Significance of Financial Modeling – An All-Inclusive Guide

March 17, 2023 Lekshmi S S Financial Modeling, Knowledge

Financial models are important as they help in answering various financial queries including investments, debt/ equity systems, mergers and acquisitions, to name a few. It can be time and money-consuming, but a good financial model is worth every effort. In this article, we will help you understand the Significance of Financial Modeling.

Significance of Financial Modeling – Introduction

While trying to understand the significance of financial modeling let’s look at what financial modeling is all about. Financial models are used for financial analysis wherein it combines finance, accounting, and business metrics to predict the future results of a company. It is a simple spreadsheet usually done in Microsoft Excel that is made based on the company’s past performances as well as present performance results to predict future results. This also requires careful preparation of financial statements such as the cash flow statement, balance sheet, and income statement, as well as a supporting schedule like a three-statement model. This is the simplest of the financial models. There are also advanced models such as discounted cash flow analysis (DCF model), mergers and acquisitions (M&A), sensitivity analysis, and leveraged buyout (LBO).

Who Uses Financial Models?

Financial Models Are Used in Industries Like:

Investment Banking:

Where the models are prepared by investment bankers to help the company to raise their overall capital as well as execute well-informed transactions like mergers and acquisitions (M&A)

Corporate Banking:

Here the financial models are most likely prepared by corporate bankers whose goal is to recruit and retain clients to will consistently hire their bank for any transactions with greater fees and can include debt & equity insurance, merger & acquisitions deals, etc.

Private Equity:

These private firms also use financial models to help raise capital from external investors and then use the same capital for business deals like buying, operating, and improving companies, before selling them all together for a better profit.

Hedge Funds:

Managers of hedge funds use financial models to make decisions on raising capital from their institutional investors and accredited investors to invest in other financial assets.

Corporate Development:

Here financial models are mainly used to focus on acquisitions, joint venture deals, divestitures, internal partnerships of the company, etc.

Venture Capital:

These firms also use financial models for raising capital, especially those that were invested in the budding stage, rapidly growing companies with a focus to exit through acquisition or IPO.

Equity Research:

Equity research analysts prepare financial models, where the model aids the analyst in better understanding the business and ultimately making the well-informed decision of whether or not to buy or sell a company’s stakes and shares.

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Advantages and Disadvantages

There are always two sides to anything like the two sides of a coin, truth and false, light and dark, tea and coffee, etc. Like this, let us see the advantages and disadvantages of financial modeling.

Advantages

A Deeper Understanding of the Business:

Preparing a financial model lets you have a deeper insight into the business/ company finances. Since the preparation of the financial model requires collecting and comparing past financial data and present data, it makes you think about changes that had occurred in the industry over time and how each change had made an impact of various degrees on the business. The changes are mostly external factors but internal factors are also important. Thus, a good financial model creation brings out higher diligence when compared to the older counterparts. Through this, we get a much better understanding of how the company is doing in the present but also how it can be in the future. They can also be created to learn about the factors that affected the company’s competitors and prepare for any uncertain rules.

Review of Performance regularly:

It is always important to review the performance of the business by conducting a variance analysis. This is usually done during the creation of financial models, where the budgets are compared against the actual results of the business. Performance review is done periodically to have a piece of in-depth knowledge of business operations. Some advanced financial models directly help businesses to make adjustments and readjustments in their business operations based on the results of variance analysis so the overall capital and profit can be improved.

Helps with Business Valuation:

Financial models are used by companies to determine their business worth by determining free cash flows that are expected to benefit the business at different periods. This is an important piece of information to have while the company is undergoing any sort of restructuring like selling stakes to investors or any other external parties. If not financial models, companies can use disconnected cash flow models to calculate the worth, but some of these models assume linear relationships between expenses and revenues, which is not always true. Thus, financial models are commonly used as they give a more accurate view of the business value.

Helps in Deciding the Actual Fund Requirements and Best Possible Strategy:

we know that using financial models gives us a clear picture of expected cash inflows and outflows. Thus, it will be easier for the business to know the net cash flows that would be required or arranged to operate the business. After knowing the amount, the source of the funding should be decided, i.e., debt vs. equity. Here also financial models can be used to determine the cash flow position after the repayment of loans and meeting the interest expense. It helps to make decisions on whether the company should take a loan or to what extent the company can take a loan/ debt along with the level of equity financing. For example, if it is a start-up company that has pretty fixed expenses but uncertain revenues, financial models can be used to decide the amount of money to be considered for a loan/ debt to run the company until they have a stable flow of revenue. Here, they can decide on the amount of equity stake to be sold to reach their next goal/ milestone.

Quick Results:

If companies are taking months to decide on, say, an investment, they may end up losing the deal altogether, and impact their own business adversely. Financial models are quick and accurate decision-making tools that have become very important in the business field.

Minimizing Risks:

As we mentioned before, financial models are prepared with due diligence to bring out more accurate results. This also makes sure that risk in business can be avoided by the company.

Accuracy

As financial models are built on business and finance data of past and present, expected budgets, and also taking in all the conditions existing in the industry like current trends and impacts, the final result of the financial model tends to be accurate. Companies can use these results and budgets to operate their business accordingly so that their business remains within a healthy structure. It can adversely affect a business if the company does not follow any business strategy or well-defined budget.

Helps in Overall Business Growth:

All the above-mentioned points together contribute to business growth, be it by suggesting fields capable of generating higher profits, or by carrying out a cost-benefit analysis of new and upcoming projects. These models can help the business to understand where more investment should go for higher profit and growth.

Disadvantages Include

Data Limitations Causing Inaccuracy:

Financial models use the data of past and present financial and business statements, as we discussed earlier. And the model is only as accurate as the data used and the assumptions made. Even if the model is considered accurate, the results provided should still be taken with a grain of salt, since no model can have 100% precision while making predictions on factors such as taxes, interest rates, market shares, or trends. If the data or assumption made is incorrect, then it can cause more harm than good. Also, these predictions work mostly well when it is predicted within a short period, if the prediction is made far into the future, the results are most likely not going to be the same.

The Making of Financial Model Can Be Time-Consuming:

While the results may not take much time to be concluded from the model, making the actual model can be painstakingly slow. It is a rather complex procedure considering all the numbers and values going into it. And even before that, the data collection part is there, all important underlying factors need to be identified, and the model also needs to be tested for technical as well as financial irregularities. It should also be kept in mind that the model needs to be user-friendly and intuitive. Altogether, this can be a money and time-consuming process. Most companies especially start-ups and other small companies, will not have enough to spare for the financial model preparation.

Model Risk:

When a financial model that was used to calculate quantitative information such as the value transactions or a company’s market risks, fails to produce reliable results or performs inadequately leading to unfavorable outcomes for the company, this causes a risk called model risk.

Some Other Factors:

The financial model only accounts for the business and financial part of the company. Any other factors like cultural freedom, work environment policies, etc. cannot be considered in the model. In the case of a merger, the financial model may depict its success in numbers, but the merger of two companies or a parent company’s subsidiaries can still fail if they cannot understand one another’s cultural conditions and personalities.

We have discussed how complex the financial modeling process can be, and things that can go wrong if not for careful calculations. So let’s briefly see the exact process of financial modeling.

Process of Financial Modeling

The Process of Financial Modeling Can be Divide Into Several Steps:

Data Collection and Data Entry of All/ or Relevant Past Financial Data:

Financial modeling starts with collecting data and making data entries of yesteryear’s financial statements. Once the data is entered into an Excel spreadsheet by a financial modeler or analyst, the process of financial modeling is started officially. Due to the inevitable changes in trends and market interest, there might be drastic differences in the data if data is collected from way back in the past. Hence, modelers prefer 3 up to 5 years of past data to be considered to provide an insight into the company’s financial well-being and business trends of the recent past. A mistake made during this can effectively produce incorrect results and fail the model. this is one of the most importance significance of financial modeling.

Data Analysis:

This is where the knowledge of accounting and finance is most useful. The data collected and entered must be analyzed to draw relevant insights and identify the major industry trends. Usually, the data from income statements, balance sheets, and cash flow statements are used for this. The data analysis can reveal the points of profitability (its increase and decline), growing revenue, overall capital structure, etc. Once a trend is identified, the modeler can begin to understand the factors driving the trend.

Making Assumptions:

The next step is to figure out the right assumptions to be used for prediction. One way for this is to build assumptions from past data and their trends to project future results. Most stable companies use this method because they can predict the gross margin or revenue growth by using the average of the past data, or an average of the past revenue growth.

Predicting the Future Financial Statement Using the Assumptions Made:

After the assumptions are made, future financial statements, mostly the future income statement and balance sheet are made. From this data, the cash flow statement is made by linking the income statement and balance sheet to figure out the cash movement for the foreseeable future. Here, there are two things to be considered – the total asset value should match the sum of all liabilities and the shareholder’s equity, and the cash balance recorded in the balance sheet and cash flow statement should match.

Risk Assessment:

Another point in understanding the significance of financial modeling is risk assessment. The modeler should keep in mind the probable future risks. The result of the final financial model is always as per the needs of the company/ business, but all possible risks and ways on how the business might behave in the upcoming years, or the possible market changes, all based on the financial model should be taken into consideration.

Sensitivity Analysis:

In this step, analysis is done to predict the time when the performance of the business/ company starts to decline, and to what extent it can decline. Sensitivity analysis tests the resilience of the company in different scenarios. This analysis also helps in assessing the performance of the company in case of any unexpected event.

Stress Testing:

This testing considers the absolute worst-case scenario of an unexpected event for a specific period. This analysis also helps in understanding how the business will react in the face of such an extreme situation, like a period of recession, and how it will recover from it.

Ratio Analysis:

This analysis is done to predict the profitability and liquidity ratios to help investors to make well-informed investment decisions.

Indexing and Formatting:

Once the model is complete, the data will only require some formatting, inserting statements, making them into tables, etc. Proper preparation is a good sign of professionalism while presenting the final financial statement.

Presenting with Charts and Graphs:

Rather than explaining an Excel sheet full of numbers, it is easier to prepare and present the final data using charts and graphs for easier understanding.

Now, let’s combine them all and discuss the actual importance of doing financial modeling.

Significance of Financial Modeling

Significance of Financial Modeling #1 – Learning the Value of the Company and Raising Capital:

Financial models are used when you want to establish a company’s net value. If the company is trying to raise its capital by selling, taking loans, or through any other financial ventures, these models can help to determine how much amount they need to stay afloat until they have a steady revenue input. In the same way, an investment banker will rely on a financial model to figure out what per cent of the company’s share need to be sold to an IPO.

Significance of Financial Modeling #2 – Allocating the Capital:

Every business requires capital to be used to be invested in various projects, assets, operations, and new ventures, each of which will have different requirements, needs, and returns to the company. This must be pre-determined by the company. And this is where financial modeling comes into play, as financial models can point out the best projects and ventures to allocate their capital for maximum profit and business growth. This information is especially useful when the company is looking to expand its business by trying out a new market, acquiring various assets, opening branches in new locations, etc.

Significance of Financial Modeling #3 – Budgeting and Business Forecasting:

Like allocating capital, financial modeling can also be used to analyze the company’s budgeting. Using the past and present financial data, the company can predict future needs and ensure they have enough budget to meet the said requirements or if not, then how much to be arranged, i.e., the debt/equity system with the expected returns for the investors. All this information can be found through financial modeling.

Significance of Financial Modeling #4 – Maintaining Partnerships:

Every company requires certain partnerships for the success of their business, be it in the form of vendors or suppliers, who provide them with products, raw materials, or technical support and services. Financial modeling can help with sourcing the right partners. Just like how the financial model can help to know your own company’s monetary health, like that it can also be used to determine the vendor company’s financial health along with their cost of business. Selecting the right vendor is one of the important factors in the success of the company.

Significance of Financial Modeling # 5 – Credit Analysis:

A type of financial analysis conducted by the investors on businesses, companies, municipalities, or any other such debt-issuing organizations to calculate the issuer’s ability to meet the set debt obligations. Financial models help investors to know which company to invest in for maximum returns on their money. Lenders and suppliers use the financial model to calculate a company’s creditworthiness. The financial model helps them to determine if the said company will be able to receive investments and funds enough to make a profit.

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Significance of Financial Modeling #6 – Management Accounting:

Financial reports are made for the company/ business managers and owners with profit and loss reports, capital returns, and a balance sheet. This report is usually prepared monthly or quarterly. These can be considered similar to the final financial statement prepared at the end of the year, but much less complex, less formal, and often customized to meet user requirements. Management accounting also has an impact on the company’s financial health since it can also be looked at as the evaluation reports of how the decisions from management if affecting the business.

Frequently Asked Questions (FAQs) on the significance of financial modeling

Q1. Is financial modeling a hard task?

Financial modeling is a complex task that needs to be done diligently but when it is carried out in a structured manner, it becomes easier to prepare.

Q2. Are there any prerequisites for doing financial modeling?

Yes, knowledge of accounting and finance is required to understand the data used in the process and make error-free financial models.

Q3. What is the average salary of a financial modeler in India?

The average annual salary of a financial modeler is INR 4 to 5 lakhs, though it can vary with the number of years of experience.

Our Concluding Thoughts on the significance of financial modeling

Hence, while at a first glance, financial modeling may seem like an easy procedure, we’ve seen it is far more complex than that. It requires time and industry know-how knowledge to ensure the financial models can be as reliable as possible. Since we’ve discussed the Significance of Financial Modeling, we know that the effects of the decision made with the help using these models can make or break the company/ business. Hence why it is important to make reliable and maximum error-free financial models.