past, present, and potential future financial performance.
Such as a virtual replica of a company's financial situation helps in testing different "what if" scenarios that inform strategic business decisions. For instance, it can help a CEO, investor, or advisor get answers to questions such as:
So, learning financial modelling will help you analyze complex financial data, identify trends and opportunities, and communicate your findings effectively to stakeholders. This guide will help you understand the basics including how to learn this skill. Let’s get started!
Financial models work like sophisticated smart calculators. Each model may differ in complexity, but they generally follow a consistent structure with three main components: inputs, calculations, and outputs.
The inputs or assumptions section is where you enter historical data and your best guesses about the future of the business. They are the “what if” scenarios that influence the model’s outcomes. Examples include revenue growth rates, discount rates, and interest rates. In most pre-built models, inputs are color-coded to make them easy to identify and modify.
After feeding the assumptions, the calculations section uses formulas to link them together and calculate different things like revenue, expenses, profits, cash flow, and asset or liability balances. This section usually includes detailed schedules for items like depreciation, debt, and working capital.
Then the outputs section gives the results of the calculations in the form of projected financial statements and key performance indicators (KPIs). These KPIs might include profitability ratios, leverage ratios, and valuation multiples. The outputs provide the answers to your questions and you can play around with different assumptions to see how the results change.
There are various types of financial models since each helps answer different questions. Here are the most common types of financial models:
Discounted Cash Flow (DCF) Model: It estimates the value of an investment or business based on its expected future cash flows, discounted back to their present value using the Weighted Average Cost of Capital (WACC).
👉 Check your knowledge on the DCF analysis in our Valuation Interview Questions for Finance.
M&A Accretion/Dilution Model: Evaluates the financial impact of mergers or acquisitions. It tells whether the deal increases or decreases earnings per share.
👉 Test your technical M&A skills with our "M&A Interview Questions for Finance."
Leveraged Buyout (LBO) Model: Helps private equity firms to understand the profitability and risk of acquiring a company primarily using debt.
👉 Check out our LBO Interview Questions in the Case Library to practice using this model.
A strong financial model follows a clear and structured process. It’s not just about typing formulas into Excel, it’s about answering strategic questions and enabling well-informed decisions. In this section, we’ll walk you through each step from defining the problem to conducting the final analysis.
Step 1: Define the Problem or Opportunity.
As you already know by now, the general purpose of a financial model is to help in decision making by forecasting future performance or valuing a business or asset. So, the first step in building a financial model is to define the problem or opportunity you want to model. What are the key objectives and questions you want to answer?
Your objective determines the model's complexity, required inputs, and appropriate outputs. For instance, if you want to determine if an acquisition is financially viable and at what cost, the questions might include:
These questions naturally lead to building an M&A model with accretion/dilution analysis.
Step 2: Gather Data and Information.
The next step is to gather the necessary data and information to build the model. This includes collecting historical financial data, such as income statements, balance sheets, and cash flow statements. You'll also need to research industry trends, market data, and competitor information to get a comprehensive view of the business.
All this data determines the assumptions and projections you’ll make. So, study it thoroughly to identify patterns, seasonality, and growth trajectories.
Step 3: Structure the Model in a Spreadsheet.
At this point it should be clear what type of financial model you want to build, such as a three-statement model or a discounted cash flow (DCF) model. Then you can follow the general guidelines for building that specific model. However, there are variations of each depending on the level of detail and granularity required, as well as the timeline and forecast period for the model.
So, you’ll decide on the structure of your model based on its purpose and set it up including the sheets, tabs, and sections. Common structures include sections for inputs, calculations, and outputs. You can also use a predefined model template that offers a standardized structure to save time and maintain consistency.
Step 4: Create Assumptions and Inputs.
Once you have the model structure, it’s time to accurately enter the historical financial statements into the designated "Historical Data" tab.
Then develop reasonable projections or assumptions for key business drivers based on historical performance, industry benchmarks, and management guidance. Clearly document the reasoning behind each assumption and cite sources where appropriate. This helps others understand your logic and makes future updates easier.
Step 5: Build the Calculations Engine.
With your assumptions and inputs in place, you can build the calculations portion. This is where you create formulas to link the different parts of the model such as the input assumptions and the projected line items in the income statement, balance sheet, and cash flow statement.
Building formulas involves:
Step 6: Add Scenarios and Sensitivity Analysis.
A financial model should be a dynamic decision tool, not a static one. This is the step that helps with that. Sensitivity analysis, also known as "what-if" analysis, evaluates how changes in key assumptions affect a financial model's outcomes.
Incorporating sensitivity analysis in your model also helps to identify which variables have the most significant impact on financial metrics. So, you’ll need to determine and list which input variables are most critical to the model's outcomes.
Step 7: Review, Test, and Refine the Model.
It's time to review, test, and refine it. Test the model for accuracy, consistency, and completeness. This is the stage where you answer questions like, “Do the model's outputs and results make sense when considering logical reasoning and accounting principles?”
Based on your findings and feedback from stakeholders, you can refine and then deploy it. You'll want to update and maintain the model to reflect changes in the business or market, and continuously refine and improve the model based on user feedback and new information.
Don’t expect to learn financial modelling in an hour, at least if you want to become proficient in it. Mastering how to build financial models includes starting with the basics, mastering Excel or specialized financial modeling software, choosing learning resources, and practising a lot.
➡️ Start with the Basics.
Learning the basics will help you master advanced and technical concepts better. Thus, master the fundamentals of financial modeling, including types of models, how they work, differences, and their applications. You should also aim to:
➡️ Learn Excel Proficiency.
Since most financial models are built in Excel, develop strong Excel skills. Focus on learning:
Choose Learning Resources
Once you have settled the basics, decide what learning resources you will opt for. You may choose online comprehensive courses on financial modeling, certifications, books, and tutorials. The best resources should offer step-by-step guidance on building models and align with your learning methods.
➡️ Practice Building Models.
Theoretical knowledge is great but you must combine it with practice to excel. You can start by utilizing existing financial modeling templates to understand how models are structured. Analyze these templates to learn best practices in organization, formula usage, and presentation.
Then you can build your own financial models from scratch using historical data from real companies. Begin with simple models, such as a basic three-statement model, and gradually increase complexity by incorporating advanced features like scenario analysis and sensitivity analysis.
If you want to create more accurate, reliable, and effective financial models, be aware of the following common mistakes and avoid them.
Financial modelling is an important skill in finance careers, especially investment banking and private equity. Building financial models is like creating virtual replicas of a company using numbers, formulas, and assumptions.
These models make it easy to test different “what if” scenarios that help to make decisions like funding, resource allocation, and operation strategies. Learning financial modeling involves gaining theoretical knowledge, practical skills, and hands-on experience. So, choose your learning resources wisely and practice extensively. You can build financial models in Excel, although there are specialized financial modeling software out there.
