Financial Modeling

Financial modeling

Financial modeling is the process of building a model to forecast a company's future financial performance by combining historical data with assumptions about future conditions.

It is used to create a numerical representation of a company's financial situation to support decision-making, such as:making investment, raising capital, or evaluating potential acquisitions.

These models are typically built in a spreadsheet and can project future revenues, expenses, cash flows, and company valuation. 

Key assumptions:

1) Revenue: revenue growth rate, pricing strategy, sales volume and mix (businesses selling multiple products), customer metrics 

2) Cost and expense: COGS, operating expenses (SG&A, R&D), cost inflation (all as % of revenue/fixed/inflated amount) (because as revenue grows, so does cost)

3) Capital structure & financing: PPE, D&A, debt and equity financing, dividend policy

4) Working capital: AR, AP and inventory

-AR days=365/AR turnover ratio (Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable)

-Inventory days= Inventory turnover ratio*365 (Ratio= COGS/average inventory)

5) Macroeconomic & valuation: tax rate, WACC (if DCF), economic conditions (inflation, interest rate, GDP, forex), terminal growth rate 

Book value vs Market value

Book value is a company's asset value based on its historical accounting records (assets minus liabilities), while market value is the current price an asset or company's stock would sell for in the open market, driven by supply, demand, and investor sentiment.

Book value is static, found on the balance sheet, whereas market value is dynamic and fluctuates constantly based on market conditions and expectations. 

Free cash flow

To calculate free cash flow (FCF), subtract a company's capital expenditures from its operating cash flow.

The formula is: FCF = Operating Cash Flow - Capital Expenditures.

This calculation shows the cash a company generates after accounting for investments needed to maintain or expand its assets.  

Modeling depreciation

To model depreciation, create a separate depreciation schedule linked to the capital expenditure (CapEx) schedule. First, project future capital expenditures and the useful life for each asset.

Then, calculate the annual depreciation expense for each asset using a chosen method, such as straight-line, and sum them to get the total depreciation for the period.

This total is then linked to the income statement and cash flow statemen

Assumptions

Assumptions in financial modeling are the explicit or implicit inputs, estimates, and parameters about future business and economic conditions that drive a model's forecasted outputs.

These assumptions are the foundation of all projections, such as revenue, expenses, and cash flows, and are typically based on historical data, market research, industry benchmarks, and strategic plans.