The financial modeling skills to advance your career

Since publishing my article Financial modeling: the career game-changer, many people have asked me what skills they require to be deemed a good financial modeler.

In most cases, I'm asked about the relative importance of particular applications of financial modeling such as M&A, LBOs, DCFs and project finance. And I always give the same answer: the foundational skills are the same for all types of financial models, so focus on these first.

Many expert financial modelers love to tell you how complex things are, and how their models are very sophisticated. But their motivations often lie in protecting their self-proclaimed genius status and their domain, not empowering you, and I can assure you that, after spending almost two decades building different types of financial models of different types of businesses, the core skills are predominantly the same.

The 7 core areas of knowledge

From my experience, the core skills required to be a good financial modeler can be segregated into 7 areas of knowledge. And the vast majority of the 'engine' of any financial model (i.e. its key assumptions and outputs) can be allocated to one of these knowledge areas

These 7 core knowledge areas have proven so reliable that we have used them to simplify the scoping and planning process for every model that my companies have built over the last decade. We also use them to more clearly understand and communicate model build progress, and to identify which areas of each model require specific customizations.

So if you can understand the core principles within each of these 7 knowledge areas, you can confidently say that you're a good financial modeler. And you'll probably find that your career starts moving a bit faster too.

1. Revenue & expenses

When accountants talk about revenue and expenses, they usually start talking about debits and credits. When building financial models, it's less about debits and credits and more about understanding the relationships between each of the areas within a financial model, and their impacts on the financial statements.

For example, when an invoice is sent out by a business reporting revenue on an accrual basis, their accountant will usually debit accounts receivable and credit revenue. Later, when the invoice is paid, cash will be debited and accounts receivable will be credited.

When building a financial model, revenue and expenses are usually modeled independently of accounts receivable and payable, and linked directly into the income statement and cash flow statement. Adjustments are then made to the balance sheet and cash flow statement for movements in accounts receivable and payable balances during each period to ensure correct cash flows.

Understanding such nuances of financial modeling is the key to becoming a good financial modeler.

• Resources: Revenue, Operating Expenditure
• Examples: Revenue, Operating Expenditure

2. Working capital

If you read accounting and finance textbooks, working capital can quickly get very scary, with broad and complex-sounding phrases about current assets and liabilities, liquidity, and quick ratios.

When building financial models, the foundations of working capital lie in debtors, creditors and inventory. Inventory can be a nightmare to model in some cases where LIFO and FIFO considerations can cause headaches, so I'd recommend starting with debtors and creditors.

In most cases, debtors and creditors can be modeled by applying debtor and creditor days assumptions to projected revenue and expenses. The debtor and creditor days approach is simply a way of estimating the proportion of invoices sent out and received during each period which have not been received or paid in cash before the end of the period. It's globally recognized by financial modelers, so you need to properly understand it.

• Resources: Working Capital Modeling, Debtors, Creditors
• Examples: Debtors, Creditors

3. Assets

The assets area within a financial model can refer to all kinds of current and non-current assets, but the primary focus is usually on tangible and intangible assets which are depreciated and amortized over their useful lives in accordance with the matching concept in accounting.

Simple financial models often contain only tangible assets, which are in most cases depreciated using the straight-line depreciation method. More complex models will contain intangible assets, which is an important distinction because intangible assets often have no value in an insolvency event.

Assets may also become more complicated by the inclusion of both book and tax assets in your financial model, which may also result in accelerated depreciation methods (such as the declining balance method) being used for tax depreciation or amortization.

The big thing to bear in mind with assets is that, in most cases, this area of a financial model is very similar in most financial models, even for different businesses in different industries. So once you've become familiar with the primary depreciation and amortization methods, and the formulas required to model them, this is usually one of the easiest areas of the financial model to build.

• Resources: Assets Modeling, Fixed Assets, Capital Expenditure
• Examples: Fixed Assets, Capital Expenditure

4. Capital structure

The capital structure area within a financial model is another area which can become very complicated when a business has several different forms of funding, so as a starting point you should get comfortable with the two extremes: senior debt and ordinary equity.

Senior debt and ordinary equity, while exposing their providers to very different risk profiles, are quite similar in how they are modeled. Both have a return of capital - i.e. debt repayments for debt and share buybacks for equity - and a return on capital - i.e. interest payments for debt and dividends for equity. And understanding the similarities and differences between the modeling of these different types of returns for different forms of capital is the key to good capital structure modeling.

• Resources: Capital Modeling, Debt, Ordinary Equity
• Examples: Debt, Ordinary Equity

5. Taxation

Like capital structure, the taxation components within a financial model have the potential to get very complicated, so you should start by focusing on the basics and building more advanced skills over time.

In most financial models, this means focusing on corporate taxation and ignoring other forms of taxation - such as sales and payroll taxes - which can add another layer of complexity to the entire model.

When modeling corporate taxation, start by calculating tax expense by simply applying a tax rate to net profit before tax (NPBT), then allow for tax losses. Tax losses can't really be ignored, even in a simple financial model, because tax authorities don't give businesses back a percentage of their losses (unfortunately), so including tax expense/paid as a positive revenue/cash flow in tax loss periods is completely wrong.

Once you have a solid understanding of basic tax expense and losses modeling, you can move onto more advanced considerations such as deferred tax assets and liabilities, permanent differences and tax payment timing delays.

Corporate taxation modeling is one of those areas that separates good financial modelers from great financial modelers, and I can still recall the many months I spent getting my head around it when I built my first advanced financial model in investment banking. Like many things in life that are challenging, corporate taxation modeling will become a great source of pride for you if you have the patience and determination to become good at it.

• Resources: Basic Corporate Taxation Model
• Examples: Detailed & Comprehensive Corporate Taxation Examples

6. Other financial statement items

In a perfect world, every non-financial statement piece of a financial model that impacts the financial statements would be classifiable as either revenue and expenses, working capital, assets, capital structure or taxation. However, in the real world, there's always a bunch of items in the financial statements that don't obviously fit into one of these areas.

Common examples of these other financial statement items include interest revenue, non-core revenue and expenses, provisions, other assets and other liabilities. In many cases, these items are relatively immaterial, but they must be included within your financial model to ensure that your historical financial statements reconcile with financial reports.

As a starting point, you should focus on reconciling your income statement and balance sheet, which is most easily done by including other income statement items in the income statement and other balance sheet items in the balance sheet, and then including corresponding cash flow movements within the appropriate sections of the cash flow statement to ensure that the balance sheet remains balanced. You can then break out the modeling of the more material other financial statement items as a second step.

• Resources: Other Revenue & Expenses, Interest on Cash, Other Balance Sheet Items
• Examples: Other Revenue & Expenses, Interest on Cash, Other Balance Sheet Items

7. Financial statements

Before building my first financial model, I assumed that much of the logic in a financial model was contained within the financial statements themselves. For example, I thought that tax expense was calculated within the income statement by multiplying net profit before tax (NPBT) by the corporate tax rate, not calculated within the corporate tax area of the financial model before being linked into the income statement.

In a well-built financial model, financial statements are really just a reconciling summary of the content within the surrounding model, with each area having a balancing impact on the balance sheet. As a result, the only links between the income statement, balance sheet and cash flow statement are net profit after tax (NPAT) flowing from the income statement to the retained profits section of the balance sheet, and the change in cash on the cash flow statement flowing into cash at bank on the balance sheet.

To become a good financial modeler, it is important to understand these relationships between the financial statements, and how each of the other areas within a financial model impacts each of these financial statements. Personally, I find financial statement impacts diagrams to be the best way to explore and understand these relationships, so I'd recommend using them as a starting point.

• Resources: Financial Statements Modeling, Opening Balance Sheet, Income Statement, Balance Sheet, Cash Flow Statement
• Examples: Opening Balance Sheet, Income Statement, Balance Sheet, Cash Flow Statement

Becoming a great financial modeler

A solid understanding of the 7 core areas of knowledge will make you a good modeler, but becoming a great modeler will require you to layer this knowledge with more advanced financial modeling skills, including:

• Cost of goods sold / inventory
• Sales taxes / GST / VAT
• Advanced corporate tax: DTAs / DTLs, permanent differences
• Rolling financial modeling (i.e. incorporating historical data)
• Budgeting
• DCF valuations
• Dashboard outputs
• Advanced driver-based modeling

The important thing to bear in mind is that each of these advanced skills can be learned incrementally, and builds upon the core skills within the foundational 7 knowledge areas. The biggest mistake many people make when learning financial modeling is failing to compartmentalize complexity. Very few things a difficult to understand if you break them down into small enough pieces.

Where do I start?

The 7 core areas of knowledge are covered in detail in Modano's free practical Financial Modeling Fundamentals Certification (you can view the full agenda here). The exercises will take you somewhere between 10-20 hours to complete, but each contains movie tutorials and learn-by-doing practical exercises which will leave you with hands-on financial modeling skills and knowledge.

Once completed, you can upload your certification to your LinkedIn profile so that your boss, or potential employers, can see that you've acquired these core skills.

As for the more advanced financial modeling skills, Modano is aiming to add a full range of free advanced learning and assessment exercises going forward. To ensure that you're notified of these exercises as we release them, create a Modano account and make sure you're subscribed to the Modano newsletter. We'll also be hosting a wide range of free financial modeling webinars which you can register to attend.

Many businesses around the world remain unable to access high quality financial models due to the severe lack of good financial modelers. And this imbalance of demand and supply is creating significant career opportunities for anyone willing to invest the time in learning the core skills. So if you're looking to take your career to the next level, this is a great place to start.

Onwards.

Michael Hutchens