Financial modeling is the process of creating a mathematical representation of a company's financial performance. It involves building spreadsheet models that capture historical data and project future financial results. These models help businesses make informed decisions about investments, budgeting, and strategic planning.
Financial models are built around three core financial statements. The Income Statement shows revenue, expenses, and profit over a period. The Balance Sheet displays assets, liabilities, and equity at a point in time. The Cash Flow Statement tracks cash movements from operating, investing, and financing activities. These statements are interconnected - profit flows from the Income Statement to the Balance Sheet, and changes in balance sheet items affect cash flow.
Financial models are driven by key assumptions that determine future performance. These include revenue growth rates, cost structures as percentages of revenue, capital expenditure plans, working capital changes, and tax rates. Each assumption feeds into specific formulas that calculate the financial statements. For example, a 15% revenue growth assumption directly impacts next year's revenue calculation, while a 60% gross margin assumption determines cost of goods sold as 40% of revenue.
The Income Statement is typically built first in financial modeling. It starts with revenue at the top, subtracts cost of goods sold to get gross profit, then deducts operating expenses to reach operating income or EBIT. Finally, interest and taxes are subtracted to arrive at net income. Each line item is usually calculated based on the key assumptions we discussed earlier, such as growth rates and cost percentages.