How do you build a financial model?

1. Historical results and assumptions

Every financial model starts with a company’s historical results.  You begin building the financial model by pulling three years of financial statements and inputting them into Excel. Next, you reverse engineer the assumptions for the historical period by calculating things like revenue growth rate, gross margins, variable costs, fixed costs, AP days, inventory days, and AP days, to name a few.  From there you can fill in the assumptions for the forecast period as hard-codes.

2. Start the income statement

With the forecast assumptions in place, you can calculate the top of the income statement with revenue, COGS, gross profit, and operating expenses down to EBITDA.  You will have to wait to calculate depreciation, amortization, interest, and taxes.

3. Start the balance sheet

With the top of the income statement in place, you can start to fill in the balance sheet.  Begin by calculating accounts receivable and inventory, which are both functions of revenue and COGS, as well as the AR days and inventory days assumptions.  Next, fill in accounts payable, which is a function of COGS and AP days.

4. Build the supporting schedules

Before completing the income statement and balance sheet, you have to create a schedule for capital assets like Property, Plant & Equipment (PP&E), as well as for debt and interest. The PP&E schedule will pull from the historical period and add capital expenditures and subtract depreciation. The debt schedule will also pull from the historical period and add increases in debt and subtract repayments. Interest will be based on the average debt balance.

5. Complete the income statement and balance sheet

The information from the supporting schedules completes the income statement and balance sheet. On the income statement, link depreciation to the PP&E schedule and interest to the debt schedule. From there, you can calculate earnings before tax, taxes, and net income. On the balance sheet, link the closing PP&E balance and closing debt balance from the schedules. Shareholder’s equity can be completed by pulling forward last year’s closing balance, adding net income and capital raised, and subtracting dividends or shares repurchased.

6. Build the cash flow statement

With the income statement and balance sheet complete, you can build the cash flow statement with the reconciliation method. Start with net income, add back depreciation, and adjust for changes in non-cash working capital, which results in cash from operations. Cash used in investing is a function of capital expenditures in the PP&E schedule, and cash from financing is a function of the assumptions that were laid out about raising debt and equity.

7. Perform the DCF analysis

When the 3 statement model is completed, it’s time to calculate free cash flow and perform the business valuation. The free cash flow of the business is discounted back to today at the firm’s cost of capital (its opportunity cost or required rate of return). We offer a full suite of courses that teach all of the above steps with examples, templates, and step-by-step instruction.  

8. Add sensitivity analysis and scenarios

Once the DCF analysis and valuation sections are complete, it’s time to incorporate sensitivity analysis and scenarios into the model. The point of this analysis is to determine how much the value of the company (or some other metric) will be impacted by changes in underlying assumptions. This is very useful for assessing the risk of an investment or for business planning purposes (e.g., does the company need to raise money if sales volume drops by x percent?).

9. Build charts and graphs

Clear communication of results is something that really separates great from merely good financial analysts. The most effective way to show the results of a financial model is through charts and graphs, which we cover in detail in our advanced Excel course, as well as many of the individual financial modeling courses. Most executives don’t have the time or patience to look at the inner workings of the model, so charts are much more effective.

10. Stress test and audit the model

When the model is done, your work is not over. Next, it’s time to start stress-testing extreme scenarios to see if the model behaves as expected. It’s also important to use the auditing tools covered in our financial modeling fundamentals course to make sure it’s accurate and the Excel formulas are all working properly.