What is a financial model?

One of the main tasks of an analyst is to prepare a robust and complete financial model for the investment for which he is doing analysis, which can be an existing business or a new project. In most simple terms, a financial model depicts the outgo (s) for investment and the revenues/cash flows from the investment. A financial model necessarily has to inculcate the business model of the investment - whether it is selling a product or a service.

typically a financial model should answer the following questions:

1. When and how much needs to be invested?
2. How the funds for investment will be raised (debt or equity or both)?
3. Life of project?
4. Major assumptions which will have a bearing on the numbers - like inflation rate, market interest rate, taxes, customers, etc.
   
5. What will be the recurring cash flows (due to various reasons including different accounting policies adopted by companies, artificial inflating of revenues, etc. cash flows are most preferred tool for an analyst for adjudging an investment)?
6. How much will be the cost of operations?
7. What will be the return to various stakeholders - debt providers, government (in form of taxes), shareholders?
   
8. What are the sensitive areas of which analyst has to take note?
9. What are risks which can affect the future cash flows?

The above list is not at all exhaustive. There can be countless variables which can be built in within the model.

Though, a financial model gives information only quantitative outcomes for an investment, it is the most pertinent task for an analyst in investment analysis. Once the model is complete, he should be able to know the NPV (the net of PV of Cash inflows and PV of investment (s) / IRR (annualized effective compounded return rate which can be earned on the invested capital) and other metrics for measurement of return from investment.

Scenario Analysis and Sensitivity Analysis are major tools for assessing the vunerability of investment. Former involves changing many variables (affecting the future cash flows) and then observing the outcome of these changes to the return on investment (or equity). In sensitivity analysis, analyst changes one variable at a time to know the result. For e.g. what will be the effect of a 1% rise in inflation rate or how much would the cash flows rise with 5% increase in number of customers. By these two excercises, one gets to know the trigger areas which could lead to fall of the project.

Some pointers I remember while preparing financial models:

• Put (or try to put) all assumptions on a single sheet
• Highlight the cells which have entered value (instead of calculations) - standard is to use blue color
• Separate sheets for tax calculations, revenue detail, cost detail and outcomes (with scenario category - worst, most likely or best)
• Focus on what the output should be and what the users of model like to see.
• Try to complete the revenues, costs, cash flows, etc for a year and then extend to future years based on the assumptions.
  
• Minimum number of sheets not only helps the analyst but the readers of the model too.
• Make use of comments feature to highlight important information.