Advanced Financial Modeling. Unit 1

Transcription

1 Advanced Financial Modeling Unit 1

2 Introduction to Financial Modeling What is Financial modeling Recap of Major Functions in Excel Accuracy, Flexibility and User Friendliness of Models Model objectives, setting up models Identifying Inputs and Variables Defining Deliverables Stress Testing Model Documentation

3 Financial Modeling Financial Modeling is the task of building an abstract representation (a model) of a real world financial situation. This is a mathematical model designed to represent (a simplified version of) the performance of a financial asset or portfolio of a business, project, or any other investment. Financial Modeling is a general term that means different things to different users; the reference usually relates either to accounting and corporate finance applications, or to quantitative finance applications. Definition as per Wikipedia

4 Financial Modeling In simple words, the process to solving a problem in the financial services world, using a tool like Excel is known as Financial Modeling.

5 Applications of Financial Modeling The key Applications of Financial Modeling are Business valuation Scenario planning Capital budgeting Financial statement analysis Project finance Risk Management Portfolio Evaluation Data Representation

6 Features of a Financial Model Unlike simple spreadsheets, a financial model is much more 1. It is Structured with a logical flow of assumptions, inputs, calculations and outputs 2. It is Dynamic, thus allows the user to change inputs and observe what happens to outputs. This allows for sensitivity analysis 3. It is more Readable as compared to a general spreadsheet 4. It allows for Error Handling 5. It should have an objective

7 Features of a Financial Model Remember, in today s world, collaboration is very important. Multiple people work on the same project. Therefore, it is important for Financial Models to be 1. Accurate and Reliable 2. Flexible 3. User Friendly

8 Questions Define Financial Modeling Define the major features of a Financial Model

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10 Features of a Financial Model Remember, in today s world, collaboration is very important. Multiple people work on the same project. Therefore, it is important for Financial Models to be 1. Accurate and Reliable 2. Flexible 3. User Friendly

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12 Major Do s and Don ts For a financial Model, some major things to be taken care of are All items should be in the same font unless something is a header that needs to attract attention Decimal points should be same across the entire model Units should be displayed prominently Model objectives should be clearly defined Model inputs, assumptions should be clearly defined Model flow should be clearly defined

13 Defining Model Objectives It is important to define model objectives first, before embarking upon creating a financial model. Why are we building this model? Is it for comparing company financials? Is it to look at asset allocation? Is it to do risk analysis? Is it to find out some repayment schedule?

14 Example Process Flow for a Model Let us assume we are building a valuation model for a company that runs cinema screens, like PVR or Inox. Let us lay down the objectives, inputs, model flow and outputs expected

15 Example Process Flow for a Model Let us assume we are looking to build a model for repayment of loans. What are the inputs. What kind of flexibility the model may need later?

16 Questions If you were to build a model for valuation of a 2-wheeler company, selling motorcycles, create a broad process flow and list of inputs and outputs for the financial model

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18 Identifying Inputs and Variables We need to define the key values we will need in any model to be able to arrive at the final conclusion. We have already seen examples of this. For example, while doing valuation, we need to identify what are the key inputs and assumptions in our model. How are we projecting those. We also need to mention these, or show them in a different color, so as to make sure that everyone understands what is an assumption, and what is data that is given.

19 Defining Deliverables The Model Output has to be defined, so that we are clear about what is it that we can expect, and where can we find it. Maybe it could also be shown in a different color, and the model introduction should mention what we are trying to find?

20 Stress Testing When a model has many inputs, they may start affecting the overall flow. It is therefore important to see if changes to one input are not affecting any other functionality anywhere. A model has to be stress tested to see if all linkages are working correctly, or not.

21 Documentation A financial Model is incomplete without some documentation about how the model flow moves. Documentation can be done in 3 ways 1. Using Name Manager Define Names for the Inputs such that understanding the model becomes easier 2. Using In Cell Comments Defining comments for any assumption, so that a user can understand why those assumptions have been made 3. Using separate columns for comments, or using an entire sheet for documenting the key assumptions and Model Flow A combination of the above can also be used.

22 Questions Why is documentation in a model necessary? What are the various ways you can do documentation in a financial model?