What is Financial Modelling? - Introduction #financialmodeling course

Summary

This script discusses the importance of financial modeling for future planning, emphasizing the need for interconnected financial statements that reflect changes automatically. It highlights the use of Microsoft Excel for creating models that link data assumptions to profit and loss, balance sheet, and cash flow statements. The script outlines the significance of financial models in resource planning, scenario analysis, and business valuation, stressing the interdependence of business elements and the need for a sophisticated approach to financial modeling.

Takeaways

• 📊 Financial statements are a summary of all the financial aspects of a business, including key reports such as the income statement, balance sheet, and cash flow statement.
• 🔑 The first three financial reports (income statement, balance sheet, cash flow statement) are crucial and are often referred to as the three financial statements.
• 🚫 The remaining two reports are considered less important and will be ignored in the course discussion.
• 🔮 Preparing financial statements for the future based on estimates is called financial modeling, which is a key focus of the course.
• 🔗 Financial models should meet qualitative requirements, ensuring that the statements are interconnected and changes in data are reflected across the model.
• 💡 Microsoft Excel is highlighted as an excellent tool for creating interconnected financial models.
• 🔄 Interconnection in financial models means that figures should flow logically between the profit and loss statement, balance sheet, and cash flow statement.
• 💼 The purpose of financial modeling includes resource planning, scenario analysis, and business valuation, which are essential for business decision-making.
• 📈 Resource planning involves forecasting financial needs such as capital, staff, expenses, and cash flow at specific times, which are all interlinked.
• 📊 Scenario analysis allows businesses to prepare for different future outcomes by adjusting input variables in the financial model and observing the impact across reports.
• 💹 Business valuation is dependent on future cash flows and profitability, which can be estimated using a comprehensive financial model.

Q & A

What are financial statements?

Financial statements are a summary of all the financial aspects of a business, providing an overview of its financial health.

What are the key reports that are part of financial statements?

The key reports that are part of financial statements include the Profit and Loss Statement, the Balance Sheet, and the Cash Flow Statement. These are also known as the three financial statements.

Why are the first three financial reports considered more important than the remaining two?

The first three reports are considered more important because they cover the main financial picture of the business, while the remaining two are not as crucial for understanding the overall financial health.

What is a financial model?

A financial model is a representation of a business's financial projections based on estimates and assumptions about future performance.

What are the qualitative requirements for preparing financial statements for the future?

The financial statements for the future should be connected to a central data source, interconnected with each other, and any changes in the data should be reflected automatically across the whole model.

How can changes in data be reflected automatically in a financial model?

Changes in data can be reflected automatically in a financial model by linking the data and assumptions page to the financial statements, so any modifications in the data will update across all reports.

Why is Microsoft Excel considered a good tool for creating financial models?

Microsoft Excel is considered a good tool for creating financial models due to its flexibility, ease of use, and ability to link data across different sheets and formulas.

What is the significance of interconnecting financial reports in a model?

Interconnecting financial reports ensures that figures that need to move from one report to another, such as from the Profit and Loss Statement to the Balance Sheet, are accurately and automatically updated.

Why is resource planning important in financial modeling?

Resource planning is important in financial modeling because it helps to determine the required capital, staff, expenses, and cash needs at specific times, which are all interlinked and dependent on various business factors like sales volume.

How does a financial model assist with scenario analysis?

A financial model assists with scenario analysis by allowing changes in input variables, which then automatically update all reports, making it easy to analyze different potential future scenarios.

What role does a financial model play in business valuation?

A financial model plays a crucial role in business valuation by projecting future cash flows and profitability, which are key determinants of a business's value.

Outlines

00:00

📈 Understanding Financial Statements and Models

This paragraph introduces the concept of financial statements as a summary of a business's financial health. It emphasizes the importance of the first three financial reports (income statement, balance sheet, and cash flow statement) over the remaining two, which are considered less significant. The speaker then transitions into discussing financial models for future projections, highlighting the need for these models to meet qualitative requirements such as data centralization and interconnectivity. The idea is that any change in the underlying data should automatically update across all connected financial reports. The paragraph concludes with a mention of using software like Microsoft Excel to facilitate this process and the importance of linking financial reports to each other, ensuring consistency and accuracy in financial planning.

05:01

💼 Importance of Financial Modeling for Business Planning

Paragraph 2 delves into the practical reasons for creating sophisticated financial models. It outlines the necessity of resource planning, where understanding sales volume and its impact on various business aspects like plant machinery, working capital, and operational expenses is crucial. The paragraph also touches on the importance of financial models for scenario analysis, allowing businesses to prepare for different future outcomes by adjusting input variables and observing the effects across all financial reports. Lastly, it discusses the role of financial models in business valuation, emphasizing how knowing future cash flows and profitability is essential for determining a business's worth. The paragraph concludes by stating that these interconnected financial aspects necessitate a comprehensive financial model, leading into the preparation of such a model in the subsequent lecture.

Keywords

💡Financial Statements

Financial statements are formal records that provide a structured overview of a company's financial performance and position. They include the balance sheet, income statement, and cash flow statement. In the video, financial statements are described as a summary of all the financial aspects of a business, which are crucial for understanding its financial health. The script emphasizes that the first three reports (income statement, balance sheet, and cash flow statement) are the most important, as they cover the main picture of the business.

💡Profit and Loss Statement

The profit and loss statement, also known as the income statement, is a financial report that outlines a company's revenues, expenses, and profits or losses over a specific period. It is one of the three key financial statements discussed in the video. The script mentions that this report is prepared based on data and assumptions, and any changes in the data should automatically reflect across the entire financial model.

💡Balance Sheet

A balance sheet is a financial statement that presents a company's financial position by listing its assets, liabilities, and equity at a specific point in time. It is one of the three key financial statements and is mentioned in the script as a report that should be interconnected with others. The script explains that changes in one part of the balance sheet should be automatically reflected in other related reports.

💡Cash Flow Statement

The cash flow statement is a financial report that provides aggregate data regarding all cash inflows and outflows a company experiences during a specific period. It is one of the three key financial statements and is highlighted in the script as a report that should be prepared based on interconnected data and assumptions, ensuring that changes in one part of the model are reflected in the cash flow statement.

💡Financial Model

A financial model is a representation of a company's financial structure, used to forecast its financial performance. It is based on estimates and assumptions about future financial conditions. The video script discusses the importance of financial modeling for preparing future financial statements and emphasizes that it should meet certain qualitative requirements, such as being interconnected and reflecting changes automatically across all reports.

💡Interconnected

In the context of the video, 'interconnected' refers to the way different components of a financial model are linked together. If one part of the model changes, it should automatically update other related parts. This is crucial for maintaining consistency and accuracy across financial statements. The script uses the term to explain how changes in data and assumptions should propagate through the entire financial model.

💡Resource Planning

Resource planning in the video refers to the process of estimating and allocating the resources a business needs to achieve its objectives. This includes financial resources, staff, and operational expenses. The script explains that financial models are essential for resource planning because they help businesses understand how changes in sales volume or other factors impact the overall resource requirements.

💡Scenario Analysis

Scenario analysis is a method used to evaluate the potential impact of various future events on a company's financial performance. The video script mentions that a fully interlinked financial model allows for easy scenario analysis by changing input variables, which then updates all related reports. This helps businesses prepare for different possible future outcomes.

💡Business Valuation

Business valuation is the process of determining the economic value of a business or its components. The script discusses how financial models are crucial for business valuation because they help predict future cash flows and profitability, which are key factors in determining a business's value. The video emphasizes the importance of having an accurate financial model for making informed decisions about selling or investing in a business.

💡Microsoft Excel

Microsoft Excel is a widely used spreadsheet program that is mentioned in the video as an excellent tool for creating financial models. The script suggests that Excel's capabilities for linking data and automatically updating reports make it a preferred choice for preparing financial statements and models that meet the qualitative requirements discussed.

💡Retained Earnings

Retained earnings refer to the cumulative net income that a company has retained, rather than paid out as dividends to shareholders. In the video script, retained earnings are highlighted as an example of how the balance sheet is interconnected with the profit and loss statement. The script explains that changes in the profit value from the profit and loss statement should automatically update the retained earnings figure in the balance sheet.

Highlights

Financial statements are a summary of all the financial aspects of a business.

The first three reports of financial statements are also called the three statements and are the most important.

The remaining two statements are not as important and will be ignored in the course discussion.

Preparing financial statements for the future based on estimates is called a financial model.

Financial models must meet qualitative requirements, such as being connected to a central data source.

Changes in data should be automatically reflected across the entire financial model.

Microsoft Excel is recommended for creating interconnected financial models.

Financial models should interconnect reports, ensuring figures move accurately between them.

Retained earnings in the balance sheet should be linked to the profit from the profit and loss statement.

The cash flow statement's closing cash value must match the balance sheet.

Financial models are crucial for resource planning, including cash and staff requirements.

Sales volume impacts many aspects of business, and financial models help plan for these interconnections.

Financial models are used for scenario analysis to prepare for different future outcomes.

Business valuation depends on future cash flows and profitability, which a financial model can predict.

The lecture will cover the preparation of a three-statement financial model starting from the next session.

Transcripts

welcome back so we have learned what are

financial statements and we saw that the

financial statements are basically a

summary of all the financial aspects of

business

we also saw that what are the key

reports that become part of financial

statements and what is covered in each

of these reports

we also told you that the first three

reports are also called the three

statements and the remaining two

statements are actually not that

important the first three reports

actually cover the main picture of the

business so we are going to ignore that

for the remaining discussion in this

course because because the topic that we

are going to talk about is only focused

on these three reports

now you have learned how to prepare

financial statements from the past data

but what if if we have to prepare

financial statements for the future

based on the estimates definitely

if we do that that is called a financial

model

but that is not just it you just simply

cannot produce your financial statements

for the future in any random format and

call it financial model that is not the

way

we have to make sure that our financial

statements that we are preparing for the

future do meet some qualitative

requirements and these are

financial statements should be connected

to a central data and then these should

also be interconnected

and this also means that any changes if

we make in the data should be changed

across the whole model now let me

explain that to you with the help of a

diagram

let us say we have all the data and

assumptions and estimations that we have

made for our business according to the

business plan so what is going to be the

price how many units we are going to

sell what is going to be the cost Etc

once we have all this data we will

prepare profit and loss statement

balance sheet and the cash flow

statement Based on data but that data

will be linked from the data and

assumptions page in a way that if I go

back and make any changes in that data

that change should be reflected

automatically in all of these reports

and this can be done very easily using a

software and Microsoft Excel is

definitely the best for that

and the second thing is not just we have

to connect these reports with the data

we also have to interconnect these

reports and with interconnect we mean

that if there are any figures that have

to go from profit and loss statement to

balance sheet that should be done and

similarly if there are any values that

have to go from profit and loss

statement and the balance sheet to the

cash flow statement that should also be

done and similarly if there is any value

that has to come from cash flow to

balance sheet that should also be

covered let me quickly give you some

examples of that we know that in the

balance sheet the retained earnings that

are reported also include the profit

value from the profit and loss statement

so we have to link that together

and then

there are values in the profit and

losses statement and the balance sheet

on the basis of which we prepare our

cash flow statement that is also going

to be the case and we know that the cash

flow statement has the closing cash and

cash equivalent value that matches the

balance sheet so we have to take care of

that as well in fact we will be

discussing even more when we will

actually be preparing that so the last

point will be discussed in even further

detail

but now let us talk about a very

important thing and that is why why we

have to prepare a financial model

especially in such a sophisticated way

and there are multiple reasons for that

the first one is resource planning

you need to plan your resources like how

much money do you need how much how many

staff members do you need what are going

to be the expenses how much cash you are

going to need at what specific time

and the thing is everything in the

business are is interlinked what that

means is so for example if we talk about

sales if the sales volume increase or

decrease that will be impacting a lot of

different things and until you know your

sales volume you can't even plan how

much plant and Machinery you are going

to need what will be your working

capital and what are going to be your

operational expenses all of these things

are actually some way or the other

dependent on sales

and unless you need your got to know all

of these things planted Machinery

working capital and operational expenses

you cannot answer the requirement of the

questions like what are going to be the

capital requirements I mean I mean how

much money do you need what are going to

be the labor related or HR staff related

requirements and what are going to be

the cash inflows and outflows at what is

specific times you you will not know

that and finally

until you know the capital requirements

and the cash flows you won't know how

much debt and Equity you need to start

your business so all of these things are

interlinked we first need to identify

what is going to be the volume of my

business I mean what is going to be the

volume of sales and then we have to work

backwards and all of these things are

going to be interconnected so that if

the volume of sales changes at any

specific time everything else should be

automatically updated in my model so the

first thing that we need financial

modeling for is the resource planning

secondly we need financial model for the

scenario analysis listen when we start a

business or when we are in a business

and planning for the future we cannot

certainly say that what is going to

happen in the future

things may God in go in a little bad

direction or may sometimes go in an even

better Direction so we should be able to

analyze different scenarios and once you

have a fully interlinked financial model

we are just changing input variables on

one sheet can give you the complete

update on every other sheet on every

other report you can do the scenario

analysis very easily and the third

reason is business valuation

if I have to sell my business today or

even a component like five percent or 10

percent of my business today I need to

know the value of my business and the

value of the business is dependent on

the future cash flows and future

profitability so unless I know what is

going to happen in the future and how

much money in the business is going to

generate in the future I can never know

the value of my business so all of these

things are interlinked and to answer

these questions we basically need a

financial model to begin with

and now we are moving towards

preparation of financial model and we

will begin from the base base value base

form of the financial model that is the

three statement model so we will prepare

these statements in the way we have

described let us start doing that from

the next lecture