Why Should We Use Financial Models? Reasons, Uses, FAQs, And More

March 25, 2023 Jayant Sharma Financial Modeling, Knowledge

A business cannot grow in the modern business without a good financial setup. The business environment today is extremely competitive. All businesses are competing for the attention of consumers and wish to know how they are performing on shared statistics so that they improve. Simple forecasting statements, however, do not fit the bill as they are simple direction indicators and do not tell the financial details for measured allocation. A financial model is key to figuring out the funding for different products, the value of certain features for customer retention, and the current value of future projects as well.

Before we get to the meat of the article i.e., the potential uses of financial models, we need to understand the technicalities of the finance that lend themselves to financial models. Furthermore, a simple understanding of financial models cannot be derived without a simpler and clearer grasp of financial statements and overall forecasting. We will also look into multiple facets of financial models like their uses, the process of building an effective model, and many other aspects. So, without any delay, let’s begin with…

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Understanding Financial Modeling Through Finance:

When finance solutions and goals are the objectives of mathematical models, financial models are the combination received. Finance is a field that studies business quandaries regarding money management, cash flows, and the overall wellness of financial setup. When we consider the major arenas of finance, we find that financial models have already assumed one of the most important places in a setup. They are sensible decision-making tools for businesses, and essential tools for government enterprise and economics while also being useful for personal finance. They provide incredible value by taking into account the financial statements of an entity. Preparing the majority of important financial forecasting’s statements like income statement, and balance sheets are critical for the development of seamless models.

These statements bring out the future trends of accounting values but do not release key performance indicators that give a comparative outlook on the entire financial situation of the business in key areas of output and customer satisfaction. Finance is essentially divided into three major categories:

Public Finance
Personal Finance
Corporate Finance

All these categorizations can utilize financial models in different ways. Where public finance may require heavy sifting of data collected through samples and surveys, personal finance will utilize models for improving the client’s portfolio. Moreover, for corporate finance, the data of the last three to five will be utilized depending on the complexity of the project whereas, in the public sector, the modeling requires even more data due to the added assumptions dictated by the economic policy of a country. The effectiveness of variables being reflected in the performance of an enterprise is one example of the same. Even the market conditions at play are different under different arenas of finance as financial models work on a global scale for many organizations and authorities but may not do so for an individual using it to diversify their portfolio.

Financial models define macroeconomic trends and give a general picture of how economic conditions might induce a shift in business metrics. These can be predicted by models if the assumptions suit the expected downturn thus informing decision-making and assuaging the blow of the fall in financial metrics.

Now you must know that a spreadsheet is key for understanding the working of a financial model, but you need to realize that such models are not created out of thin air. To help with that let us talk about…

Financial Statement & How to Compile Them for Modeling:

Financial statements are year-on-year documentation of the allocation of funds of a company, the means through which these funds are gained, and many other financial details. These convey important data about the well-being of a financial enterprise. These are subject to regular auditing by banks and the government to assure the smooth functioning of a business while holding the capacity to meet its short-term obligations. Financial statements are usually constrained to four in number i.e., the balance sheet of the business concerned, the income statement, the real cash flows statement of an enterprise, and the official statement of changes in equity.

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The balance sheet shows the total assets of a firm and the total liabilities that it has to meet. The income statement not only outlines the various sources of income but also focuses on the costs incurred in total during the working of the business. Equity can change hands and have steep effects on decision-making at a firm without any tangible change. However, there are also equity changes after processes like IPOs and buyouts from some angel investors as well as changes incurred due to changes in cash flows. Cash flows are requisite to meet up with short-term obligations like repayments for interest loans, etc. They depict the actual in-hand profits of a business. This can be seen in the real-world example of Amazon, where the unfavorable net income of 240 million but an overall increase in cash flows of 4 billion USD.

Financial forecasting through these statements is extremely tough though it does not suffice for the precision required of business processes. Regardless, financial modeling without these statements as a foundation for financial data is not considered secure. Now that we have cleared up the finance-related concepts and general ideas for finance models, we can move on to.

Uses & Building A Financial Model:

These models are built for financial purposes and since the scope of finance is extensive, the models have tons of uses. These are as follows:

A financial model is a predicting tool that is used to predict future performance changes due to changes in different variables. To test out future performance, past performance, future market trends, and sensitivity analysis figures are crucial pieces of the puzzle.
Financial models are extremely useful for telling business revenue and expenditure in real terms and clarifying the exact sales required to reach a break-even point.
They are good tools for foretelling future market predictions to inform decision-making.
Capital expenditure is the money spent on acquiring fixed for multiple financial year use. The exact output can be calculated via models and then acquired as per requirement.
Since models predict funds required for business activities in exact terms, we can also gather an image of inadequate funds through them. The calculations are assumed to be exact; funds are borrowed from third parties accordingly.
Models like the DCF (discounted cash flow) model allow for the calculation of free cash flows and their continued growth or fall is predicted through these models. The generation of free cash flows is considered extremely valuable for any business and lends greatly to managing future projects and other expenditures.
These models support equity financing i.e., pricing the issued initial public offering or the general value of equity for investment funds considered.
The business working has tons of financial data that floats around without control or management can be beneficial and detrimental for the business at large.
Models can ensure through their predictions and performance measurements that the company travels on the path of maximization of overall profits.

Such is the simple but multi-faceted uses of financial modeling. They are wide in scope and can fit the bill for many industries, thus the wide appeal of financial modeling today. As you might know, with great popularity ensues great variety. The different types of financial models like the three-statement model, the LBO model, the DCF model, and others are just some of the varieties found in the discipline of model construction. The critical points in which they differ are plenty but there are some basic commonalities among these models that display the building process of financial models at large. The step-by-step procedure is as follows:

Historical data is entered from the previous 3 to 5 years to get a grasp of the previous financial trends of a company. The data is entered into an Excel spreadsheet and then thoroughly analyzed. The data gathered needs to guide KPIs of profitability, customer value, and revenue. The analysis should not only draw out the statistics that depict these criteria but also subject them to a rigorous investigation where the underlying factors should be determined without any doubts about the matter.
Next, the assumptions for the model are set up exactly as directed by the business. Assumptions can be built based on historical performance and trends in the industry and the predictions of this method would work for an industry that is stable over time. Current industry trends work much better for volatile and emerging industries that possess limited historical data. The assumptions once built must be reviewed by the company or the financial entity in question, keeping in mind whether these are acceptable or not.
The assumptions formulate the foundation for forecasts, the ones we have discussed previously. The key things to keep in mind are that the total assets need to be equal to the liabilities and equity value. Furthermore, the total cash flows found at the end of the cash flow statement must match the cash flow values on the balance sheet. These are necessary to link the statements properly, otherwise, internal discrepancies may occur that will ruin the accuracy of the model.
The next step includes the interpretative analysis of the risk management of the company and its financial processes. The step answers pertinent questions like ‘Is the company at risk of defaulting on short-term obligation?’ or ‘By what time will the firm clear off its debt?’. Such questions once answered are steppingstones for risk management and allocation of business resources.
Sensitivity analysis is conducted next wherein changes in ratios and variables are tested and key KPIs for the functioning of the firm are given the highest priority. Scenario analysis and stress testing therein are also conducted. Three different scenarios are depicted: the best scenario, the normal scenario, and the worst scenario. The business results are elicited from these models and the changes in KPIs symptomatic to each case are noted. The information gained is used by businesses to counteract or sustain different scenarios a business may find itself in the future.

Now that we have an idea of the uses of models let us get into…

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Misconceptions & Reasons for Using Financial Models:

Financial model all info focused on the spreadsheet ability. need to work on how it works, what the key takes to be utilized, and the essential misconceptions that surround the concept. Clearing them away is a big task as well. Something at which you throw expenses, data, and assumptions and expect some sort of meaningful outcomes. You compare your results with benchmarked values of other companies to gain an understanding of what is the situation of your company. Furthermore, the results gained are in the form of questions.

Short-term, mid-term, and long-term questions like how much runway you have, what is your business valuation, and how much money you require. Few companies just handle very pertinent questions like these by handing numbers based on user acquisitions and revenue assumptions. They assume that revenue growth is going to be constant over time and that forms the basis of their financial model predictions.

They dish out the goals they have kept and just push the factors that allow them to achieve these goals, treating them as subsidiaries to revenue even though they are essential drivers of business growth. due to a lack of understanding on our part modeling is by assuming revenue or customer acquisition numbers when those are the effects not the cause of driver-based modeling.

We need to understand the basics of financial modeling and then insert the logic we build off of these basic ideas into a spreadsheet model. A financial model necessitates the use of formatting canvases to color code the financial data collected from an organization, with revenues marked as green, costs of goods sold as coded as red, yellow for sales, general & administrative costs, and capex or capital expenditure incurred by a firm can be presented through blue highlight. Other factors that play into the cost can be broken down into their specific marginal price which can all be bunched together and multiplied by the total change in the headcount of a company.

In the model pushed by most courses on the subject, as previously mentioned, the revenue is inserted into the business as an input that works as a limiter and guide. It constrains the business to the idea of increasing returns by increasing numbers i.e., increasing marketing or sales team size. In reality, the world does not work in such an ideal way and there are obvious pitfalls and shortcomings in the achievement of business goals. the part of the analysis that is required is to ask questions of the kind where you get to understand how much an increase in the number of the member’s sales team or different kinds of marketing tool expenses fetches you in terms of sales increase. These ratios are so formed and well-researched that they need to be invested so that you can be assured of the increase and not just throw away investor money based on general rules of thumb. No investor would want that the money provided is not used efficiently, therefore calculation of benefits from an increase or decrease in variables relating to variables of these fields is key to the financial model and the modeling process.

The KPIs that are provided by these drivers source the increase in sales and total revenue generation of a business. Conversion rate and cost of acquisition are some KPIs used to check whether the assumptions held by a model are even real.

For instance, any app is driven by the internal costs of making the app and the sustained costs to ensure its availability for installation. Once installed some users grow accustomed to these apps and become active users. They can only do so if the app works efficiently and effectively. Then those users can be incentivized to purchase in-app purchases and subscriptions. Some apps even generate revenues.

from in-app adverts which can be added to the mix if the active user base is significant for different brands to approach the app developer for increasing sales. Supposing we take the avenues in marketing like influencer marketing, sponsored events, and ads on google. The demographic for industries and different services can result in marketing heads checking the performance ratios of funding allocated to such avenues and the short as well as long-term benefits of funding one over the other. The cost-benefit analysis is conducted while keeping both quantitative and qualitative metrics in mind focusing on the efficiency of overtime downloads, they can provide or the rapid influx they can generate through their brands in the case of influencers.

Macro trends and figures are of the most importance to the construction of a good financial. Surely the option of improving specificity and complexity can be critical when studying the effect of certain significant variables, however, the simplicity of a model is key for proper comprehension of the financial questions and business tendencies exhibited by the financial figures. Ultimately the function of a model is not to be a research model in its processes. Worrying about attaching every key indicator is not recommended because building models is a cost-to-benefit proposition that businesses must consider. The information’s value and the cost of hiring professionals for the same are constantly evaluated, thus, functional insights are salient. Insights that can predict certain trends and ask crucial unanswered questions from the goal of financial modeling. Easy management and meeting are other secondary goals that need to be fulfilled by such models.

When you build models with meaningful assumptions, the downside is certain expenses become unquestionable and immutable. Expenses follow the modeling assumptions but there is only one valuable metric that does not require metric, organic traffic i.e., the natural traffic your site gains through the search algorithm recommendations or searches. It is allowed in a model if you take into account that your expectations of this organic traffic need to be on the conservative side based on data trends. Organic traffic as a driver can be used for modeling with three tips in mind:

Properly budget the team used to maintain and grow organic traffic.
Make reasonable assumptions.
Realize that increased traffic will lead to a lower conversion rate but not overall sales.

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To gauge the effect just calculate the average markup or pricing of each unit and formulate the total revenue with the previously calculated sales through organic as well as paid traffic. The inputs that you utilize in these financial models are KPIs that need not be formulated by yourself. You can ask other businesses in your industry for help and match the metrics you do get with your first users to gain sufficient knowledge for a reliable estimate.

FAQs: (Financial Models)

Q1. What are the several categories of models of finance?

The several categories of models of finance are as follows:

Three-statement model
Merger Account Model of Finance
DCF Model
The sum of Parts Model
LBO Model of Finance
Comparable Company Analysis
IPO Model
Option Pricing Model

Q2. What are some of the guidelines for making a good model of finance?

A good model of finance must abide by the FAS acronym. Every financial model should be versatile in its application and adaptable to any scenario (as emergencies are a critical part of any business or industry). A financial model’s adaptability depends on how simple it is to change the model wherever and whenever it is required. F, therefore, stands for flexibility.

A is for Appropriate: Too much information should not be included in models of finance. The financial modeler should constantly be aware of what a financial model is, i.e., a good depiction of reality, while creating one.

S is short for Structure: The reasonable consistency of a model of finance is of the utmost significance. Since the model’s creator may alter, the structure must be exacting, and integrity must always come first.

Q3. What is a logical & integrity error in a model of finance?

The idea of integrity errors revolve around inconsistencies in the financial data used in the model and the working of the model based on faulty finance principles whereas logical errors are issues in the assumptions made in the model from an operational or financial standpoint.

Conclusion:

We hope you learned more about why these models should be used.

Why Should We Use Financial Models? Reasons, Uses, FAQs, And More

Understanding Financial Modeling Through Finance: