What Is Financial Modeling?

Introduction

Financial modeling is the process of creating a concise representation of a firm or financial asset’s only possible performance based on various inputs. Financial models are used as a tool for assessment, evaluation and decision-making relating to financial changes for companies, organizations and individuals. Financial models are composed of assumptions, postulations and projections that manage to represent the past, present and future performance of an asset based on a few variables.

Definition

Financial modeling is essentially the process of building an abstract representation of a financial situation in order to better understand it. Financial models are used by different parties that have an interest in the financial situation, such as investors, accountants and bankers, to provide them with an insight into the financial operations and outcomes of a situation they are interested in.

Advantages

• Aids decision-making
• Enables forecasting
• Helps gauge potential outcomes
• Provides clarity on financial situations

Common Uses

• To value a company
• To analyze potential investments
• To project economic conditions
• To assess the impact of mergers, acquisitions and other strategies

Data Gathering

In order to build a financial model, you need to start with collecting relevant information. This data forms the basis of your model and allows you to make realistic assumptions and estimates that accurately reflect the situation. Generally, data gathering involves researching market trends, collecting documents and financial statements, and consulting experts.

Collecting Relevant Information

When it comes to financial modeling, data gathering is a crucial aspect of the process. You need to make sure that you’re collecting all of the necessary data points that are relevant to the model you’re building. This includes both historical and current data, as well as relevant industry trends. You may also need to collect specific information related to the company you’re modeling, such as financial statements and other documents.

Defining Assumptions

In addition to collecting relevant information, you also need to define the assumptions that you’ll be making when building the model. These assumptions will have a significant impact on the accuracy and validity of your model, so you need to make sure that they’re appropriate and realistic. Your assumptions should take into consideration current market trends and historical data, as well as any other relevant information. It’s important to remember that your assumptions can always be revisited and amended after the model is built, so you don’t need to be perfect with them from the start.

• Research market trends and collect historical data
• Gather relevant financial statements and documents
• Consult experts for input and guidance
• Define the assumptions that you’ll be making

Structuring a Model

Financial models are often the foundation for the development of financial plans and the decision making process of senior executives. The primary purpose of a financial model is to identify the past performance, present condition, and future outlook of a company or project. Structuring a model is the process of organizing all of the key information and data, by linking elements and calculations and incorporating key components in order to effectively convey a given message.

Linking Elements and Calculations

The most essential part of constructing a financial model is ensuring that it is fully connected and each element is accurately represented. Linking elements and calculations together, implies that the model must be built with clean, error free, and logical equations and calculations. To ensure each element and calculation is properly connected and represented, a financial modeler should use absolute and relative cell references and double check the accuracy of all numerical data.

Key Components

Financial models are comprised of key components that support the development of financial plans and the decision making process of upper management. Among these key components are the following:

• Income Statement: a financial statement that summarizes a company’s revenues, expenses, and profits.
• Balance Sheet: a financial statement that summarizes a company's assets, liabilities, and shareholders’ equity.
• Cash Flow Statement: a financial statement that summarizes a company’s cash flow over a given period of time.
• Operating Assumptions: projections for the upcoming plan year that are based on current market trends and industry performance.
• Discounted Cash Flow Analysis: a financial analysis model based on the time value of money that that expresses the current value of future cash flows.

The structure and content of each financial model varies based on its purpose and intended use, however, all models should include the key components necessary to accurately reflect a company’s performance and forecasted outlook.

Model Validation

Financial modeling is a process of building a quantitative representation of a financial situation and it is used for making informed decisions. To ensure the accuracy and quality of the output, model validation is an utmost important process. Validation should be done at all stages of the modeling process to ensure the accuracy of the model’s results and make sure that the projections are reliable and realistic.

Testing for Overall Accuracy

The overall accuracy of a financial model can be tested by performing a sensitivity analysis. This analysis can help to determine the dependence of the output on different types of inputs. It can also be used to test the accuracy of the assumptions used in the model. The result of the sensitivity analysis can also be used to identify possible errors or areas which require further analysis.

Validating Calculations

Validating calculations is one of the most important steps in validating a financial model. Calculations should be checked to make sure that they are correct and that the assumptions used in the model are valid. To validate calculations, a quality assurance procedure should be implemented, which involves manual and automated tests. Automated tests should include tests of the formulas and the calculations used in the model and manual tests should include checks of the processes and methods used to calculate the results.

Validation is a crucial process for eliminating potential errors that could lead to inaccurate and unreliable results. To ensure the quality and accuracy of final output, model validation should be done carefully and thoroughly throughout the whole modeling process.

Benefiting from Model Output

Financial modeling allows for an array of outcomes and simulations to be analyzed. Leveraging model output is key to accurately predicting financial outcomes and informing decisions. Model output help to:

Analyze Simulations

Financial models allow you to accurately simulate different outcomes and scenarios that can have an impact on financial performance. By analyzing these simulations, businesses are able to accurately measure the value of potential investments, calculate potential future outcomes, and understand potential risk factors. These simulations are based on high-quality data collected over a long period of time, allowing businesses to gain better insight into their financial performance and accurately account for possible outcomes.

Calculate Financial Outcomes

Financial modeling allows businesses to predict and calculate financial outcomes by analyzing key financial metrics such as forecasting cash flow, asset values, and expected returns on investments. By leveraging models, businesses can accurately assess financial outcomes and make informed decisions that will ensure the long-term sustainability and success of the business. Models are also able to provide projections and forecasts based on current market conditions and industry trends. Businesses can benefit from these projections in order to make accurate predictions and prepare for potential outcomes.

Automating Processes

Automation of tasks is widely used in the business world. In fact, automation plays a particularly important role in the field of financial modeling. Automating calculations and processes can result in considerable efficiencies and time savings.

Streamlining Calculations

Automation within financial modeling enables users to decrease their dependence on manual calculations. Rather, a model can be equipped with scripts which manage tasks related to calculation and input. This can lead to reduced coding time, faster execution times and decreased chances of error.

Increasing Efficiency

It is also possible to use automation within financial modeling to increase the efficiency of a forecasting process. Through automation, a model can be structured so that algorithms quickly analyze data and produce a result. This process can be structured for different types of data, helping to make the establishment of solid projections more efficient and reliable.

Conclusion

In conclusion, financial modeling is a powerful resource that allows businesses and individuals to better understand finances and make more informed decisions. Financial models are often used to explore business potential and improve communication between investors and stakeholders. Analysis of the financial model allows businesses to juxtapose the current financial state of a business to its potential future earnings, while also gaining insight into the future health of the organization.

Benefits of Financial Modeling

• Better understanding of business finances
• Exploration of business potential
• Improved communication between investors and stakeholders
• Aid to forecasting future earnings
• Ability to monitor current financial health