Financial modeling is a method of forecasting how a company may perform in the future. It combines various company data from accounting statements,𒉰 such as revenue, expenses, income, and earnings.

The insight that financial modeling provides can be used to help a company's management maintain business practices that get results (and change those that don't). It can help companies make important business decisions, such as those relating to annual planning efforts or to exploring the sale of a division or entire company.

What Is Financial Modeling?

Theoretically, a financial model is a set of assumptions about future business conditions that drive projections of a company's revenue, earnings, 澳洲幸运5开奖号码历史查询:cash flows, and 澳洲幸运5开奖号码历史查询:balance sheet accounts.

In practice, a financial model is a spreadsheet (usually in Microsoft's Excel software) that analysts use to forecast a company's future financial performance.

Properly projecting earnings and cash flows into the future is important since the 澳洲幸运5开奖号码历史查询:intrinsic value of a stock depends largely on the outlook for the fiไnancial performance of the i❀ssuing company.

A Spreadsheet of Quarterly Projections

A financial model spreadsheet usually looks like a table of financial data organized into fiscal quarters and/or years. Each column of the table represents the balance sheet, 澳洲幸运5开奖号码历史查询:income statement, and 澳洲幸运5开奖号码历史查询:cash flow statement of a future quarter or year.

The rows of the table represent all the line items of the company's financial statements, such as revenue, expenses, share count, capital expenditures and balance sheet accounts.

Like financial statements, one ﷽generally reads the model from the top to tꦑhe bottom (or revenue through earnings and cash flows).

Each quarter embeds a set of assumptions for that period, such as the revenue 澳洲幸运5开奖号码历史查询:growth rate, the 澳洲幸运5开奖号码历史查询:gross margin assumption, and the expected tax rate. These assumptions are what drive the output of the model—generally, earnings and cash flow figures th𓂃at are used to value the company or help in making financing decisions for th🔜e company.

History As a Guide

Whܫen trying to predict the future, a good place to start is the past. Therefore, a solid first step in building a model is to fully analyze a set of historical financial data and link projections to the historical data as ꦚa base for the model.

✤ For instance, if a company has generated gross margins in the 40% to 45% range for the past ten years, then it mi🌸ght be acceptable to assume that, with other things being equal, a margin of this level is sustainable into the future.

Consequently, the historical track record of gross margin can be𝕴ℱcome somewhat of a basis for a future income projection.

Analysts are always smart to examine and analyze historical trends in revenue growth, expenses, capital expenditurꦆes, and other 💜financial metrics before attempting to project financial results into the future.

For this reason, financial model spreadsheets usually incorporܫate a set of historical financial data and related analytical measures from which analysts derive assumptions and projections.

Revenue Projections

Revenue growth rate can be one of the most important assumptions in a financial model. Small variances in top-line growth can mean big variances in 澳洲幸运5开奖号码历史查询:earnings per share (EPS), cash flows, and therefore stock valuation.

For this reason, analysts must pay a lot of attention to getting the top-line projection right. As explained above, a good starting point is to lookও at the historic track record of revenue.

Perhaps revenue is stable from year to year. Perhaps it is sensitive to changes in national income or other economic variables over time. Perhaps growth is accelerating, or maybe the ꩲopposite is true. It is important to get a feel for what has affected revenue in the past in order to make a reliable assumption about the future.

Once you've examined the historic trend, including what's been going on in the most recently reported quarters, check to see if management has given 澳洲幸运5开奖号码历史查询:revenue guidance (which is manꩲﷺagement's own outlook for the future).

From there analyze whether the outlook is reasonably conservative or optimistic,ও based on a thorough ana꧟lytical overview of the business.

A future quarte꧃r's revenue projection is frequently driven by a formula in the worksheet such💃 as:

$\begin{aligned} &R_1=R_0 \times (1 + g) \\ &\textbf{where:}\\ &R_1=\text{future revenue}\\ &R_0=\text{current revenue}\\ &g=\text{percentage growth rate}\\ \end{aligned}$​R1​=R0​×(1+g)where:R1​=future revenueR0​=current revenueg=percentage growth rate​

Operating Expenses and Margin

Again, begin by examining the historic trend when forecasting expenses. Analysts who understand that there are big differences between the fixed costs and 澳洲幸运5开奖号码历史查询:variable costs incurred by a business ꧋are smart to consider both the dollar amount of costs and their proportion of revenue over time.

If 澳洲幸运5开奖号码历史查询:sellin🌱g, general and administrativeও (SG&A) expense has ranged betweౠen 8% and 10% of revenue in the past ten ye💝ars, then it is likely to fall into that range in the future.

This could be the basis for a projection—again tempered by management's guidance and an outlook for the business a🌺s a whole.

If business is improving rapidly, reflected💦 by the revenue growth assumption, then perhaps the fixed cost elemℱent of SG&A will be spread over a larger revenue base and the SG&A expense proportion will be smaller next year than it is right now.

That means that margins are likely to 🍨increase, which cﷺould be a good sign for equity investors.

Expense-line assumptions are often reflectedᩚᩚᩚᩚᩚᩚ⁤⁤⁤⁤ᩚ⁤⁤⁤⁤ᩚ⁤⁤⁤⁤ᩚ𒀱ᩚᩚᩚ as percentages of revenue and the spreadsheet cells containing expense items usually have formulas such as:

$\begin{aligned} &E_1=R_1 \times p \\ &\textbf{where:}\\ &E_1=\text{expense}\\ &R_1=\text{revenue for the period}\\ &p=\text{expense percentage of revenue for the period}\\ \end{aligned}$​E1​=R1​×pwhere:E1​=expenseR1​=revenue for the periodp=exp🌃ense percentage of revenue for the period​

Non-Operating Expenses

For an industrial company, non-operating expenses are primarily 澳洲幸运5开奖号码历史查询:interest expense and income taxes. Bear in mind when projecting interest expense that it is a proportion of debt and is not explicitly tied to operational income streams. Consider the curr🌊ent level of total debt owed by the company.

Generally, taxes are not linked 🦩to revenue, but rather to pre-tax income. The tax rate that a company pays can be affected by a number of factors such as the number of countries in which it operates.

If a company is purely domestic, then an analyst might be safe using the state tax rate as a good assumptio🌠n in projections. Once again, it is useful to look at the historic track record in these line items as a guide for the future.

Earnings and Earnings Per Share

Projected 澳洲幸运5开奖号码历史查询:net income available for 澳洲幸运5开奖号码历史查询:common shareholders is projected revenue minus projected expenses.

Projected earnings per share (EPS) is projected net income divided by the projected 澳洲幸运5开奖号码历史查询:fully diluted shares 澳洲幸运5开奖号码历史查询:outstanding figure.

Earnings and EPS projections are generally considered primary outcomes of a financial model because they are frequently used to value equities or generate 澳洲幸运5开奖号码历史查询:target prices for a stock.

To calculate a one-year target price, the analyst can simply look to the model to find the EPS figure for four quarters in the future and multiply it by an assumed 澳洲幸运5开奖号码历史查询:P/E multiple. The projected return from the stock (excluding dividends) is the percenta♈ge difference betwಌeen that target price and the current price:

$\begin{aligned} &\text{Projected return}=\frac{(T-P)}{T} \\ &\textbf{where:}\\ &T=\text{target price}\\ &P=\text{current price}\\ \end{aligned}$​Projected return=T(T−P)​where:T=target priceP=current price​

Now the analystﷺ has a simple basis for making an investment decision—the expected return on the stock.

The Bottom Line

Since the present value of a stock is inextricably linked to the outlook for financial performance of the issuer, investors are wise to create some form of💎 financial projection to evaluate equity investments.

Examining the past in an analytical context is only part of the story. Developing an understanding of how a company's financial statements might look in the future is often the key to equity valuation. Financial modeling can help.