What is the purpose of financial modelling: A complete guide

What is financial modeling?

Financial modeling is the best future predictor for businesses-it projects the future performance of a business based on consolidated historical data and assumptions that they expect for future periods. Financial models outline revenue, expenses, and cash flows. It is helpful for decision-making in investment, budgeting, and strategy by leaders, and also assists the analysts in evaluating the company’s valuation and risks under dynamic conditions.

Financial Modelling

Summarizing a company’s historic financial performance in order to forecast future performance is what financial modeling basically means. A model is derived from all core accounting statements, an income statement, balance sheet, or cash flow statement for example, combining them with some assumptions toward future prospects of sales, expenses, and capital investment. The financial model will therefore combine data on historical performance with some predicted trends to give an estimate of future performance in terms of sales for the coming quarters or the valuation of the company.

Financial modelling allows company leaders to make informed decisions on investments, budgeting and projects. Actual models help in increasing the profitability and growth of the company by enabling their leaders to know the possible outcome of financial decisions and build future plans based on data-driven evidence. Models are beneficial for external analysts to understand the value of business and decide accordingly on acquisition, investment, and lending.

Purpose of Financial Modelling

There are many different kinds of outputs that a financial model can provide, including a very wide variety of uses. Scenario modeling, for example, is widely applied to aid analysts to run “what if” assessments. Such analyses take account of the principal drivers and assumptions of a model, apply a range of values, and then determine the best, worst, and most likely outcomes. Such models can prove invaluable in assisting leaders make high-level company strategy decisions, such as:

• Securing Funds: Financial modeling provides an outlook of the kind of financial health a company has, and an estimate on how much valuation the company will make in the future-all with ramifications as to how much capital a company can raise and how much is going to cost.

• Merger & Acquisition (M&A): If a company is considering an acquisition, or is likely to be targeted for one, financial modeling lies at the heart of its valuation and, therefore, of how much the buyer should pay and what the seller should demand.

• Allocating Capital: The investment prioritization in location decision making involves a pool of considerations. For example, the firm may invest in long-term assets whose values systematically decline with time, such as manufacturing equipment to increase production levels rapidly. Alternatively, it may put money into the appreciation-potential assets in the form of real estate for a banking branch.

• Annual budgeting and forecasting: Annual plans are based on financial modeling, typically rolling up department models and plans from across the company, including sales, marketing, manufacturing, and research and development. These drive budget and headcount for the next fiscal year.

• Providing financial guidance: Publicly traded companies also make an offer of guidance during quarterly investor conference calls in which they give estimated revenue and earnings per share for the following quarter. Guidance may have a huge impact on the company’s stock price according to whether the company manages to meet those targets depending on the company’s forecast.

• Risk management: With scenario modeling, leaders of the company are positioned to anticipate critical risk and consider how they ought to respond to it. Financial modeling can assist them in better understanding the factors that may drive existential risk for the company, such as at what level of a sales decline they would run out of cash and go bankrupt.

• Investing in new project: This would include expansion-new stores creating either selling in a new country.

Types of Financial Model

There are numerous specific financial models designed to support a business. There is clear classification into the following forms:

• Three-statement Model: It combines the income statement, balance sheet, and the cash flow statement of the company. This model may also include support schedules. Some of these schedules are working capital, debt, depreciation, and many more. A three-statement model usually provides a base for complex financial models.

• Discounted cash flow (DCF) Model: The most common method of valuation is the DCF model, where the cash available in a company is considered to be more valuable than future cash since cash available can be invested to earn future revenue.

• Leveraged buyout (LBO) Model: This model will determine whether a company is the right choice for an LBO or not. In simple terms, LBO stands for the use of debt to acquire a business. An LBO model estimates minute details, including cash flows, revenues, expenses, and debt payments, about a business’s future performance and hence give a value to the business.

• Comparable company Model: This approach compares and contrasts companies in the same industry and location but is reviewed based on financials and valuations. Therefore, when you’re looking at a home construction business you wish to purchase, you can review the publicly traded similar home construction companies in the same country or region, compare comparable ratios such as P/E price, enterprise value to revenue, profit margins, and any other measure of value and profits.

How to build a Financial Model

Alternative shortcut: make use of software that includes many models and formulas already preset for revenue forecasting, profitability modeling, scenario modeling, and even capital expenses-all integrated and readily available to help create a financial model. Some planning software also provide free-form environments that look and act like a spreadsheet but pull the data from other systems in real time to keep the model running with the latest number.

If you are creating a financial model from the ground up in a spreadsheet, the process will depend on the kind of model. But generally, there is a basic list of steps you should include:

1. Decide the type of financial model you want to build: Most of these models have formulas set up on existing accepted accounting principles, but if it gets really complex, then you would need to create a formula that best works for you.

2. Review the company’s financial statements and compare it to similar companies in the same industry: Examine the history of the company, its revenue streams, capital base, and so on. These will help identify some of the assumptions going to be key in your model concerning revenue growth, total addressable markets, operating costs, and profit margins you may assume in your model and the critical risks.

3. Input historical data: The inclusion of financial results of the past three years, often known as “actuals”, helps in achieving better accuracy in respect of forecasts. This is helpful in mapping past trends and extrapolating the future accordingly.

4. Calculate any financial ratios that you’ll need for your formula: These can include forecasted gross profit ratio or net profit ratio of the company, year-over-year growth rates, and so on, depending on what you’re trying to model.

5. Calculate your projections and forecasts: Again, these estimates will depend on what you are trying to model. Line items such as revenue are typically modeled off growth rates. Cost items such as COGS, R&D, and general and administrative expenses are usually a function of historical revenue margin expressed as a percent of sales. But the kind of assumption that you make for the future should depend on the overall trends of the market rather than the trends of your company. Clearly make these in the model with simple ways for changes and how it would result in a range of outcomes.

6. Interlink your statements: Projections depend on proper historical data. To adjust for new actuals, projections must be updated by.

Best practice of Financial Model

Best practices often vary with the industries or even from company to company. Generally, the following are best practices in case you are building your models:

• Choose your Model: Form and build the model as required and run the output through the model, discussing this with your employer as appropriate in order to keep communications open.

• Plan and outline your model: Determine the timeline, and how much historical information you’re going to include in the model. List drivers and assumptions that will influence the model; these vary with each company and industry. From reading the last annual report from your company, you would know what the previous finance teams considered important drivers for their business.

• Start with accurate data: Be sure to use current actuals to get an ideal forecast. Then bring plans from departments such as finance, human resource, sales, and operations into alignment.

• Keep your assumption reasonable: Nobody wants to report bad news, so inevitably everyone always wants to be overly optimistic about the next quarter or year. Be realistic and as close to what the business company realistically can anticipate to deliver considering the present market conditions, industry health, and other factors.

• Test for accuracy: Your formulas should be understandable to other members of the finance team, so that they can check that these formulas make sense and recompute the results and agree with your general conclusions. More errors than you would like are inevitable; regular peer review and testing will prevent most of them.

• Keep good notes: Each day, FP&A professional’s switch to a new position, team, or company, thus passing over the financial models to the new incumbents. Under such an arrangement, it should be easy for the new person to understand the model and repeat the same process for succeeding forecasting periods.

• Keep model flexible: Conditions can swing sharply up or down anytime, and thus you need to adapt your models accordingly as acts of nature and unforeseen scenarios change.

• Be transparent: Many organizations’ financial models must be sent to several individuals, most of whom are not members of the accounting department. They will want to know how you arrived at an answer. Solve it in a way that shows your work, so that model users can debate the assumptions. Be able to present your findings in easy-to-understand conversation-no math speak.

Conclusion

Financial modeling is basically the backbone of how strategic decisions in finance are made, as it enables one to have an organized assessment of what may probably occur, thereby their efficiency in using the resources, and at the same time their profitability. It thereby gives clarity in risk and other opportunities, from that viewpoint, finance personnel at various levels of analysis and planning find it necessary to their profession.