Financial modeling uses accounting principles to create a model that can be used to assess a potential investment, long-term profitability, or project future changes in the value of a business. It is a way of prediction based on past data and depends on a sound understanding of the basic accounting principles. This blog post will provide an overview of the basic accounting principles necessary for financial modeling in Excel.
The main focus of this blog post is to cover the resources which can be used in Excel to understand basic accounting principles. We will discuss the fundamental concepts such as income statement, balance sheet and cash flow statement. We will also discuss key accounting principles, their purpose and the ways to apply them in Excel.
- Understanding the basic accounting principles
- Learning resources on the income statement, balance sheet, and cash flow statement
- Applying the key accounting principles in Excel
Understanding the basic principles of accounting is essential when it comes to financial modeling in Microsoft Excel. Accounting terms provide the building blocks for financial modeling and can be divided into three main categories: balance sheet, income statement, and cash flow statement.
Overview of Accounting Terms
When it comes to accounting, the three main categories of terms are assets, liabilities, and equity. Assets are resources that a company has acquired and are expected to generate future economic benefits. Liabilities are debts or obligations that arise during the course of normal business operations. Equity is the residual interest that is left over after taking assets and subtracting liabilities.
The balance sheet is the most fundamental of financial statements and serves as the foundation of financial modeling. It is a snapshot of a company's financial situation at a particular point in time. The balance sheet lists a company's assets, liabilities, and equity at a specific point in time. It is structured as follows:
- Assets = Liabilities + Equity
- Assets - Liabilities = Equity
The income statement is the second most important financial statement for financial modeling. It lists a company's revenues and expenses over a specific period of time and is used to calculate the company's net income or net loss. It is structured as follows:
- Net Revenues - Expenses = Net Income
- Net Revenues - Net Income = Expenses
Cash Flow Statement
The cash flow statement is the third and final financial statement for financial modeling. It lists a company's cash inflows and outflows over a specific period of time and is used to calculate the company's net cash flow. It is structured as follows:
- Cash Inflows - Cash Outflows = Net Cash Flow
- Cash Inflows + Net Cash Flow = Cash Outflows
Defining Accounting Rules
The double-entry accounting system is one of the core underlying principles for financial modeling. Double-entry accounting ensures that for every financial transaction, two entries are made in the books: a debit entry (factors that increase assets, decrease liabilities, and decrease equity) and a credit entry (factors that increase liabilities, decrease assets, and increase equity). This helps balance the books of the company and verifies all the financial entries.
Revenue and expenses are recorded in detail whenever they occur. For example, normal purchases and sales of goods, cash received against services provided, etc., are recorded in the books. Accrual accounting involves including transactions in the accounts of the period in which they occur, regardless of whether there has been an actual cash exchange. On the other hand, cash-basis accounting is where the transactions are only included when there is an actual exchange of cash on the transaction. The accounting rules that decide which system should be used vary from country to country.
The matching principle ensures that all the expenses of the year are matched with the corresponding revenues generated. This demonstrates how the cost of goods sold has been used to acquire the revenues. The matching principle helps users of financial statements to better estimate the reported earnings.
The reporting period convention explains when a financial statement should be reported. Normally these reports take place at the end of the financial year and include all transactions for the entire year.
a. Double-entry accounting system
- Debit and Credit entries
- Helps balance the books of the company
b. Revenue and expenses
- Follow the guidelines of the double-entry accounting system
- Accrual vs. cash-basis accounting
c. Accrual vs. cash-basis accounting
- Accrual: record transactions in the period in which they occur, regardless of whether there has been an actual cash exchange
- Cash-basis: record transactions only when there is an actual exchange of cash on the transaction
d. Matching principle
- Match expenses with the corresponding revenues generated
- Helps users of financial statements better estimate reported earnings
e. Reporting period convention
- Explains when financial statements should be reported
- Usually at the end of the financial year, including all transactions for the entire year
Understanding Debits and Credits
Debits and Credits are the fundamentals of financial statements, double-entry bookkeeping, and financial modeling in Excel. Both are concepts that are essential to understand when doing financial modeling, as it is a common practice for analysts to manually input entries that appear on a company’s financial statements into Excel.
Definition of Debits and Credits
Debits and Credits can both refer to decreasing (debit) or increasing (credit) a company’s liabilities, equity, or assets. To simplify, when debits are entered, the company’s assets go down and either its equity or liabilities go up. Conversely, when credits are entered, the company’s assets go up and either its equity or liabilities go down.
Accounts Impacted & Direction
The right hand side of double-entry bookkeeping records credits and the left hand side of double-entry bookkeeping records debits. Depending on the type of account, debits increase the balance of the account while credits decrease the balance. The accounts impacted in that process are split into three categories:
- Assets: Increase with credits and decreases with debits
- Liabilities & Equity: Increase with debits and decrease with credits
- Revenue & Expenses: Increase with debits and decrease with credits
Understanding the basics of debits and credits will help financial analysts to make accurate entries in Excel when doing financial modeling.
Categorizing Assets & Liabilities
Financial modeling in Excel relies on understanding the categorization of assets and liabilities in order to accurately report and predict the financial situation of businesses. It is important to understand the differences between the categories of assets and liabilities and the factors that affect them in order to utilize accurate financial modeling techniques in Excel.
Categories of Assets
The most common assets include cash, inventories, investments, receivables, and tangible property. Cash includes cash held on hand, as well as short-term funds in an accessible account. Inventories refer to merchandise, raw materials, work-in-process, and finished goods held for sale. Investments refer to funds invested in stocks and other securities. Receivables are amounts due by customers for goods and services provided. Tangible property includes land, buildings, machinery, and other physical assets.
Categories of Liabilities
Liabilities, like assets, are divided into different categories. These categories include current liabilities, long-term liabilities, and equity. Current liabilities are amounts due to pay within a year, including taxes, accounts payable, wages and salaries, and interest payments. Long-term liabilities are amounts due to pay beyond a year, such as mortgages and long-term loans. Equity refers to shareholders' investment and retained earnings.
Financial Modeling Techniques
Financial models are complex tools used to make projections concerning financial decisions. Excel serves as an ideal tool for creating such models since we can make use of formulas, manipulations, and functions to build them. It is important to understand the basics of financial modeling to create an accurate and precise model. The following topics detail the principles underlying financial modeling with Excel.
High-level Overview of Modeling Steps
Financial modeling employs ground rules, assumptions, and advanced structure to estimate performance and activity. A high-level overview of modeling steps for financial forecasting involves the following:
- Identify an objective.
- Define explicit assumptions.
- Create a timeline.
- Specify inputs and outputs.
- Develop original calculations.
- Prepare source data.
- Gather relevant assumptions.
- Perform financial calculus.
- Execute related calculations.
- Analyze and interpret data.
- Create graphical representations.
- Interpret the results.
Assumptions Behind Financial Models
Proper assumptions underpinning financial models are imperative to form reliable forecasts. Major assumptions from a financial model including the following:
- Neither inflation nor deflation is present.
- Sufficient capital is available.
- A static tax rate is enforced.
- The currency remains unchanged.
- The cost of investments remain steady.
- Interest rates are stable.
- Revenues and spending remain consistent.
- Unforeseen events do not impact the model.
- Revenues and expenses associated with sales are known.
Good financial modeling skills are vital for producing accurate financial projections. With the right preparation and knowledge, financial modeling can be made easier and quicker. This blog post discussed the basics of accounting, the essential skills required for becoming an effective financial modeler and the essential features of creating a financial model in Excel.
We looked at how to prepare for financial modeling and what skills are needed. We discussed how following the accounting principles helps in producing meaningful and believable financial models. We explored the various Excel techniques involved to make the process of financial modeling easier and faster.
We also explored some of the best practices and tips for creating effective financial models in Excel. Financial modeling in Excel is a complex activity and proficiency in accounting, Excel functions, and spreadsheet formatting are a must for successful results.
Recap of points discussed
- The fundamentals of accounting and its principles.
- How to become an effective financial modeler.
- Essential features of financial modeling in Excel.
- Best practices and tips for creating effective financial models in Excel
Further resources to explore
- Investopedia - Accounting
- Zack's Finance - Modeling with Excel
- Corporate Finance Institute - Financial Modeling
- Wall St Training - Financial Modeling
- 5-Year Financial Projection
- 40+ Charts & Metrics
- DCF & Multiple Valuation
- Free Email Support