How to Build a Financial Model From Scratch

A financial model is a structured tool used to represent an organization’s financial performance and position, typically over a future period. Its primary purpose is to project future financial outcomes based on various assumptions, enabling informed decision-making. By simulating different scenarios, these models help in evaluating business strategies, assessing investment opportunities, and understanding the potential impact of operational changes. They provide a quantitative framework for analyzing past performance and forecasting future financial health, offering insights into profitability, liquidity, and solvency. This analytical approach supports strategic planning and helps in anticipating financial needs or surpluses.

Gathering Foundational Data and Assumptions

Building a financial model begins with collecting historical financial data, which serves as the baseline for future projections. This includes detailed historical Income Statements, Balance Sheets, and Cash Flow Statements, spanning the past three to five years. From the Income Statement, key line items such as revenue, cost of goods sold (COGS), selling, general, and administrative (SG&A) expenses, research and development (R&D) expenses, interest expense, and income tax expense are essential. Understanding the historical relationships between these items, such as COGS as a percentage of revenue, provides insights for forecasting.

For the Balance Sheet, data points like cash and cash equivalents, accounts receivable, inventory, property, plant, and equipment (PP&E), accounts payable, accrued expenses, short-term debt, long-term debt, and equity components are gathered. Analyzing trends in working capital accounts, such as days sales outstanding, inventory days, and days payable outstanding, is important for projecting future working capital needs. The historical Cash Flow Statement provides a record of cash generated from operating, investing, and financing activities, which helps in understanding past cash flow patterns and linkages between the income statement and balance sheet.

Beyond historical financials, a comprehensive set of operational and economic assumptions is required to project future performance. These include revenue growth rates, based on market analysis or company-specific strategies, and cost assumptions like COGS as a percentage of revenue or fixed operating expenses. Capital expenditure plans are incorporated, along with the depreciation method and useful lives of assets for calculating depreciation. Debt financing terms, including interest rates and repayment schedules, are also important for projecting interest expense and debt balances.

Considerations for equity, such as potential share issuances or repurchases, also inform the model. The applicable income tax rate must be applied to taxable income. These assumptions are derived from a combination of internal company plans, industry reports, economic forecasts, and management discussions. Common sources for this foundational data include publicly available financial reports, internal accounting records, and third-party market research.

Building the Integrated Financial Statements

With the foundational data and assumptions in place, the next step involves constructing the integrated financial statements, beginning with the Income Statement. Revenue is projected first, based on assumed growth rates applied to historical figures. Cost of goods sold and operating expenses, such as selling, general, and administrative costs, are then forecast, often as a percentage of revenue or with specific growth rates. This leads to the calculation of gross profit, operating income, and, after accounting for interest expense and taxes, the net income.

The Balance Sheet is constructed by projecting each asset, liability, and equity account. Current assets like accounts receivable and inventory are linked to revenue or COGS using historical turnover ratios or assumed days. Property, plant, and equipment (PP&E) are projected by adding new capital expenditures and subtracting depreciation expense. Current liabilities such as accounts payable are also linked to COGS based on payment terms. Debt balances are updated based on new borrowings and scheduled repayments, while equity accounts reflect net income, dividends, and any stock issuances or repurchases.

The Cash Flow Statement is then built using the indirect method, which begins with net income from the Income Statement. Adjustments are made for non-cash items, primarily depreciation and amortization, which were subtracted on the Income Statement but do not represent cash outflows. Changes in working capital accounts, derived from the Balance Sheet, are then incorporated to arrive at cash flow from operations. Cash flow from investing activities includes capital expenditures and asset sales, while financing activities cover debt issuances or repayments and equity transactions like dividends.

The integration of these three statements is important, as they are linked. Net income from the Income Statement flows into the equity section of the Balance Sheet and serves as the starting point for the Cash Flow Statement. Changes in Balance Sheet accounts directly impact the Cash Flow Statement, and cash flow from the Cash Flow Statement becomes the new cash balance on the Balance Sheet. This interconnectedness creates circular references, such as interest expense on the Income Statement affecting net income, which impacts cash, which can then influence debt levels and thus future interest expense. Spreadsheet software handles these circularities through iterative calculation settings, allowing the model to converge on a stable solution.

Developing Forecasts and Valuation Modules

Once the integrated financial statements are built for historical periods, the model is extended to project performance over a detailed forecast period, ranging from five to ten years. This involves systematically applying the growth rates, margin assumptions, and working capital assumptions established earlier to project revenue, expenses, assets, and liabilities throughout this period. The objective is to create a comprehensive forward-looking view of the company’s financial trajectory. Beyond this detailed period, a terminal period is incorporated to capture the value generated by the business indefinitely, as it is impractical to project every year individually.

The projected financial statements then serve as the foundation for various valuation methodologies, with the Discounted Cash Flow (DCF) method being a primary approach. This method involves calculating the company’s free cash flow (FCF), which represents the cash available to all capital providers after all operating expenses and reinvestments are accounted for. Free cash flow is derived by taking Net Operating Profit After Tax (NOPAT), adding back non-cash expenses like depreciation and amortization, and then subtracting capital expenditures and the change in net working capital. These projected free cash flows, both from the detailed forecast period and the terminal period, are then discounted back to the present day using an appropriate discount rate, the Weighted Average Cost of Capital (WACC), which reflects the average cost of financing a company’s assets.

The calculation of the Weighted Average Cost of Capital considers the proportion of debt and equity in the company’s capital structure and their respective costs. The cost of debt is influenced by prevailing interest rates and the company’s creditworthiness, while the cost of equity is estimated using models that consider market risk and the company’s specific risk profile. The sum of these discounted free cash flows represents the intrinsic value of the business. Other valuation methods, such as comparable company analysis or precedent transactions, can also be used to cross-check the DCF valuation, providing additional context for the model’s output.

Integrating sensitivity analysis into the model allows for an understanding of how changes in key assumptions impact the valuation. This involves building in switches or input cells that allow users to easily adjust variables such as revenue growth rates, operating margins, or the discount rate. By altering these inputs, the model can instantly recalculate the resulting valuation, illustrating the range of potential outcomes. This capability helps in assessing risk and understanding which assumptions have the most significant influence on the final valuation.

Analyzing and Communicating Model Results

After completing the construction of the financial model, a thorough review and error-checking process ensures its accuracy. This involves verifying that the Balance Sheet balances in all projected periods, which is a key check for any financial model. Reconciling the cash flow statement with changes in the balance sheet and net income is another step to confirm the logical flow of funds. Common sense checks on the model’s outputs, such as reasonable profit margins, adequate cash flow generation, and manageable debt service coverage ratios, help identify any illogical results that might stem from incorrect assumptions or formulas.

Scenario analysis is then performed by adjusting key assumptions to explore a range of potential outcomes beyond the base case. This involves creating an “upside” scenario with more optimistic assumptions (e.g., higher revenue growth, better margins) and a “downside” scenario with more conservative assumptions (e.g., lower growth, increased costs). By running these different scenarios, decision-makers can understand the potential variability in financial performance and valuation under different operating environments. This provides a more comprehensive view of risk and opportunity than a single forecast.

Interpreting the model’s outputs involves analyzing the projected financial performance indicators, such as revenue growth, earnings before interest, taxes, depreciation, and amortization (EBITDA), and net income. Key financial ratios, including liquidity ratios (e.g., current ratio), solvency ratios (e.g., debt-to-equity), and profitability ratios (e.g., return on equity), are calculated to assess the company’s projected financial health. The valuation figures, particularly the equity value derived from the discounted cash flow analysis, are important for investment decisions.

Effectively communicating the model’s insights is important for its use. This involves distilling complex financial projections into clear, concise summaries that highlight the most important findings and their implications. The key assumptions driving the results should be clearly articulated, and any sensitivities to changes in those assumptions should be presented. The goal is to provide a comprehensive yet accessible overview of the company’s projected financial future, enabling stakeholders to make informed strategic and investment decisions based on the model’s analytical framework.