Modelling means creating analysing your data and creating a model for effective decision making when applied to financials is called financial modelling. It is a common misconception that financial modelling is only for financial analysts it can be used by anyone to improve personal finances. With the help of basic finance concepts and modelling software like Microsoft Excel anyone can track their financial progress. Create budget, track expenses, and monitor the performance of their investments to stay updated with their finances. It is your money so it is your responsibility to make informed decisions about it.
What is Financial Modelling?
In simple words it is just a numerical model representing the financial performance of a business in terms of money, asset based on output, or investment in terms of the results. The very same numerical techniques can be used to forecast income in future, future expenses, calculate savings, and investments. By constructing a model, you can easily visualize how various decisions will affect your finances in future which means that you can actually visualize the effect of various factors on your financial health. All you need is basic understanding of mathematics, financial factors and statistics.
Why is Financial Modelling Important for Personal Finance?
Learning financial modelling is essential to manage various aspects of personal finance like goal setting and tracking, informed decision making, risk management, budgeting, long term planning etc. Taking care of all these aspects make sure that finances are stable and progress is steady towards the financial goal.
Proper application of financial modelling realistic goals can be set up and progress can be easily monitored at any time. Financial modelling tools can be utilized effectively to aid decision making regarding expenses, saving and investing. Extrapolation techniques can help in understanding potential risks and steps required to tackle these risks. Budgeting can be made real simple using a financial modelling and it can be done even on spreadsheet tools available. Financial modelling provides excellent mechanisms to do long term planning regarding goals like retirement, buying a house and other goals.
Steps to Create a Personal Financial Model
Define Your Objectives: Defining your financial goal clearly and quantifying the objective is the first and crucial step in creating any financial model. The goals can be planning for a retirement, paying off debt, or creating a fund for emergencies.
Gather Financial Data: Once the goal is decided the next step should be to gather data for modelling including the income data which includes salary, bonuses, freelance income etc. The next data required to draw financial insights would be expenses that will require fixed (rent, utilities, insurance) and variable (entertainment, dining out, travel). The data regarding the assets which includes savings accounts, investment accounts, real estate can provide a lot of helpful information regarding financial planning. Critical aspects of financial modelling require data regarding liabilities like mortgages, credit card debt, real estate.
Choose a Modelling Tool: After the laborious task of getting data logical step would be to select a modelling tool which can be spreadsheet software like Excel or Google Sheets. You can also use personal finance software like YNAB, Mint or Quicken. The best thing about the spreadsheet software is that you can add functions and formula as per the need of analysis.
Process of Analysis
Create Income and Expense Statements: The factors used primarily for financial analysis are your income and expenses. The first step in the process of analysis would be to generate the income and expenses statements because it is essential to predict how much you would be saving in the future using the projected value for your income which will include all your income sources and your projected expenses.
Develop Cash Flow Projections: In layman terms cash flow means how much cash has actually has been moved in your account in a specific period. It is simply the income minus the expenses. It is a crucial metric to estimate your future savings and the projected amount available for investments.
Incorporate Assets and Liabilities:
Balance Sheet: Knowing your net worth is crucial in the making the decisions regarding your investments and savings and also in checking your progress towards your financial goals. Balance sheet is an excellent way of analysing your assets and liabilities to calculate your net worth for a specific time.
Debt Repayment Schedule: Financial modelling helps is efficiently scheduling your debt repayment. It is essential to make the payments on time for your debt obligations and maintaining the data regarding loan repayments, interest rates and timelines will enable to analyse and prioritize the debt repayments to ensure that you save money in terms of interest charged on the debt.
Scenario Analysis and Sensitivity analysis: It can be understood as the process of creating different scenarios and then finding how much your finances will be impacted by the change in various variables like income, expenses or major life changes like job loss, major purchases, medical emergencies etc. Knowing how your finances will change with the variation in variables is not enough managing your finances also requires the information about sensitivity of your finances which the knowledge of variables which have the major impact on your finances and how much sensitive your model is with respect to changes in these variables.
Review and Adjust Regularly: As the variables on which your personal finances depend are not constant due to factors like change in income, expenses, and other conditions like emergencies and economic conditions hence it become really important to regularly review your model whenever there is a change in the data and adjustments must be change to compensate the changes in the variable.
Example: Building a Simple Financial Model in Excel
Let us go through the process and steps to create a financial model in Microsoft Excel.
Step 1: Open a blank spreadsheet in excel and name it Income statement
In columns put the headings Month, Salary, Freelance Income, Other Income, Total Income
In rows write the months and provide the values as per the column.
Sheet 2: Go at the bottom bar add a new worksheet and name it as Expense Statement.
In columns put the headings for Month, Rent, Utilities, Groceries, Transportation, Entertainment, Total Expenses.
In rows enter the name of each month under the month column header and input respective expense values as per the column headers for each column.
Sheet 3: Create a new worksheet and name it as Cash Flow
In columns create headers for Month, Total Income, Total Expenses, Net Cash Flow (Income – Expenses)
In rows insert the data as per the headers from the income and expense statements.
Step 4: Input Historical Data
Use the data from past 12 months to create a reference base line for analysis.
Step 5: Create Projections
Now you can use the historical to create future projection by either using moving average method for forecasting. You must consider factors like inflation, and planned variations in expenses.
Step 6: Scenario Analysis
Create different worksheets for calculations discussed in above mentioned according to optimistic and pessimistic scenarios. Make adjustments according to scenarios to get the clearly reflect the impact of scenarios.
Step 7: Visualize the Data
Excel has various statistical visualization tools like histogram, line charts, bar charts, pie charts, scatter plot etc. which can be used to visualize the variation of cash flow, income, expenses and net worth with time. Visualization helps in analysing the past data to implement changes for successfully achieving the future projections.
Tips for Effective Financial Modelling
By keeping just few things in mind anyone can create efficient and effective financial models to ensure their financial progress. Your model should be realistic which means expenses should not be underestimated and income should not be overestimated. You must always update your model regularly as per the current conditions. There should always be a slack for unexpected fluctuations in income and expenses. You should always seek help of a professional financial advisor for complicated situations.
