Uses of Financial Modeling: A Comprehensive Guide
A crucial component of business accounting and management is financial modeling. The financial information that it collects enables businesses to analyze their current revenue, project future costs, and make financial decisions. A corporation might utilize a range of financial modeling strategies, depending on its professional goals. To comprehend how the uses of financial modeling help organizations, we will explore them in this article along with their advantages.
What is Financial Modeling?
Financial modeling is a highly effective method for assessing a company’s financial performance. It entails building a mathematical model (often Excel) that can assist in performing the financial statement analysis and helping business professionals make the best company decisions.
Importance Of Financial Modeling
Finance is the most crucial part of any company and contains complex data. And financial modeling helps in getting a clear understanding of all the components. Also, it helps businesses make better financial decisions at the heart of its significance. It is frequently used by organizations for strategic planning. Financial modeling enables scenario planning by simulating the effects of significant variables so that organizations may determine their course of action in a variety of potential situations.
Capital budgeting also heavily relies on financial modeling. In addition to simplifying resource allocation for the upcoming large investment and financial statement analysis, it also aids in calculating the cost of capital. In addition to the returns anticipated by investors, it gives a complete analysis of the debt/equity structure for this use.
To clearly understand the uses of financial modeling, let us first understand, what are the different types of financial models-
- IPO Model- Excel is used by corporate development professionals and investment bankers to build IPO models that help companies be valued before going public. These models take into account the analysis of similar businesses as well as a projection of the asking price that investors would be willing to provide for the company in question. To make sure the stock trades well on the secondary market, an “IPO discount” is built into the price of an IPO model.
- LBO Model- A leveraged buyout (LBO) is when one firm buys another by using a sizable amount of borrowed funds (bonds or loans) to cover the purchase costs. In addition to the assets of the acquiring company, the assets of the company being purchased are frequently used as collateral for loans.
- DCF Model- Using estimates of how much money an investment project will make in the future, DCF analysis seeks to evaluate the value of an investment today. DCF can aid those who try to decide whether to purchase securities or a firm.
- Three Statement Model– Financial modeling that links together three crucial financial statements—the income statement, the balance sheet, and the cash flow statement—to create a single, dynamically linked financial model that acts as the basis for more complex financial models.
- Mergers Model- A merger model calculates the anticipated impact of an M&A transaction on the EPS (earnings per share) of the acquirer.
- Option Pricing Model- Theories known as option pricing models can estimate an option contract’s value based on the various variables that make up the actual contract. Calculating the likelihood that the option will be “in-the-money” or “out-of-the-money” when it is exercised is the main goal of a pricing model.
Who Builds Financial Models?
Uses of financial modeling don’t restrict to financial institutions, in fact, Professionals in banks, corporates, start-ups, Government institutes, etc. also build financial models. Here is the list of sectors whose financial analysts build financial models.
a) Financial Planning and Analysis– Managers & Analysts of the financial planning and analysis department build financial models. All the top companies have this department whose major work is to forecast, plan and do financial analysis. They analyze a company’s performance through financial models by comparing actual results with the forecast and monitoring the organization’s cash flow.
b) Equity Research– Analysts analyze the company’s performance and research the industry to create a report for customers to decide whether they should invest in public securities.
c) Investment Banking– Analysts in Investment banking firms build excel models to guide companies for mergers & acquisitions, consultancy, and capital increase. Here, financial data is more complex because most customers are big organizations such as government institutions, private organizations, and public organizations.
d) Start-ups– The founder or CFO of the start-ups should use financial models for the smooth running of the business. The founder/ CFO can calculate the availability of the cash in the organization with the use of cash flow techniques, forecasting the company’s expenditure, and revenue. Financial models are very helpful, especially in the early stages of the start-up.
e) Real-estate Development– Specialists in this field require good skills as they need to build a detailed financial model to evaluate the profitability of the project. IRR and cash flow techniques are majorly used for the evaluation.
f) Credit Rating Agencies– Ratings are given to different companies by credit rating agencies, which serve as a warning to potential lenders about the risk involved in lending money to those businesses (buyers of bonds etc.). Additionally, the credit rating agencies maintain financial models for other companies and periodically update these ratings.
Career Prospects in Financial Modeling
In the present business environment, where companies rely on data science to create financial models and forecast future trends, financial modeling expertise is in high demand. It differs greatly from traditional accounting and auditing positions and has a wide range of potential applications in the finance and associated sectors.
It is unlikely that you would be unemployed when you choose to pursue a career in financial modeling. Graduates and analysts from finance backgrounds are advised to learn financial modeling for their career growth. The financial modeling services are data-driven and assist firms in successfully interpreting and making sense of data, enabling better-informed decision-making.
Research companies, credit rating agencies, banks & financial institutions, and insurance companies are among the employers of financial modeling specialists. The majority of firms have openings for financial modeling professionals due to the multiple uses of financial modeling in estimating investment, budget, and forecasting of the corporation.
Designations in Financial Modeling Are-
- Financial analyst
- Equity analyst
- Market research analyst
- Associate analyst
- Business analyst
- Financial manager
Requisites to Learn Financial Modeling
Knowledge of the required skills HR managers & recruiters look for will land you on the list of shortlisting candidates while searching for a job. Below mentioned is a list of skills you should mention on your resume-
- Spreadsheet Management
- Problem-solving skills
- Sensitivity Analysis
- Data analysis
- Presentation Skills
- Knowledge of finance and accounting principles
Keys to Creating a Vying Financial Model
The financial model needs to be detailed and simple at the same time. However, you can use these keys to create financial models.
- Well-structured and easy to follow
- In Finance, Accuracy is the key.
- Easy to understand the model.
- Focus on the main drivers of the model.
- You should use a visual output such as tables, graphs & charts.
Uses of Financial Modeling
Businesses involve the implementation of various decisions, and every decision is linked to a certain level of risk associated with it. Uses of financial modeling act as a savior in taking firm decisions. Let’s dig deep into the details of how uses of financial modeling are helping businesses in various courses of action-
1. Risk Management-
In 2008, businesses used many financial models. The severity of the 2008 catastrophe, however, compelled financial institutions to reconsider their modeling strategy. A financial model’s built-in assumptions were updated to reflect the lessons learned during the great recession. Risk management was one of these lessons. Risk modeling ultimately turned into a crucial component of every financial model.
The risk management process is centered on determining the possibility that a specific adverse occurrence will take place in the future. Once the possibility has been established, the decision-making process also takes into account the event’s impact.
A merger means the amalgamation of two companies through mutual consent. And when one business offers to pay another business for its shares or cash, this is known as an acquisition. In both mergers & acquisitions, two business entities form a single business entity with the consent of the company’s shareholders.
Before mergers or acquisition takes place, analyst analyze the deal using the merger model. The main goal of M&A modeling is to evaluate how the acquisition may affect the acquiring company’s profits per share (EPS) and how this EPS would compare to others in the same industry.
Nevertheless, M&A models can provide more in-depth financial analysis for any individual acquisition. Whether to move forward with a merger or acquisition can be determined by the financial insights and projections generated by the model. By such uses of financial modeling, Executives of the company will be better prepared to make decisions that will affect their long-term goals and the growth of the organization.
Also Read: Jobs After Financial Modeling Course
3. Valuation of Company-
Uses of financial modeling help companies determine their value. When attempting to determine a firm’s value, financial modeling can be used to determine the company value by looking at its financial accounts. Investment bankers use financial modeling to determine how much stock a firm offers for sale during an initial public offering (IPO). The same logic applies to businesses attempting to assess how much money they require through venture capital, loans, or other forms of financing.
4. Valuation of Assets-
The process of figuring out the current value of a company’s assets, such as its stocks, buildings, equipment, goodwill, etc., is known as the valuation of assets. This procedure frequently takes place before you buy, sell, or insure an asset or as part of a larger corporate appraisal. By using financial models, you will be able to calculate enterprise value and equity value and with discounted cash flow techniques, you can calculate future cash flows of the company.
5. Options Pricing-
The theoretical value of an option, or the value of an option after taking into account all the known input, is determined by financial analysts using the option pricing model. Financial analysts can use it to determine an option’s fair value. It’s a mathematical model that was created using formulas.
You can opt for the career-oriented Online Financial Modeling Courses to learn the financial modeling techniques
6. Capital Allocation-
Allocation of the company’s financial resources in such a way that its investment & distribution leads to an increase company’s profits is called capital allocation. Uses of financial modeling also prove fruitful in capital allocation. Decision makers allocate funds to various projects and financial modeling helps in evaluating the outcome of those projects. And accordingly, they prioritize the allocation of funds.
7. Raising Capital-
Whether the company needs more funding, whether it should prefer debt or equity, the cost of getting such funding, and what level of the debt-to-equity ratio it should maintain. A financial model is used to provide answers to all of these queries. Investment bankers use financial modeling to determine how much stock a firm offer for sale during an initial public offering (IPO). The same is true for businesses attempting to assess how much money they require through venture capital, loans, or other forms of financing.
8. Budgeting & Forecasting –
Budgeting is a systematic format of goals and objectives that a business wishes to accomplish in the chosen time frame, which is often a year. And forecasting refers to the estimation of goals that have been achieved and how much is still left to achieve in the remaining time. For the sake of the future, a strategy must be supported by sufficient data, and the best instrument for examining a company’s budgeting is financial modeling.
To foresee its future demands and start addressing them now, the organization will input data based on numerous business aspects, such as working capital. As a result, the business can make sure they have enough money to cover their expenses and project future financial results.
1. Who can study financial modeling?
Any Graduate/ Master’s in finance, CA, CS, finance professionals who want to upskill their career, or Start-up owner can study financial modeling.
2. What is the salary of financial modeling in India?
According to Glassdoor, the salary of financial modeling varies between 5 lakhs to 28 lakhs and the “National average salary” is 12 lakhs per annum.
3. Why does financial modeling require excel?
When generating expected financial statements, financial modeling in Excel refers to the methods used to forecast the company’s financial success for a future period using assumptions and data from past performance.
4. What are the examples of financial models?
The forecasting model, DCF model, Mergers and acquisition model, Capital budgeting model, and IPO model are some examples of financial models.
5. Is financial modeling hard?
Financial modeling is not easy as it requires practice and knowledge of the modeling process and methods. But if you are dedicated and willing to learn the uses of financial modeling for career growth then there is no hurdle. Also, you can join courses like IIM Skills, and CFI for a better understanding.
Hopefully, with the help of this article, you can now comprehend how the uses of financial modeling made it easier for businesses to evaluate and ascertain their risk, plan budgets & make investments accordingly so that businesses can run smoothly and have sustainable growth in the future. And in the Current scenario, organizations and financial analysts need to learn and use models of financial modeling to have a financially stable business.