Purpose of Financial Modeling – Definition, Structure, Types
Have you ever wondered why the purpose of financial modeling is trending among many other concepts in the current world? If yes, welcome to the club of curious people. This content is posted for everyone who wants to grab the concepts of financial modeling and its purpose. If you are a student who aspires to thrive in a career path through financial modeling or a business owner in dilemma to considering the implementation of financial modeling for your organization, this is the best article for you as you will get to learn about the basics of financial modeling, how it helps businesses, its advantages, and disadvantages.
Concept of Financial Modeling
It is a tool used for the assessment of a company’s financial performance. Mathematical formulas and assumptions are taken into consideration for the creation of a financial model that is used for the forecasting performance of a business in regard to finance operations. Many finance-related entities like mutual funds, equity research, and investment banks trust financial modeling’s ability to help them thrive in the competitive industry.
How Financial Modeling is Applied in Companies and Businesses?
The main reason for the popularity of financial modeling is its applicability. There are various applications of it in companies and businesses. Here are a few applications of financial modeling listed for your understanding.
- Financial forecasting and planning
- Assist funding
- Investment Analysis and Capital Budgeting
- Credit rating/Project finance
- Equity research/Investment banking
- Corporate finance
Financial Forecasting and Planning:
Financial modeling involves the creation of models that assist the creation of budgets to predict future financial performance and thereby analyze different scenarios. Businesses that consider market trends, historical data, and assumptions for the creation of financial models can guess their future expenses, cash flows, and revenues. This approach allows them to set financial goals, make strategic decisions, and develop operational plans.
Assist Funding:
A financial model can provide answers to many questions and help business owners take the appropriate action. For example, if you are a company founder, you can utilize the concept to find out if your firm needs funding, or if you should pick equity or debt. If you feel your entity requires funding, a financial model can help you with the estimation of the cost of funding. On the other hand, if you choose debt or equity, it can provide an approximation of debt-to-equity to be maintained. That being said, you are supposed to have a good business plan that can convince your investors and creditors to consider your company as a worthy place for investment.
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Investment Analysis and Capital Budgeting:
The purpose of financial modeling is to create models for the evaluation of investment opportunities to make decisions pertaining to capital expenditure. A business owner can utilize financial modeling to understand the success rate of potential projects, estimate cash flows, find out return on investment(ROI), alongside analyzing risks. The developed models will help businesses with the determination of investments and effective allocation of capital to obtain the highest potential returns.
Credit Rating/Project Finance:
As mentioned above, financial entities like bankers and credit analysts estimate future costs and revenues and make informed judgements about the success rate of a project. It means they will have clarity on extending loans or deciding the credit rating using financial modeling techniques.
Equity Research/Investment Banking:
Financial modeling is basically implemented for valuation and fundamental analysis which implies that the investment banker can use it for fundraising transactions. Equity analysts, on the other hand, utilize the models to assess stocks and thereby make recommendations related to buying/selling/holding stocks.
Strategic Decision Making:
It is easier to make strategic decisions with the implementation of financial models in a business as they let the businesses analyze the financial implications of available alternatives. For instance, if you as a business owner have a plan to implement cost-saving initiatives or launch new products, you can obtain an estimate of the outcomes through a financial modeling method. In simple words, the created models support the business by providing an approximation of potential returns and risks for the chosen strategies.
Private Equity/Entrepreneurs:
The life of entrepreneurs can become easy in reaching out to potential investors as financial models can assist in the creation of effective plans and strategies that can be shared with lenders. This means potential threats can be eliminated to let the company thrive.
Corporate Finance:
The crucial purpose of financial modeling is to encourage a company to assess its projects and finances. Assessment of an organization’s financial viability will assist in the creation of funding plans for corporate projects.
Common Types of Financial Models
There are a variety of financial models that lead to various results as per the given inputs. Some of the models used by companies, in general, are listed below.
- 3-statement model
- Discounted cash flow (DCF)
- Merger and Acquisition (M&A)
- Initial public offering (IPO)
- Options pricing model
3-statement Model:
This model is used by a company to project its cash flow statement, income statement, and balance sheet. An income statement contains the company’s expenses, profits, and revenues for the chosen period. Whereas the balance sheet shows the equity, liabilities, and assets of a company. Outflows and inflows of the company are included in a cash flow statement. All three statements are interlinked and changes in any one of them can impact the rest.
This model is best suited for your entity if you want to predict its financial performance for the next decade to obtain an estimate of expenses, revenue, assets, profits, cash flows, and liabilities.
Discounted Cash Flow (DCF):
This method is chosen to predict the value of a company as per its future cash flows. The entity’s future value will be estimated by finding out its current value. Hence the name discounted cash flow; future cash flows are discounted to their present value. This approach is useful to find out the approximation of a company’s future growth, discount rate, and cash flows.
For example, if you consider investing in startups, you can choose the DCF model to find out the approximate of the company’s future worth. Because it allows you to estimate the entity’s future revenue based on the time value of money.
Merger and Acquisition (M&A):
If you want to have a glance at the financial outcomes of mergers and acquisitions, then this is the right model for you. This model is sometimes referred to as the merger model. It involves the consideration of valuations and cash flows of acquiring as well as targeting companies. In simple terms, it is helpful to analysts and investors in determining the results of M&A.
The owner of a private equity firm with the intention to acquire another company can evaluate the outcomes of acquisition through the M&A model which considers valuations and cash flows of target and acquiring companies.
Initial Public Offering (IPO):
As the name suggests, the company can determine the selling price of its shares when it goes public. A company’s growth prospects, market conditions, and financials are taken into consideration in this model. It acts as a tool for underwriters and investors in determining the offer price of the shares.
If you are an investment banker who needs to offer advice to an organization at its IPO, this model is the perfect fit as it assists in finding out the estimate of the sale price of a company’s shares post considering the growth prospects, market conditions, and financials.
Options Pricing Model:
This kind of model acts as a decision-making tool for holders of options regarding the right to sell or buy an asset by determining their fair value. Asset’s volatility, price, interest rates, and depreciation are considered for the same. Investors and traders can make decisions related to trading by determining the fair value using the options pricing model.
For example, the options pricing model can evaluate a stock’s call option value by predicting the equitable value based on the stock’s volatility, underlying price, interest rate, and time for a trader.
Qualities of an Ideal Financial Mode
We have discussed the various types of models used by businesses as per their requirements. Now is the time to learn about the features of an efficient model. If a business or company wants to fulfill the purpose of financial modeling, their model i.e., the numerical representation of a company’s operational aspects must have the below characteristics.
- Completeness
- Logical
- Flexibility
- Transparency
- Accuracy
- Presentable
Completeness:
A financial model is a collection and integration of different parts. Any missing part will not serve the purpose of financial modeling for a company. Every good model should have all sets of spreadsheets that can address the needs of its end users. The common worksheets included are calculation worksheets, output worksheets, analysis worksheets, and input worksheets.
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Logical:
The developed model must represent the business’s value based on the industry, market, and economic realities. The copy must be created to display the perspectives of the users of the business. The logical aspects lie in the arrangement of the worksheets, usage of relevant industry terms, and structure of the model.
Flexibility:
Any rigid structure can’t give accurate predictions as per the changing inputs. This is why it is crucial to have a flexible model to evaluate critical economic and business assumptions. The created copy must have the ability to accept different types and levels of assumptions and accordingly forecast the outcomes. It also means that it must be flexible enough to allow removal as well as the addition of assumptions and inputs as per the requirements. It should encompass adaptable provisions to deal with changing economic issues and trends.
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Transparency:
The main purpose of financial modeling is to obtain funding from stakeholders meaning the created model should be understandable for the investors. Every aspect including the inputs, assumptions, outputs, analyses, and calculations must be well incorporated to produce results that are easier to understand. In short, an ideal model must allow the users to make decisions as per the given analyses and inputs.
Accuracy:
A model, in general, has a variety of calculations, of which some are obvious and some are hidden. The developers of the model must keep in mind the applicable business principles such as corporate finance, accounting, depreciation, and taxation to ensure the infusion of accurate calculations in the structure to make it useful for the decision-makers. This is said because an inaccurate model can misguide the end users and lead them to make wrong decisions.
Presentable:
Any structure or copy must be readable. This means it should have understandable and followable aspects. A good format is a key element of a good model as it promotes the importance of valuation. On the other hand, the wrong choice of format will result in wasting the time of the management due to miscommunication or partial readability. A well-formatted and structured model is easier to review, update based on the management requirements. The responsibility of picking user-friendly colors and fonts lies with the model developers.
Advantages of Financial Modeling
The main reasons for the implementation of financial modeling techniques in any business or company are the advantages they carry. There are a variety of benefits of financial models for an organization, of which a few are listed below.
- In-depth and improved understanding of commercial activities
- Regular review of performance
- Funding requirement and strategy decision
- Business valuation
- Risk minimization
- Quick output generation
- Accurate financial forecasts and budgets
- Increases business growth
- Better compliance
In-depth and Improved Understanding of Commercial Activities:
It requires deep insight to develop a financial model for a business. Analysts are hired to understand factors that influence a business. The copy will be created to adapt to the changes in the internal and external environments of a business. It means a thorough understanding of the business is done in order to generate forecasts related to its financial performance; more understanding of the business functionality will allow the management to take appropriate actions to tackle any uncertain event in the future.
Regular Review of Performance:
Variance analysis must be carried out to know the performance of the business. Financial models do the variance analysis by comparing the business budgets and their actual results. Regular review of results can be done by variance analysis to make required adjustments in the business operations to achieve higher profits.
Funding Requirement and Strategy Decision:
One important purpose of financial modeling is that it offers clarity on the expected inflows and outflows related to cash. This indicates that a business can forecast the required net cash flows to efficiently run its operations. The step that follows this is choosing the source of funding which is debt vs equity. Financial models are a boon to management as they produce cash flow forecasts after dealing with loan repayment and interest expense. This step helps the analyst to decide on equity financing and sheds light on the business’s eligibility to take debt.
Business Valuation:
Isn’t it clear that companies want to know their worth through financial models? If not, let me confirm it. The fair value of a company can be obtained by the determination of free cash flows that are predicted to accumulate at various points in time. This aspect is crucial for a business during restructuring activities like the sale of stakes to investors and outsider parties.
Risk Minimization:
The overall business risk can be mitigated by using financial models as they facilitate due diligence by pointing at the financial impact of any action. Suppose a business decides to enter a new niche, a financial model can show the cost of entrance, the impact of price changes, marketing, etc
Quick Output Generation:
The absence of an effective system to obtain solutions to financial problems will interfere with the successful running of a business. Most companies struggle with the same and end up losing investors and customers. A financial model, on the other hand, is quick in guiding the management toward the solutions and thereby saves the business from losing its credibility.
Accurate Financial Forecasts and Budgets:
All the financial models consider historical business data to build financial forecasts and budgets meaning they produce more accurate results. The forecast and budgets will be used by the business to let their operations continue within a defined structure. If you are curious about why we are talking about forecasts and budgets, understand that the absence of business strategies and budgets is not good for the business functioning.
Increases Business Growth:
Financial models point at areas with the scope of generating higher profits and thereby increasing the growth of the business. Not just that the developed models assist in implementing the cost-benefit analysis of freshly curated projects. In simple words, businesses can benefit from financial models by identifying areas and projects with higher profitability and taking appropriate actions.
Better Compliance:
As a matter of fact, financial models involve a review of financial statements. This means any outdated financials can be updated as per the latest changes in the accounting regulations and standards.
Disadvantages of Financial Modeling
Where there is good, there is bad. Similarly, there are some limitations of financial modeling. The same are discussed below for your understanding:
- Time-consuming
- Inaccurate
- Soft factors omitted
Time-consuming:
The creation of a financial model cannot be done within an hour or so. It requires the analysts to spend a lot of time on several related tasks such as data collection, identification of underlying factors, and model tests to find and fix technical as well as financial irregularities. The purpose of financial modeling is to let users get comfortable using a model meaning a lot of energy, time, effort, and money are required as an investment from the management side. No wonder small companies refrain from going near financial models.
Inaccurate:
Some of the businesses felt that they have found financial models inaccurate for their organizations. That being said, the main cause of inefficient models could be flaws in the model development stages. It is not wise to expect people to be well-versed in predicting factors like tax rates, market shares, and interest rates, especially every time.
“To err is human” – Alexander Pope
Any person with excellent predicting skills would do great in stock trading. Why would they work as developers? This brings us to light that financial models can go wrong at times and therefore it is important to not completely depend on them.
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Soft Factors Omitted:
Mergers that did not consider soft factors like the dual culture integration have failed. Incorporation of such intangible factors into a financial model is impossible. But the models will consider the account synergies created by the reduction of expenses due to the merging of two companies. But the funny part is they ignore the additional expenditure that arises from cultural incompatibility. This tiny negligence can result in the overvaluation of the company’s assets in the long run. This is another reason why some mergers have failed even though the analysts believed that financial models will succeed in helping a business thrive.
Conclusion on Purpose of Financial Modeling
Financial modeling is a technique used to assess the financial performance of an entity. This method involves taking in the mathematical formulas and assumptions to create a model that will be utilized for forecasting the financial position of a business or company. The purpose of financial modeling for a business or company is to let the entity become able to perform financial forecasting and planning, assist funding activities, investment analysis and capital budgeting, credit rating/project finance, equity research/investment banking, and corporate finance.
Several financial entities such as equity research, investment banks, and mutual funds seek the help of analysts to develop numerical systems to flourish in the competitive market. They mostly use ideal financial models like a 3-statement model, Discounted cash flow (DCF), Merger and Acquisition (M&A), Initial public offering (IPO), and Options pricing model as per their requirements. An ideal financial model is complete, logical, flexible, transparent, accurate, and presentable.
Businesses that choose financial modeling over other methodologies enjoy benefits such as an In-depth and improved understanding of commercial activities. Regular review of performance, Funding requirement and strategy decisions, Business valuation, Risk minimization, Quick output generation, Accurate financial forecasts and budgets, Increases business growth, and better compliance. That being said, there are a few limitations to the concept because it is time-consuming, inaccurate, and omits soft factors. It is best to evaluate your company’s needs and accordingly adopt financial models to fulfill the purpose of financial modeling.
Frequently Asked Questions- FAQs on Purpose of Financial Modeling
Q1. Is financial modeling a difficult course?
Yes. It is considered as difficult to learn financial modeling. Financial modeling is even difficult for those who are from a financial background. As it is about forecasting the future of the financial performance of the business.
Q2. What is the eligibility criteria for pursuing financial modeling?
To be eligible for the financial modeling course one must have a graduate degree from a government recognized university.
Q3. What is average salary after completing the financial modeling course?
Once you finish the financial modeling course the salary ranges between 3.2 Lakhs to 44 lakhs.
