Financial Modeling

We get many questions about what “financial modeling” means, how important it is in the finance industry, and why so many students and professionals are obsessed with learning it.

So, let’s start with the basic definition:

Financial Modeling Definition: A financial model is a spreadsheet-based abstraction of a real company that helps you estimate the company’s future cash flows, financing requirements, valuation, and whether or not you should invest in the company; models are also used to assess the viability of acquisitions and the development of new assets.

Suppose that your crazy rich uncle calls you and tells you about his latest investment: a tequila company into which he just “poured” $100,000.

He shares data about the company’s sales, employee count, and market share, and then he claims that his $100,000 investment will be worth $1 million in 5 years.

He then gently encourages you to put your life savings into this tequila company.

A robust financial model lets you input these parameters, project the company’s future cash flows, and assess the likelihood of your uncle’s $100,000 investment turning into $1 million in 5 years.

Financial models cannot predict any outcome with a high degree of certainty.

The goal is to be “roughly correct” rather than “precisely wrong.”

If a financial model tells you that a company is undervalued by 5% or 10%, that is a meaningless result because the margin of error is so high.

But if the model tells you that the company is undervalued by 90% or overvalued by 200%, those are much more useful results.

Even if you’re wrong about the percentages, you can still make money if you are directionally correct.

Returning to this tequila company example, perhaps your model produces the following results for your uncle’s $100,000 investment:

• $1 million in 5 Years: This would require the tequila company to grow from 1% to 10% market share in a very crowded market within 5 years. Alternatively, the company could also get there by selling its tequila at 3x the normal price and capturing 3% of the market.
• $500,000 in 5 Years: This would require the company to win 5% market share within 5 years or sell its tequila at 2x the normal price while capturing 2% of the market.
• $200,000 in 5 Years: This would require 3% market share within 5 years or tequila sold for 2x the normal price and 1% of the market (the same as the current share).

What’s the conclusion?

It’s unlikely that your uncle’s $100,000 investment will turn into $1 million within 5 years because the required pricing and market share are unrealistic.

We can’t assign a specific probability to this outcome, but we can say that no food & beverage company in history has ever achieved this performance in this time frame.

Therefore:

1. If the company does achieve this performance, it will likely take more than 5 years.
2. And the other outcomes here, especially the last one, are more plausible.

Doubling or quintupling your money over 5 years is still a great result, so you might take your uncle’s advice and invest some amount.

Or, perhaps you do further research into the company and its market, become more skeptical, and decide against investing.

A financial model is just a PART OF the investment process; it’s like a piece of evidence in a courtroom murder trial.

It can help persuade others that you are correct, but a spreadsheet by itself doesn’t solve the case or convince everyone on the jury.

There are 4 main categories of financial models used at normal companies, investment banks that advise companies on transactions, and investment firms:

• Category #1: 3-Statement Models (Income Statement, Balance Sheet, and Cash Flow Statement) or “Budgets” at normal companies
• Category #2: Valuations and DCF Models (Discounted Cash Flow Models)
• Category #3: Merger Models (also known as M&A Models or Accretion/Dilution Models)
• Category #4: Leveraged Buyout Models (slight variations include the Growth Equity Models and “Investment Models”)

3-Statement Models

In these financial models, you project a company’s revenue, expenses, and cash flow-related line items, such as the Change in Working Capital and Capital Expenditures.

You then use these numbers to forecast the company’s financial statements, i.e., its Income Statement, Balance Sheet, and Cash Flow Statement, over several years.

The Income Statement shows a company’s revenue, expenses, and taxes over a period of time and ends with its Net Income (i.e., its after-tax profits).

The Balance Sheet shows a company’s Assets, or its resources that will deliver future benefits, and its Liabilities & Equity, or its funding sources that have direct or indirect “costs.”

The Cash Flow Statement provides a reconciliation between a company’s Net Income and the cash it generates, which is often quite different.

For example, accounting rules state that cash outflows for spending on long-term items such as factories and properties should not appear directly on the Income Statement because these items could be useful for many years.

So, companies record the cash outflows for this spending as “Capital Expenditures” on the Cash Flow Statement.

If a company buys a new factory for $100 million, its cash flow is reduced by $100 million – but you wouldn’t know it by looking at the Income Statement.

The company’s Income Statement only shows the “Depreciation” representing the allocation of this $100 million over many years.

For example, if the factory is expected to be useful for 20 years, the company might record $100 million / 20 = $5 million of Depreciation per year on its Income Statement.

The Cash Flow Statement records all the cash inflows and outflows, which gives you a full picture of the company’s business health.

It prevents companies from hiding behind non-cash revenue and expenses that might distort their Income Statement.

These 3-statement models are widely used at normal companies for budgeting purposes and at banks and investment firms to assess companies’ financing requirements.

For example, a 3-statement model might tell you that a company will need additional capital in 3-4 years to continue its aggressive expansion strategy:

If a company has already borrowed money, a 3-statement model might tell you how well it can repay that Debt over the next 5 years.

3-Statement Model Examples

Here are a few examples of 3-statement models:

• Illinois Tool Works – Sample 3-Statement Modeling Test and Tutorial
• Industrials Investment Banking – Screenshots from an airline 3-statement model
• Healthcare Investment Banking – Screenshots from a bio/pharma 3-statement model

Valuations and DCF Models

In valuation models, you estimate the range of values an entire company might be worth today.

For example, if a public company’s market capitalization (market cap) is $10 billion, is it overvalued, undervalued, or appropriately valued?

Should it be worth closer to $5 billion, or something closer to $15 billion?

Valuations are designed to answer these questions.

You can value a company using different methodologies, but two of the most important ones are the Discounted Cash Flow (DCF) analysis and trading multiples, also called “comparable companies,” “public comps,” or “comparable company analysis.”

In a DCF, you project a company’s cash flows far into the future (5, 10, or even 20+ years) and discount them to their “Present Value” – what they’re worth today, assuming that you could invest your money elsewhere at a certain rate of return.

With trading multiples, you calculate other companies’ values relative to their financial metrics, such as revenue or profits, and you apply those “multiples” to value your company.

For example, if similar companies are worth 3x their annual revenue, and your company has revenue of $200 million, perhaps it should be worth about $600 million.

In a DCF model, similar to the 3-statement models above, you start by projecting the company’s revenue, expenses, and cash flow line items.

Unlike 3-statement models, however, you do not need the full Income Statement, Balance Sheet, or Cash Flow Statement.

Many of the items on these statements are non-recurring or have nothing to do with the company’s core business, so a partial Income Statement and Cash Flow Statement are sufficient:

This approach saves time and results in nearly the same output in most cases.

Valuation and DCF Model Examples

You can get examples of valuation and DCF models below:

• Comparable Company Analysis
• Uber Valuation
• Snap Valuation
• DCF Model – Walmart Valuation

The Walmart example also explains the “big idea” behind valuation and DCF analysis.

Merger Models (AKA M&A Models or Accretion/Dilution Models)

A merger model is different because it involves two companies rather than one.

The goal is to assess whether a larger company’s acquisition of a smaller company provides a financial benefit.

For example, will the acquirer’s Earnings per Share (EPS), defined as Net Income / Shares Outstanding, increase after the acquisition closes?

Will the acquirer’s valuation increase after it acquires the target company and properly integrates it?

Is the acquirer paying a fair price for the target based on the financial metrics of both companies?

If the acquirer is issuing new stock (shares) to acquire the target, will each company own appropriate percentages after the deal closes?

Merger models are designed to answer these types of questions.

Similar to valuations and DCF models, you do not need a company’s full Income Statement, Balance Sheet, and Cash Flow Statement to build a merger model.

You just need the Income Statement and a partial Cash Flow Statement for the acquirer and the target:

More complex merger models often include the full financial statements, but they’re not required for a basic analysis.

Other key assumptions include the price paid for the target, the form of consideration (Cash, Debt, or New Shares Issued), and the expected synergies (ways for the combined company to cut costs or increase sales).

As with all other financial models, a merger model is just one piece of evidence in the process of negotiating a deal.

A company’s Board of Directors would never approve of an acquisition solely because of a merger model’s output.

There must be other perceived benefits, such as strategic, market, and competitive advantages from the deal.

For example, maybe the target company gives the acquirer access to a high-growth market that would have taken years to enter independently.

Or maybe the target company has valuable intellectual property (IP) that the acquirer cannot easily develop on its own.

M&A and Merger Model Examples

You can view a few sample M&A and merger model tutorials below:

• Merger Model Walkthrough: Combining the Income Statements
• Merger Model: Cash, Debt, and Stock Mix
• Merger Model Interview Questions: What to Expect

Leveraged Buyout Models (AKA Growth Equity Models or “Invest Models”)

This last category is a variation on the first category (3-statement models).

We’re listing it separately because most people consider them separate, despite the similarities.

In leveraged buyout models (LBO models), the goal is to calculate the multiple or annualized rate of return you could earn by investing in a company, holding your stake, and eventually selling it.

For example, if a private equity firm acquires a company for $1 billion, operates it for 5 years, and sells it, could it potentially earn an average annualized return of 20%?

Or would that require implausible assumptions, such as the company going from a 10% profit margin to a 30% margin within 5 years?

The full financial statements are not required for these models because the investment returns are linked primarily to the company’s cash flow and cash flow growth rate.

And the “exit value” when the company is sold is usually linked to metrics that act as proxies for cash flow, such as EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization).

As with the other models above, you start building an LBO model by projecting the company’s revenue, expenses, and cash flow line items.

These give you a sense of the company’s Free Cash Flow, or the cash it generates from its core business operations after paying for funding costs, such as interest on Debt:

Based on the purchase price, the exit value, and the cash flows generated in the holding period, you can calculate the multiple of invested capital (MOIC) and the internal rate of return (IRR), also known as the average annualized return.

This model is known as an LBO model or leveraged buyout model because private equity firms use a combination of Debt and Equity to fund acquisitions of entire companies.

It’s similar to buying a home using a down payment and a mortgage, but on a much larger scale.

The private equity firm operates the company, uses the company’s cash flows to repay the Debt, and sells the company after several years.

The need to track this Debt repayment and the associated line items makes the Excel formulas more complex than those used in a standard 3-statement model.

If the private equity firm does not use Debt, the model is much simpler because you need only the cash flow projections, the purchase price, and the exit value.

This variation is often called a “growth equity model” or simply an “investment model.”

Regardless of the model variation, though, the goal is always the same: determine plausible ranges for the multiple of invested capital and the annualized returns.

You can get example LBO models, growth equity models, and leveraged buyout tutorials below:

• Growth Equity: Full Tutorial and Sample Case Study
• Simple LBO Model – Case Study and Tutorial
• IRR vs. Cash-on-Cash Multiples in Leveraged Buyouts and Investments

In addition to the categories above, there are also specialized financial models in industries such as commercial real estate, project finance, and infrastructure private equity.

In these industries, financial modeling is based 100% on cash flows rather than accounting profits, so the three financial statements are not used.

Revenue and expense projections also differ significantly.

For example, in real estate financial modeling, revenue and expenses are based on individual tenants and the terms of their leases, including annual rent escalations, the expenses paid by the tenant, and the probability of leases expiring.

In project finance and infrastructure, the projections are often based on individual contracts as well – and there may be hundreds or thousands of them.

Another difference is that in addition to modeling the acquisitions of existing assets, you may also model new developments in both these industries.

To do that, you assume that a new development initially draws on Equity (i.e., cash from outside investors) and then switches to Debt once a funding threshold has been met.

When the asset is under development, it does not generate cash flow, so the interest and fees on this Debt are capitalized.

Once the development is complete, a loan refinancing occurs, the construction lenders are repaid, and new lenders fund the stabilized asset.

Specialized Financial Models for Real Estate and Construction

If you want examples of these specialized models, please see our coverage below:

• Real Estate Financial Modeling
• The Real Estate Pro-Forma
• Infrastructure Private Equity
• Project Finance Jobs

There are model variations in other industries as well.

For example, with oil & gas companies, the Net Asset Value (NAV) model is a variation of the traditional DCF analysis that does not have a Terminal Value – because oil & gas assets have limited economic lives.

Once enough oil or gas is extracted from a field, further extraction is no longer economically viable – even if some resources remain in the ground.

The asset is effectively “dead” until market conditions change.

Therefore, you cannot assume that the asset will keep generating cash flows indefinitely into the future.

With banks and insurance companies, there are DCF variations such as the Dividend Discount Model (DDM) and the Embedded Value (EV) model for life insurance.

These models have some differences, but they still value companies based on their future cash flows or proxies for cash flow, such as dividends.

The financial models described here are widely used in the following industries:

If you look at the articles above, you’ll see compensation estimates for fields such as investment banking, private equity, and hedge funds.

As a senior professional in these industries, you can earn $1 million+ if you count the base salary, bonus, and other incentive-based compensation.

However, you rarely do “financial modeling” at the senior levels in these fields.

Senior-level roles are almost always sales or negotiation jobs, where your role is to generate revenue by bringing in new clients, raising capital, or closing deals.

Most of the financial modeling is done by junior-to-mid-level professionals, such as Analysts, Associates, and Vice Presidents.

The total compensation for these roles might range from $100K USD on the low end up to $500K USD depending on the industry, firm size, and location.

For example, Investment Banking Analysts often earn total compensation in the $150K – $200K USD range in major financial centers in the U.S.

Private Equity Associates might earn $150K up to $300K or even $350K, depending on the firm.

And a Vice President will progress toward mid-six-figure compensation.

Outside of these fields, financial models are used in other industries, such as corporate finance, corporate development, and Big 4 Transaction Services.

The compensation in these fields is lower than the ranges quoted above; for more details, please click through to the links above.

If you poke around online, you’ll see a wide range of opinions on the importance of financial modeling:

• Some people claim you need to know it perfectly, even for entry-level interviews and internships.
• Others say that it’s overhyped and not that important; they point out that many groups are not especially technical and do not do much Excel-based modeling.
• And others say it’s only important for the “exit opportunities” following investment banking, such as private equity.

As usual, the truth is somewhere in the middle.

You do not need to know financial modeling “perfectly” for entry-level interviews and internships, but you do need a solid base of technical knowledge to be competitive.

For example, how do the 3 financial statements link together? How do you set up a DCF and use it to value a company? What are the trade-offs of different valuation methodologies?

You could memorize the answers to these questions, and that might work to some extent.

But the best way to mastery this technical knowledge is to learn and practice financial modeling. It’s the difference between passively listening to a foreign language and actively practicing by speaking and writing in that language.

Financial modeling matters less for the direct benefit and more for the indirect benefit of mastering the accounting, valuation, and transaction analysis concepts that you’ll be asked about in interviews.

It is true that certain groups in investment banking, such as equity capital markets, do not do much financial modeling work (they spend more time in PowerPoint and Word creating market updates).

But in interviews, they’re still going to test you on the key technical concepts.

Finally, it’s also true that financial modeling is more important in some fields than it is in others.

For example, modeling skills do not matter much in early-stage venture capital investing because investing in startups is a much more qualitative process.

An early-stage startup does not have cash flows to model, and the founder’s personality and drive matter more than any spreadsheet.

But modeling skills matter more at late-stage VC firms and private equity firms since they invest in mature, established companies.

If you want to learn the fundamentals of the DCF analysis, one of the most important models, you can sign up for our free 3-part tutorial series below:

• 3-Part Financial Modeling Series: The DCF

This series walks you through each step of the analysis, from projecting the company’s Unlevered DCF to estimating its Discount Rate and Terminal Value.

If you want tutorials on other topics, you can also consult our YouTube channel for hundreds of examples:

• YouTube – Financial Modeling

Finally, if you want comprehensive, structured training that teaches you financial modeling from the ground up, our Financial Modeling Mastery course or the BIWS Premium package (which includes Financial Modeling, Excel, and PowerPoint training) are your best bets:

• Breaking Into Wall Street Investment Banking Courses

These courses are for candidates who are serious about winning internships and full-time offers at banks, private equity firms, and hedge funds by spending significant time preparing.

If you have no interest in working at these firms and you just want quick tips and tricks, these courses are not appropriate for you.

But if you want to gain the technical skills of someone who has several years of work experience, they are perfect.

Of course, there’s more to the job than Excel-based analysis, but mastering the technical side goes a long way toward the rest of the skills.