Tuesday, April 12, 2011
The Art of Financial Modeling
I often being asked, “How to better be a Financial Modeler?” The answer lies into understanding what goes beyond Financial Modeling. Of course someone will always argue that Modelers would need to be experts on using Excel and its complex functions and we strongly believe that this is something that is undeniable.
However, Financial Modeling is not only about knowing Excel. I would like to affirm that Excel skills come last when it comes to being a good Financial Modeler. From looking into and asking many analysts during visits I personally made with the Equity Analyst Team, in addition to the current financial modeling work that I am currently doing, I can assure you that you need specific skills and knowledge to be as good as the Goldman Sachs’s Analyst who is being paid twice or more the average analyst somewhere else.
Economics: It goes without saying that a good Financial Analyst needs to understand Economics for the reason being that an analyst would need a good judgment in order to well forecast some variables. In addition, in many occasions, the analyst would need to justify his/her numbers to the portfolio manager by giving good justifications that are based on some good economic readings. For instance, modeling a Financial Institution needs well understanding of the economics behind interest rate for the reason being that interest rate income is a major source of income to banks.
Accounting: Understanding accounting is vital in doing FM. However, when talking about accounting here I don’t mean Journal Entry and that sort of things, but understanding the flow of the financial statements and the relationship between each one of them. More importantly, the analyst needs to know the effects and changes within certain items of the financial statements, meaning, the analyst should be able to explain changes in net working capital, depreciation, short term debt vs. long term debt, etc. and how these items cold affect the overall operation of the business.
Finance: The challenge here lies in the ability of separating financial theories with real world applications. Financial theories are meant to explain the science behind financial events and variables such as discount rate, WACC, term structure of interest rate and others. However, when it comes to financial modeling the analyst would need to add some flavors to make such variables work for a real world application.
Finally, I would like to say that Financial Modeling is an Art and not a Science. Two different analysts analyzing the same company with the very same numbers will get different results and have totally two different conclusions. The case is being this way is because both analysts are seeing the economics of the company differently and from different angles. It is important for the analyst here to have the ability to explain the choices behind the numbers and be ready also to explain the assumptions that have been made regarding the future of the company being analyzed.