Chapter 1. Introduction to Financial Analysis and Modeling

Although many people think that financial analysis and financial modeling are very different, they are actually two sides of the same coin. If you have been developing Excel worksheets to solve financial problems, chances are you have been developing financial models without knowing it. Your financial analysis worksheets would be more useful if you viewed them as financial models and incorporated in them some of the basic principles and characteristics of financial models.

Let me explain what 1 mean by first addressing the question, What is a financial model? A simple, practical answer is that a financial model is designed to represent or capture in mathematical terms the relationships among the variables of a financial problem so that it can be used to answer "what if" questions or make projections.

This may sound a little abstract. So let us look at a simple, concrete example. Suppose you are using a spreadsheet to calculate, based on your taxable income, what your after-tax income was last year. Income tax rates vary in steps (brackets) for different income levels. So you cannot simply calculate your taxes by multiplying your taxable income by one tax rate (30%, for example) and subtracting it from your taxable income to get the after-tax income.

Consider two approaches to setting up a spreadsheet to calculate the after-tax income. In the first approach, you enter your taxable income in a cell, in a second cell you write ...

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