Addis Ababa University, School of Commerce

Department of Accounting & Finance

Financial Modelling
(AcFN 3044)
For Accounting Undergraduate Students
By: Tamrat Mengesha, Chartered MCSI, ACCA, CMA, CMSA

October, 2023
 Chapter 1

Introduction to
Financial Modelling
&
Valuation
 Introduction to Financial
Chapter 1 Modelling & Valuation
Learning Objectives
After studying this chapter, you should be able to:

1. Explain what Financial Modelling is all about.

2. Compare and contrast Financial Model with Spreadsheet.
3. Explain the use and purposes of Financial Models.
4. Enumerate types of the various financial models used for various
purposes
5. Explain the three major stages in modelling various business queries
6. Identify the essential skills a modeler should aquint with
7. States what is needed to be an ideal modeller
 What is a Financial Model
▪ Danielle Stein Fairhurst, a senior practitioner in the area of financial
modelling, has made a survey about the attitude, trend and uses of financial
modelling asking a question

“What do you think a financial model is?”

▪ Participants were asked to put down the first thing that came to mind,
without any research or too much thinking about it.

▪ She reported that the responses she found were interesting, amusing, and
sometimes rather disturbing. Some answers were overly complicated and
highly technical.
 What is a Financial Model, Cont’d…
Let’s see some of the responses she obtained:

▪ “Representation of behavior/real-world observations through mathematical

approach designed to anticipate range of outcomes.”

▪ “A set of structured calculations, written in a spreadsheet, used to analyze the

operational and financial characteristics of a business and/or its activities.”

▪ “Tool(s) used to set and manage a suite of variable assumptions in order to

predict the financial outcomes of an opportunity.”

▪ “A construct that encodes business rules, assumptions, and calculations

enabling information, analysis, and insight to be drawn out and supported by
quantitative facts.”

▪ “A system of spreadsheets and formulas to achieve the level of record

keeping and reporting required to be informed, up-to-date, and able to track
finances accurately and plan for the future.”
 What is a Financial Model, Cont’d…
Let’s see some of the responses she obtained:
Some philosophical:
• “A numerical story.”

Some incorrect:
• “Forecasting wealth by putting money away now/investing.”
• “It is all about putting data into a nice format.”
• “It is just a mega huge spreadsheet with fancy formulas that are streamlined
to make your life easier.”

Finally, the author says that she prefer the last definition:
“As long as a spreadsheet has financial inputs and outputs, and is dynamic and flexible,
she said she is happy to call it a financial model! Pretty much the whole point of financial
modelling is that you change the inputs and the outputs. This is the major premise behind
scenario and sensitivity analysis; this is what Excel, with its algebraic logic, was made
for.”
 What is a Financial Model, Cont’d…

➢ Therefore, a financial model is simply a spreadsheet which is usually built

in Microsoft Excel, that forecasts a business’s financial performance into
the future.

➢ The forecast is typically based on the company’s historical performance

and assumptions about the future, and requires preparing an income
statement, balance sheet, cash flow statement, and supporting schedules
(known as a 3-statement model).

➢ From there, more advanced types of models can be built such as

discounted cash flow analysis (DCF model), leveraged buyout (LBO),
mergers and acquisitions (M&A), and sensitivity analysis and many more
 What is a Financial Model, Cont’d…

More Scientific Definition

A model is a numerical or mathematical representation of a real-life
situation.
A financial model is one which relates to business and finance
contexts.
The typical objectives of financial modeling include to support
decisions relating to:
➢ business plans and forecasts,
➢ to the design, evaluation and selection of projects,
➢ to resource allocation and portfolio optimization,
➢ to value corporations, assets, contracts and financial instruments, and
➢ to support financing decisions.
 TYPES AND PURPOSES OF FINANCIAL MODELS

There are many types of financial models with a wide range of uses. The output of a
financial model is used for decision-making and performing financial analysis, whether
inside or outside of the company.
Financial models are used to make decisions about:
• Raising capital (debt and/or equity)

• Making acquisitions (businesses and/or assets)

• Growing the business organically (e.g., opening new stores, entering new markets, etc.)

• Selling or divesting assets and business units

• Budgeting and forecasting (planning for the years ahead)

• Capital allocation (priority of which projects to invest in)

• Valuing a business

• Financial statement analysis/ratio analysis

• Management accounting
 TYPES AND PURPOSES OF FINANCIAL MODELS, Cont’d…

Models in Excel can be built for virtually any purpose—financial and nonfinancial, business-
related or non-business-related—although the majority of models will be financial and
business-related.
The following are some examples of models that do not capture financial information:

❑ Risk management. A model that captures, tracks, and reports on project risks, status, likelihood,
impact, and mitigation. Conditional formatting is often integrated to make a colorful, interactive report.

❑ Project planning. Models may be built to monitor progress on projects, including critical path
schedules and even Gantt charts. (See the next section in this chapter, “Tool Selection”, for an analysis
of whether Microsoft Project or Excel should be used for building this type of project plan.)

❑ Key performance indicators (KPIs) and benchmarking. Excel is the best tool for pulling together
KPI and metrics reporting. These sorts of statistics are often pulled from many different systems and
sources, and Excel is often the common denominator between different systems.

❑ Dashboards. The popularity of dashboards has increased in recent years. The dashboard is a
conglomeration of different measures (sometimes financial, but often not), which are also often
conveniently collated and displayed as charts and tables using Excel.

❑ Balanced scorecards. These help provide a more comprehensive view of a business by focusing on the
operational, marketing, and developmental performance of the organization as well as financial
measures. A scorecard will display measures such as process performance, market share, or penetration,
and learning and skills development, all of which are easily collated and displayed in Excel.
 THE STAGES OF MODELLING
• The modelling process can be considered as consisting of several
stages, as shown in in figure below:
 Specification

This involves describing the real-life situation, either

qualitatively or as a set of equations. In any case, at this
stage one should also consider the overall objectives and
decision-making needs, and capture the core elements of
the behavior of the real world situation.

One should also address issues relating to the desired

scope of model validity, the level of accuracy required
and the trade-offs that are acceptable to avoid excessive
complexity whilst providing an adequate basis for
decision support.
 Implementation

This is the process to translate the specification

into numerical values, by conducting
calculations based on assumed input values.

For the purposes of this course, the calculations

are assumed to be in Excel, perhaps also using
additional compatible functionality (such as VBA
macros, Excel add-ins, and so on).
 Decision support

A model should appropriately support the decision.

However, as a simplification of the real-life situation, a
model by itself is almost never sufficient.

A key challenge in building and using models to greatest

effect is to ensure that the process and outputs provide a
value-added decision-support guide (not least by
providing insight, reducing biases or correcting invalid
assumptions that may be inherent in less-rigorous
decision processes), whilst recognizing the limitations of
the model and the modeling process.
WHAT SKILLS DO YOU NEED TO BE A GOOD FINANCIAL
MODELLER?

When considering the skills that make up a good financial modeller, we need
to differentiate between conceptual modelling, which is to have an understanding
of the transaction, business, or product being modelled, and spreadsheet
engineering, which is the representation of that conceptual model in a spreadsheet.

Spreadsheet skills are reasonably easy to find, but a modeller who can understand
the concept of the purpose of the model and translate it into a clear, concise, and
well-structured model is much rarer.

People who need to build a financial model sometimes think they need to become
either an Excel super-user or an accounting pro who knows every in and out of
accounting rules.
However, you need a blend of both, as well as a number of other skills,
including some business common sense! Let’s see them
WHAT SKILLS DO YOU NEED TO BE A GOOD FINANCIAL
MODELLER? Cont’d…

1)Spreadsheet and Technical Excel Skills

In financial modelling, Excel skill is very crucial. So, to be a good financial modeller,
you do need to know Excel exceptionally well. You don’t have to be a super-user—the
99th percentile in Excel knowledge—but you must certainly be above average.

So, if you are considering a career as a financial modeler, improving your

Excel knowledge is an excellent place to start.
WHAT SKILLS DO YOU NEED TO BE A GOOD FINANCIAL
MODELLER? Cont’d…

2)Industry Knowledge
One of the fantastic things about financial modelling is that it is applicable across
so many different industries. Good financial modelling skills will always stand you
in good stead, no matter which industry or country you are working in. Financial
modelling consultants or generalists will probably work in many different
industries during their careers and be able to build models for different products
and services.

For example, when building a pricing model, the modeller needs to understand
the product and how the costs and revenue work. Experience with regulatory
constraints will help the modeller to understand the basis of regulation and its
components (e.g., cost building blocks, cost index, revenue cap, weighted
average price cap, maximum prices, etc.).
WHAT SKILLS DO YOU NEED TO BE A GOOD FINANCIAL
MODELLER? Cont’d…

3) Accounting Knowledge
Elements such as financial statements, cash flow, and tax calculations
can be an important aspect of many financial models. Professional
accountants know every single accounting rule and law there is, but this
certainly does not by definition make them good financial modellers.
In fact, financial models are often relatively straightforward from an
accounting standpoint. You certainly do not need to be a qualified accountant
to become a financial modeller, although a good understanding of accounting
and knowledge of finance certainly helps.
WHAT SKILLS DO YOU NEED TO BE A GOOD FINANCIAL
MODELLER? Cont’d…

4) Business Knowledge
Business acumen is particularly important when commissioning, designing,
and interpreting a financial model. When creating the model, the modeller
needs to consider the purpose of the model. What does the model need to tell
us? Knowing the desired outcome will assist with the model’s build, design,
and inputs.
If, for example, we are building a pricing model, we need to consider the
desired outcome—normally, the price we need to charge in order to achieve a
certain profit margin. What is an acceptable margin? What costs should we
include? What cost will the market bear?
Modellers should also have an understanding of economic concepts, such as
efficient costs and how these are calculated, an expected return on an asset
base, operating costs and working capital, or long-run versus short-run
marginal costs.
WHAT SKILLS DO YOU NEED TO BE A GOOD FINANCIAL
MODELLER? Cont’d…

5) Aesthetic Design Skills

This is an area that many modellers and analysts struggle with, as aesthetics
simply do not come naturally to left-brain thinkers like us. We are mostly so
concerned with accuracy and functionality that we fail to realize that our
model is ugly!
Some aesthetic formatting is critical for the functionality and to avoid error,
but mostly it adds credibility and makes your model easier to work with.

But remember that models can become complex very quickly and without a
well-planned design, they can be unintelligible.

Some basic components of a model should be a cover sheet, instructions, and

clearly labelled inputs, outputs, workings, and results. For extremely long and
complex models with many sheets, a hyperlinked table of contents is also a
valuable addition to help the user navigate the model.
WHAT SKILLS DO YOU NEED TO BE A GOOD FINANCIAL
MODELLER? Cont’d…

6) Communication and Language Skills

This is also an area that we analytical, financially orientated people are not
always good at. Some analysts like to lock themselves away, working on
spreadsheets without communicating with other people. If this is your
tendency, then you might need to consider whether financial modelling is a
good career choice for you, because there is a surprising amount of human
interaction required for most financial modellers.
Fore example it requires
- Assumption Validations
- Data Gathering
- Presentation Skills
- Client Skills

7) It also highly requires Numeric Skills & Ability to think Logically

 THE “IDEAL” FINANCIAL MODELLER

What financial modellers bring to the table is a combination of skills. First, they know
Excel well enough to be able to choose the simplest and most functional tool to build a
model. They can create a PivotTable, array formula, or macro (but only when
necessary, of course), use a simple or complex nested formula, and choose the best
technical tool to perform a scenario analysis. They also understand all the relevant
business and accounting principles. At the end of the day, the balance sheet has to
balance, and the ending cash on your cash flow statement needs to tie to the balance
sheet, for example.

The ideal financial modeller brings a unique combination of skills that neither an Excel
guru nor an accounting whiz possesses. He or she understands sensitivity and
relationships between variables, how fluctuations in inputs will impact the outcomes,
and how this needs to be modelled in Excel. A financial modeller can also take a step
back and realize what the ultimate goal of the model should be. Are we building a
model for in-house use, or to present to investors? Do we need a valuation, a variance
analysis, a nice summary, or a detailed month-by-month profit and loss report? The
financial modeller can take information, build an Excel model that is technically correct
from an accounting standpoint, set up the model, and ultimately reflect what the
business is looking to achieve.
 Summary

Financial modeling is one of the most highly valued, but thinly

understood, skills in financial analysis. The objective of financial
modeling is to combine accounting, finance, and business metrics
to create a forecast of a company’s future results.

Key Points
• Financial modeling combines accounting, finance, and business
metrics to create a forecast of a company’s future results.
• The main goal of financial modeling is to accurately project a
company’s future financial performance.
• Modeling can be useful for valuing companies, determining
whether a company should raise capital or grow the business
organically or through acquisitions.
 END
CHAPTER ONE