To rightly earn the title “Master of Business Administration” (MBA), one must know the ins and outs of business management. While there are various units within an MBA, financial modeling is one of the most important aspects of a business. On that note, MBA graduates are expected to come into the marketplace with advanced knowledge of some of these vices.
What is Financial Modeling?
This term bears different meanings to different users but no matter how you look at it, it all culminates into one thing; the preparation of specific mathematical models used to aid in decision making and financial analysis purposes. It is the art of combining finance, accounting, and business metrics to create an absolute representation of a company’s future. This is mainly done in excel sheets and by applying several mathematical models, one is able to evaluate the company’s financial position and even predict its future.
The industry is pro spreadsheets and knowing your way around one is beneficial. In essence, the in-depth knowledge of MS Excel is mandatory for any MBA graduate. Business Management is basically a decision-making position and walking into the market straight from college requires that you are well equipped to handle what the business world throws at you.
Who Builds Financial Models
There are many career paths in financial modeling:
- Investment Banking- Analysts and Associates build financial models that deal with mergers, acquisitions, and capital banking.
- Equity research- Analysts and Associates make recommendations about which companies to invest in. This is a process that requires the application of a fully functional financial model.
- Private Equity- Analysts and Associates build models to decide which companies a private equity firm should acquire and how much the acquisition should cost them.
- Credit analysts need models to figure out how much money they can lend into a business.
- Financial Planning and Analysis- Analysts and Managers need models to forecast and plan an operating company.
- Corporate Development- Analysts and Managers at an operating company need models in order to access mergers and acquisitions.
In-depth Look at the functions
This is the skill of applying a chosen set of procedures in order to determine the economic value of a business. Knowing the value of a business places one in a better position to know how much you can sell a particular business or how much another costs and if it would be worth the trouble of purchasing it.
This is usually at an operating company where the finance, cooperate development, treasury or any other group in the company have a model that they use to make decisions in the business. A great model will help answer questions of “how”, “when” and “what” based on previous performance records as indicated in the excel sheet. Such a form will help give an estimate of future expectations and hence be a valuable guide in decision making.
Having a good financial model in place will help you determine whether to take on huge investment ventures in a bid to increase the valuation of the business to the investors. It helps one figure out what machinery to purchase, which property to acquire etc. all by revealing the financial situation of the company and showing future projections.
Financial statement analysis
Keeping tabs on your financial situation is the whole point of Financial Modeling. This is basically the entire driving force of the business. The management should have an idea of how much cash is flowing in and how much is flowing out and to where. This step enables the company to figure out its week points and its strengths and allows for the appropriate steps to be taken.
This is the process of determining the allocation of financial support for a project based on estimated figures of the said project. This process includes risk identification and allocation which may be dependent on external forces based on project location. Well outlined records will help your sponsors make an informed decision of whether to invest in your project or not.
Cash flow forecasting
Keeping a keen eye on your cash flow is important to all businesses be it a large corporation or a small business. An effective financial model will ensure that all important sectors are covered and that none is left unattended. This will help you spot a situation from afar and ensure it is dealt with before it becomes a problem. Well-kept cash flow records will appeal to any entities looking to invest in your business and therefore this is an important and disciplined venture of financial modeling.
A financial model is important while evaluating securities in the event of either issuing more shares or debt. Applying various models, for example, the “constant growth model”, one is able to calculate the market price for equity securities.
Assessing Mergers and Acquisitions
A well utilized financial model will help a manager determine the pros and cons of undertaking either a merger or an acquisition. Evaluating such a process will tell one beforehand of the prospects of increasing or downsizing a company.
Steps in Building a Model
Step 1: Historical Data
Take three years of data and input it into excel.
Step 2: Ratios and Metrics
Calculate historical ratios and metrics like margins, growth rate, inventory change, asset turnover. By studying past performance you might get a good idea of what the future holds.
Step 3: Assumptions
Once you have a good idea of your company’s past performance, you are in a better position to make assumptions of the future based on margins, growth rate, capital spending, etc.
Step 4: Forecast
The assumptions lead to a forecast which is basically three financial statements all linked together in excel. It is a future foretelling of around three to five years.
Step 5: Valuation
The most common form of valuation is the discounted cash flow analysis method.
Step 6: Additional Analysis
This is the stage where you feature sensitivity, scenarios, graphs, dashboards, charts, etc.
Characteristics of a good financial model
- Well-structured with an easy to follow layout
- Easy to understand
- Drivers and assumptions should be well laid out and clearly labeled
- All calculations have to be correct
- Focus on important issues
- Make use of visual outputs
Financial Modeling can only be learned in practice. The above is a basic guide of what it is and its functions within the business world. As an MBA graduate, a better way to appeal to your employer and stand out from your peers is by taking an in-depth financial modeling course. Pick a field and specialize because most MBA courses teach basic excel knowledge and as indicated above, you will need more than the basics to cut it in the marketplace.
David is a seasoned Marketing Analyst and writer at https://admissionsroadmap.com/gmat-101/