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What is Financial Modeling?
I am a solo consultant who specializes in financial modelling. Financial modelling is not a tool or a spreadsheet; it’s more like a skillset.
I like to compare it with presenting. There are many different types of presentations; depending on the topic and audience, we select the style of the slides and the content design and adjust our presentation style. A TED talk-style presentation is quite different from a board meeting presentation.
Similar it is with financial modelling. It’s a skillset we apply to answer specific questions a client or coworker may raise regarding a project, an investment, a business decision or even a startup.
So, we build a financial model to answer a particular set of questions. But depending on the questions, our modes can range from a simple break-even calculation to a complex financing deal for an infrastructure project.
I will explain it by showing you a few different examples of financial models I build. It will give you a better understanding of what this skill includes.
Defining a financial model
When building a new model, it’s essential to understand the client’s requirements; otherwise, the modelling process will be a never-ending task.
I divided them into 5 different areas, which we clearly defined at the beginning of the modelling process.
Purpose
What is the core question the model should answer? What are the essential values we would like to know? Are there different scenarios to be considered? What would it be if you could only get one insight from the model?
Scope
Which timeframe would you like to evaluate? Which products or departments should be included. What external factors may impact the result of the model and be considered?
Complexity
At what level of detail do you want your results to be based? Should each product be forecasted or consultation on product groups? When considering the operations of a business or project, which aspects should the model cover?
Audience
With whom is the model shared? How is the person that makes the adjustments to the assumptions? Will it be shared with external investors or banks? What level of financial knowledge does the audience have?
Output
How should the results be presented? Do we share the whole calculation file or create 1 summary page with the core results? Is this model part of a formal bidding process or included in fundraising activities? What languages should be considered?
As you may have guessed by the questions, a model can differ depending on the purpose, scope, complexity, audience and output format.
Three simplified examples
Here are three simplified examples from my past models.
- Fundraising for a SaaS Business
- A new product line of an existing business
- Funds investment in a warehouse
Fundraising for a SaaS Business
Purpose: Show investors the earning potential and identify the funding needs for the first 18 months.
Scope: Model 5 years, including the complete set of financial statements
Complexity: Show the pricing model selected and the user acquisition cost from different channels in detail. A detailed hiring plan and other costs are summarized on a higher level.
Audience: VCs and Angel Investors
Output: A lean annual financial forecast statement in Excel with some charts related to SaaS KPIs and User Growth.
A new product line of an existing business
Purpose: Evaluate the potential costs and risks of a new product line.
Scope: 10-year P&L, Operating Expenses and Capex shown. No financing needed
Complexity: Show detailed operating expenses, break-even analysis and unit economics at different output levels. The worst-case scenario would mean a Product Flop, showing potential losses.
Audience: Company Board & Management Team
Output: Slidedeck with details on cost, PDF printout of the model as an attachment.
Funds investment in a warehouse
Purpose: Evaluate potential RoI & IRR at the current quote price
Scope: 20-year holding period, Project Finance Model
Complexity: Operational level simulated, mainly lease duration from different tendents. Detail debt financing schedule, CAPEX Schedules and potential operational risk (Utilization, Price per SQM)
Audience: Investment Board, Partner Bank, 3rd Party Investors
Output: Detailed Financial Model, with documentation and detailed report on the selected assumptions. Excel File, Printour PDF & Dataroom.
Another definition of financial modeling
As you can see, these are 3 very different financial models. Still, each model is generally designed to answer a particular set of questions based on a predefined scope and purpose.
To summarise, a financial model is a calculational framework designed to calculate particular values based on a wide range of assumptions and calculation logic.
Or how I tell my friends, “I make calculations in Excel”.
Building blocks of a financial model
Fundamental Structures
This is the core building structure of the model; it defines the overall structure of the timeline and the elements needed for calculations.
- 3 Statement model
- Project Finance
- Business Case
- Individual Calculation
Calculation Blocks
- Revenue Model
- COGS Model
- Opex
- Capex
- Working Capital
- Financing
- Equity
Add on calculations
- Valuation Concepts (DCF, Multiples, Growth Models, etc.)
- Scenario Analysis
- Sensitivity Analysis
- M&A, Synagies Modeling
- Operating Models
- Break-Even Analysis
- Unit Economics
In practice, we first define the structure, then build the calculation blocks, and last apply the needed additional calculations into the model. As shared before, depending on the model’s scope, we will have a wide range of complexity here.