A financial model or financial modelling is the process of constructing a spreadsheet that contains a summary of a company's expenses and earnings and may be used to evaluate the impact of a future event or decision.
For business executives, a financial model can be useful in a variety of ways. It is most commonly used by financial analysts to examine and forecast how future events or executive choices will affect a company's stock performance.
Financial modelling is a numerical representation of a business's operations in the past, present, and predicted future. Models like these are meant to be used as decision-making aids. They could be used by company leaders to estimate the expenses and profitability of a proposed new project. Inside a company, executives will use financial models to make decisions about:
A financial model is a lot more than just an excel spreadsheet. It has certain components that are universal to all sorts of financial models created globally by businesses:
Many different types of people create and use financial models for various purposes and objectives. Financial models are typically created to address real-world issues, and there are as many distinct types of financial models as there are real-world issues to address. Anyone who uses Excel for financial purposes will, in most cases, create a financial model for himself or others at some point in their careers.
Financial models are frequently used by bankers, CFO's, Startup founders, particularly investment bankers. Because of the nature of financial institutions, modelling is ingrained in their culture – the business's foundation is founded on financial models. Accountants, outside of the banking business, are heavy consumers of financial models. Bankers frequently assess other businesses for credit risk and other factors. The models of an accountant, on the other hand, are frequently inward-looking, focusing on internal operations reporting and analysis, project appraisal, pricing, and profitability.
There are easily more than 10 financial models that are being used today however this section will discuss only a few in detail and the rest are listed in the infographic provided below.
The three statement model is the simplest basic financial modelling configuration. The three statements (income statement, balance sheet, and cash flow) are all dynamically linked with Excel formulas in this model, as the name implies. The goal is to integrate all of the accounts such that a set of assumptions can trigger changes across the entire model. It's crucial to understand how to connect the three financial sectors.
There are several steps required to build a three statement model, including:
The two models below are based on the three statement model, DCF is more towards valuation whereas budget model is quite self-explanatory, relates to budgeting.
The DCF model builds on the three-statement approach to value a firm based on its future cash flow's Net Present Value (NPV). The DCF model uses Excel features to discount the cash flows from the three-statement model back to today at the company's Weighted Average Cost of Capital (WACC).
This applies to decisions made by investors in companies or securities, such as acquiring a company, investing in a technology startup, or purchasing a stock, as well as capital budgeting and operating expenditures decisions made by business owners and managers, such as opening a new factory or purchasing or leasing new equipment.
The goal of a DCF analysis is to calculate how much money an investor would get from a given investment after accounting for the time value of money. Because money may be invested, the temporal value of money assumes that a dollar today is worth more than a dollar tomorrow. As a result, a DCF analysis is suitable in any case where a person is spending money now in the hopes of obtaining more money in the future.
These types of financial models are used in equity research and other areas of the capital markets. A DCF is not best for startups but works best for businesses and companies that have stable cash flows and are in their later stage of development. Initially, startups won't have that.
This is used to model finance for financial planning and analysis (FP&A) specialists who are putting together the budget for the following year(s). Budget models are often based on monthly or quarterly data and place a strong emphasis on the income statement.
You can find more types of financial models here by the Corporate Finance Institute.
Practice is the most effective technique to learn financial modelling. To become an expert at constructing a financial model, you'll need years of experience and a lot of practice. Reading equity research reports can be a good approach to practice because you can compare your results to theirs. Using a mature company's past financials to develop a flat-line model into the future and practising calculations. Some of the key things to practice are mentioned below:
The process of financial modelling is ongoing. You have to work on different portions until you can finally tie everything together.
Financial models are useful anywhere there are financial problems or circumstances in the real world that need to be solved, analysed, or translated into a numerical representation. Sometimes all that is required is the conversion of an idea or concept into a business case or feasibility plan. A professional financial modeller may give the idea solidity by adding enough information to create a workable model that can be used to make choices, raise funding from investors, or hire staff.
For example, financial models can help investors decide which project to put their money into, an executive track which marketing campaigns have the highest return on investment, or a factory production manager decide whether to purchase a new piece of machinery.
The video below summarises financial modelling by the Corporate Finance Institute.