Financial modeling, often considered synonymous to financial statement forecasting, is an effective tool for providing a clear picture of the forecasted financial performance of a company. The process results in the construction of a mathematical model that assists in firm’s decision making as well as financial statement analysis.
Financial modeling skills, therefore, refer to the talent of converting a set of assumptions, which any company makes regarding the market behavior, into numerical predictions. It is the ability of an individual to perform calculations and construct a simplified financial representation of one or more aspects of any given firm. These skills encompass simulating the impact of certain variables such that the company has planned course of action in case they actually occur.
Why is financial modeling important
The importance of financial modeling is mainly rooted in its capability to enable better financial decisions within a firm. It is widely used by organizations for the purpose of future planning. By simulating the impact of important variables, financial modeling allows for scenario preparation so that organization knows its course of action in various situations that may arise.
Financial modeling also plays an important role in capital budgeting. Not only does it make financial statement analysis and resource allotment for the next big investment easier, but it also helps in determining the cost of capital. It provides a thorough analysis of debt/equity structure for this purpose, along with the returns expected by investors.
How to improve financial modeling skills
Whether you believe in the use of pen and paper for the construction of a financial model, or computer software, following are some tips that can help you improve your financial modeling skills:
- Understand that no one right way exists. Even if the same person were to create a set of models for two different companies, they would vary. So, if you have been spending countless hours under the pressure of making the models “right”, this is your time to feel relieved. The approach towards its development and the model itself vary for each company due to individual preferences, level of complexity demanded by the firm (i.e. how detailed it needs to be), and the varying assumptions undertaken by every firm.
- Align your model with researcher’s views. In order to improve your financial modeling skills, it is important that you ensure the ultimate consistency of the model with the views and expectations of the researcher regarding their firm’s future performance. Instead of undertaking a purely number-crunching task, this process should be considered more of a logical reasoning exercise.
- Make it simple to understand. As mentioned (in tip # 01), the complexity of models varies depending upon the level of details and elaborated calculations involved. However, despite the inevitable complexities, there are ways in which the model can be kept simple to understand. For instance, you can differentiate the assumptions involved in the model from all the calculated figures by listing all assumptions at one place or using different font colors etc. This prevents misunderstandings quite often.