- Financial modeling remains built on the three-statement model, which links the income statement, balance sheet and cash flow statement
- The discounted cash flow method values a company as the present value of its expected future free cash flows, discounted at the weighted average cost of capital
- CFA Institute survey data shows about 87 percent of analysts using DCF rely on a discounted free cash flow model, with firm-level (FCFF) models used roughly twice as often as equity-level (FCFE) models.
What Is Financial Modeling?
Financial modeling is the process of building a spreadsheet representation of a company's finances to forecast its future performance. Analysts link the income statement, balance sheet and cash flow statement so that changing one assumption flows through the model, helping them estimate value, test decisions and quantify the impact of future events.
At its core, a financial model is a tool that translates assumptions about a business into projected numbers. It usually starts with historical financial statements, applies drivers such as revenue growth and cost margins, and produces forecasts that decision-makers can rely on.
Because a well-built model links the three financial statements together, changing a single input, such as sales growth or interest rate, updates the entire workbook. This makes financial modeling essential for valuation, budgeting, fundraising and scenario analysis.
Accounting Standards ExplainedRead →Where Is Financial Modeling Applied?
Financial modeling is used across investment banking and equity research to value companies for M&A and fundraising, in corporate finance to plan budgets and projects, in project finance and credit rating to assess loan viability, and by entrepreneurs and private equity firms to pitch investors and test strategies before committing capital.
- Investment banking and equity research: modeling is used to arrive at a valuation in M&A deals and fundraising, and to value stocks and produce buy, sell or hold recommendations.
- Project finance and credit rating: models help lenders and credit analysts project future cash flows and costs, then judge whether to extend loans and what credit rating a company deserves.
- Corporate finance: companies use models to assess their own finances and projects, feeding directly into budgets and capital-allocation plans.
- Entrepreneurs and private equity: founders and investors use models to pitch plans to potential backers, plan strategy and run simulations that help avoid risks.
In each case the goal is the same: turn uncertain future events into structured, testable numbers so that a decision can be made with more confidence.
CFA - Chartered Financial AnalystRead →Which Are the Main Types of Financial Models?
The most common types are the three-statement model, which links the income statement, balance sheet and cash flow statement, and the discounted cash flow (DCF) model. Others include the leveraged buyout (LBO) model, the merger (M&A) model, comparable company analysis, the initial public offering model and credit rating models.
- Three-statement model: the foundation of all financial modeling, linking the income statement, balance sheet and cash flow statement so a change in one assumption flows through all three.
- Discounted cash flow (DCF) model: values a company as the present value of its projected free cash flows, discounted at an appropriate rate.
- Leveraged buyout (LBO) model: assesses an acquisition financed largely with debt, testing whether the business can service and repay that debt and what return the buyer earns at exit.
- Merger (M&A) model: measures the impact of an acquisition on the acquirer's earnings per share, showing whether the deal is accretive or dilutive.
- Comparable company analysis: values a company relative to similar firms using multiples such as EV/EBITDA, P/E and P/BV.
- Credit rating model: used by credit analysts to assess a company's creditworthiness and ability to pay interest and principal.
How Does a DCF Valuation Model Work?
A discounted cash flow model estimates a company's intrinsic value as the present value of its expected future free cash flows. Analysts project those cash flows, then discount them back using a rate that reflects risk, typically the weighted average cost of capital. The sum of the discounted flows gives the business's value.
DCF analysis rests on the principle that the value of a business equals the sum of its projected future free cash flows, discounted back to today. The discount rate must match the type of cash flow: cash flows to equity are discounted at the cost of equity, while cash flows to the firm are discounted at the cost of capital.
This is why DCF is one of the most widely taught valuation methods. It forces the analyst to be explicit about growth, margins and risk, and it produces an intrinsic value that does not depend on how the market happens to price comparable companies at that moment.
How Do You Build a Simple Financial Model?
Start by gathering historical financial statements and identifying the key drivers, such as revenue growth. Build the income statement, then link the balance sheet and cash flow statement so they update automatically. Add assumptions in clearly marked input cells, use formulas for calculations, then run scenarios to test how outcomes change.
- Enter historical financial data as the base for your forecasts.
- Identify the main drivers, for example sales growth measured as the change from the prior period to the current period.
- Create input cells for last year's and this year's figures so the user can change assumptions.
- Write formulas, such as a growth formula that divides the difference between the two periods by the earlier period, and hard-code these calculation cells.
- Link the income statement, balance sheet and cash flow statement so the model updates automatically.
- Run different scenarios to estimate how growth and value change if a specific decision is taken or event occurs.
The example above shows the essence of financial modeling: a stock analyst is ultimately interested in potential growth, and any factor that affects that growth can be modeled and tested.