Financial Modeling
Financial modelling
A model links drivers to the three statements so that assumptions become visible, testable consequences.
Definition
Financial modelling is the practice of building a structured forecast in which revenue, costs, capital, and financing are expressed as drivers, and the resulting flows are carried through the income statement, balance sheet, and cash flow statement consistently.
The defining test of a model is not its accuracy but its integrity: given the inputs, every statement is internally consistent, the balance sheet balances, and any change in an assumption produces an explainable change in the outputs.
Intuition
The model is a decision machine. Its value is not the number it prints but the ability to ask what if this driver is wrong, and see the consequence immediately.
When to use it
- Sizing a funding need before a growth decision.
- Stress-testing a plan under different growth and margin assumptions.
- Sensitivity analysis on the one driver the decision depends on.
When not to use it
- As a substitute for judgement: a large model can hide a weak assumption behind detail.
- When a rule of thumb or a small sensitivity table answers the question.
Formula
Free cash flow
FCF = Net income + D&A − ΔWC − Capex
The cash the model generates after funding growth and maintaining assets.
Formula
Balance check
Assets − Liabilities − Equity = 0
The integrity test that proves every flow was routed to the right place.
Worked example
One forecast year
Revenue ৳100,000,000 grows 12%; gross margin 40%; opex 25% of revenue; debt ৳40,000,000 at 9%; tax 25%.
- 1
Revenue
৳100,000,000 × 1.12 = ৳112,000,000.
- 2
EBIT
Gross profit ৳44,800,000 − opex ৳28,000,000 = ৳16,800,000.
- 3
Net income
EBIT − interest ৳3,600,000 = ৳13,200,000 before tax; × 0.75 = ৳9,900,000.
- 4
Free cash flow
৳9,900,000 + ৳6,000,000 D&A − ৳2,000,000 ΔWC − ৳8,000,000 capex = ৳5,900,000.
Profit is ৳9,900,000 but the cash left after growth and capex is ৳5,900,000. The model's value is showing why those differ and which driver would change them.
Common mistakes
- Hard-coding a number instead of a driver, which hides the assumption.
- Letting the balance sheet stop balancing and plugging it with a made-up line.
- Driving interest from a debt balance that itself depends on interest without a deliberate treatment of the circularity.
How it connects
is an advanced form of
The source extends the target once the basics are secure.
- How the three statements connect: A model operationalises how the three statements connect.
is used in
The source appears as an input to the target.
- Working capital management: Growth absorbs working capital, and the model has to show it.
- NPV and IRR: The forecast supplies the cash flows an appraisal discounts.
affects
Changing the source moves the target.
- Financial risk management: A model is where solvency risk is stress-tested before it is real.
relates to
Useful to study together, in either order.