What is Financial Modeling? (Full Beginner’s Guide)

If you're working in FP&A and you've ever been asked to build a financial model, you probably know that feeling of staring at a blank Excel spreadsheet, wondering where to even start. And over the past decade, leading FP&A teams, companies like Unilever, Procter & Gamble and Squarespace, I've seen countless finance pros struggle with this exact challenge. So today I'm making this video to give you everything you need to know about financial modeling when you're getting started. From my five-step framework for building any model to the six most important model types every finance professional needs to master. Let's dive straight in. What is financial modeling? I define it this way. A financial model is a way to assess a slice of reality by simplifying and quantifying it. It helps a company see the likely financial results of a decision. Financial modeling is more than just what you do in Excel. There's an entire process around it that we'll cover in this video. We use financial modeling for two main purposes. There's decision support. So when the company wants to make a big investment and isn't sure if it's financially viable or when the team has many investment ideas but limited funds and needs help with prioritization. And then there's planning and forecasting. So creating models to build plans and forecasts that help evaluate investment decisions. Before I show you my framework for creating any financial model, I wanted to quickly mention that I've created a mini course about financial modeling and I'm giving it away for free for a limited time. In the course, you'll learn how to apply best practices to create financial models that are robust, error-free and optimized for fast iteration. To enroll for free, you can just click the first link in the video description. Now back to the video. There's an entire process around financial modeling. It's more than what you do in Excel and these are the steps you need to master. Step 1. Model planning. You have to decide what kind of model you're going to build. Choose the right model type for the specific business case. Step 2. Data collection. Gather all necessary inputs and assumptions. It's important that we challenge the assumptions during this phase. Step 3. Building the model in Excel. This is where most people think the work begins but it's actually just one part of the process. This phase is critical to make sure the model is accurate. Step 4. Review and sensitivities. When you're done building your model, you need to plan time for review and sensitivities. There's nothing worse than presenting output from a complex model and then realizing mid-sentence that you made a mistake you didn't catch. Step 5. Presentation and iteration. Present your findings and be prepared to iterate based on feedback. The model often needs refinement after the initial presentation so you need to make sure it was built to accommodate fast iteration. Before you start building your model, you need to choose the right type depending on the business case. To show you why this is important, let's say your marketing business partner comes to your desk and says, hey we're considering offering a 30% discount in quarter 3. Do you think it makes financial sense? You might be tempted to fire up Excel and dive straight into building a complex discounted cash flow model to evaluate the promotion but that would be a mistake. There are several model types that FP&A commonly uses. ROI models, discounted cash flow models, custom lifetime value models, breakeven analysis and which model you choose matters for two main reasons. First, with the wrong model type, the output may be inaccurate. Certain models are great for specific cases but poor matches for others. Second, if the model is unnecessarily complex, it likely won't get buy-in from other departments. Even if your model is technically perfect, it's useless if people don't take action based on it. A financial model makes a recommendation and you need people from other departments to agree with that recommendation. If you always use the most complex model type for simple decisions, people may not have the patience to understand how it works and they'll be less likely to trust the output. Fortunately, there are different model types you can use to tailor to the decision at hand. The six most important model types. Number one, return on investment. In its simplest form, it's calculated by dividing revenues from an investment by the cost of the project. The ratio indicates that the project is worth pursuing if it exceeds one. Meaning, revenues are higher than costs and the project is profitable. This metric is popular because it's easy to understand and communicate. Its meaning is immediately clear to stakeholders who don't have a background in finance. Use it when the relevant time horizon is short, that's typically less than a year, because then the time value of money doesn't play a role. I'll explain this important concept in a moment. Second, payback period. Payback analysis is closely related to return on investment. It expresses how many months it takes until an investment is paid back in full. You calculate it by dividing 12 by the ROI that yields the number of months it takes to break even. Or you calculate it by taking the cost of the investment and dividing it by the average annual cash flow to arrive at the number of years it takes to get your money back. Companies use payback models to set targets on acceptable investment levels in relation to revenues. They also help to ensure that the company does not underinvest. For example, the target for a marketing team may be a playback period of around 9 months. Third, we have net present value. Before we can discuss net present value, we need to understand the concept of the time value of money. In a nutshell, it means that a dollar I receive today is more valuable than a dollar I get in a year from now. That's because I could take the dollar today and invest it and so it may be worth more than a dollar in a year from now, whereas a dollar in a year is just a dollar. The net present value is the output of a discounted cash flow model, an NPV, that's net present value for short, of zero. It means that the present value of cash generated by the project is equal to the present value of the investments. The concept at its core is simple. The longer I have to wait for my investment to pay back, the higher are my opportunity costs because I cannot invest the allocated funds elsewhere. This means that future cash flows need to be discounted by the rate of return we could reasonably expect from an alternative investment. Typically, this discount rate is equal to a company's weighted average cost of capital. That's the average return that both bondholders and shareholders demand in order to provide the company with capital. I'm not explaining the math of how you calculate net present value by hand because one, you can easily google that or ask your favorite AI chatbot, and two, Excel does all the math for you in the background. Capital budgets tend to be limited, so net present values are often used to prioritize among different investment options. But in the end, you should always calculate net present value if you need to include cash flows from more than one year in your model because then you need to consider the time value of money to make different projects comparable. Fourth, internal rate of return. Net present value estimates what the return on investment may be today in absolute terms. However, to assess risk in relation to returns of investments, you need to also take a look at the internal rate of return. It specifies the discount rate that would result in a net present value of zero. To put it differently, net present value is the amount of money we make from an investment, while the internal rate of return tells us the equivalent rate of return of the project. Internal rate of return is critical when we want to compare projects to each other that have different risk profiles. To make them comparable, companies assign different target rates to each type of investment. These targets are also called hurdle rates. Fifth, customer lifetime value. Customer lifetime value estimates how much net profit we expect to receive on average from customers over their lifetime. That is over the period of time they spend money on our products or services. It's the future value we expect to receive on a per customer basis. The measure is typically an output of a predictive model but can also be estimated using past periods. Companies apply this concept with various degrees of complexity using different formulas and methods depending on what best fits their industry, business model, and data availability. But here's the simplest formula. Take the average dollar amount of a purchase times the number of customer purchases per year times the average length of the customer relationship in years. Companies that sell subscriptions heavily rely on customer lifetime value to make decisions because they need to take customer loyalty into account. The model type is often used to determine how much a company can spend on acquiring new customers. Sixth, break-even analysis. It determines how much you have to sell of a given product or service to break even. Breaking even can mean different things depending on the context. It could mean turning profit for the first time, reaching an ROI of one or a net present value of zero. It's used to determine how long it takes for the company to reach the break-even milestone. And this model type has another important use case in FP&A. You can use it to deal with uncertainty. Companies often struggle with estimating revenues of launching a brand new product. Expenses are often easier to project. So you can build a break-even model to determine how much the company would theoretically have to sell for the product launch to be financially viable. Then you can present this number to sales and get quick feedback about realistic that number is. If it looks good with a healthy safety margin, you can go ahead with the project. And if sales says there's no way they can sell that much, then you can go back to the drawing board and investigate with the other teams. Product or marketing costs can get reduced to lower the necessary break-even volume. And that's your beginner's guide to financial modeling in FP&A. Now that you know which model types you need, it's time to dive into how to actually build them in Excel. And that's why I've created my mini course called Introduction to Financial Modeling Standards, where you'll learn how to apply best practices to create models that are robust, error-free, and optimized for fast iteration. And the best part is you can get the online course now for free for a limited time. Just click the first link in the video description to get it for free. And if want to learn more about financial forecasting, I've recently made a video going over the seven best forecasting methods and how to use them. You can check it out by clicking here on the screen.