What is a Financial Model
What is a Financial Model?
A financial model is created to forecast an organization’s financial performance over time. Models are typically built-in Excel, with historical data used to help forecast how the organization will perform in the future. Financial models play an important role in helping firms make important decisions, such as whether to invest in a project.
Key Learning Points
- Financial models are used to forecast a company’s future financial performance and then use the forecast for a variety of purposes, including company valuation, project appraisal, acquisition decisions, debt issuance, credit ratings, and more.
- Financial models are used by bankers, accountants, consultants, economists, portfolio managers, quantitative analysts, and financial planners, as well as anyone who will benefit from forecasting the future financial performance of an organization.
- It’s essential to have a strong understanding of accounting to build a financial model. Modeling is typically learned through specialized courses or in-house training at financial services companies.
What is a Financial Model Used For?
A model is a basis for any decision that involves forecasting the future of a company.
For example, an M&A (mergers and acquisitions) analyst would build a model to determine whether merging two companies would yield financial performance that exceeds the results generated by each company independently.
A credit rating model will forecast future results to determine whether a company will be able to maintain certain financial ratios and meet its debt obligations, thus maintaining its credit rating. A valuation model forecasts the future cash flows of a company and then asks how much we would pay now for those future cash flows. This is called Discounted Cash Flow analysis, which yields a figure called Net Present Value.
An operational model will focus on forecasting a company’s revenue and costs, and then alter the model’s assumptions to determine whether performance can be improved through measures such as cost-cutting.
What Does a Financial Model Typically Include?
Financial models typically include pro forma versions of a company’s balance sheet, income statement, and cash flow statement. However, the emphasis on each particular financial statement may vary according to how the model will be used. Management consultants, for example, might focus more on revenue improvement and therefore focus their attention on the factors that drive revenue.
Who Builds Financial Models?
Professionals in many different areas of the financial services industry depend on financial modeling in their decision-making processes.
Investment bankers include professionals working in M&A, equity and debt underwriting, credit, and trading. A financial forecast is an important component underlying every banking transaction.
Investment managers such as mutual fund and hedge fund managers, private equity investors, and venture capitalists all use financial models as the basis for investment decisions.
Management consultants offer advice and expertise to help organizations improve business performance in terms of operations, profitability, management, structure, and strategy. A financial model provides a base case for the company, and consultants can alter assumptions to determine the optimal course of action.
Equity analysts rate stocks on a buy, sell, or hold basis that is determined through valuation models. Through various methods, including discounted cash flow analysis, analysts determine the fair value of a stock and compare it to the stock’s market value to recommend a course of action. When a company discusses financial results, issues a trading update, or provides management guidance, analysts adjust their financial models and offer an investment recommendation
How Can You Learn Financial Modeling?
Textbooks on topics such as corporate finance or business valuation may provide an introduction to financial modeling. Articles or blogs (such as those found on this website) can offer useful insights on financial modeling. Please go to the Finance Library section of our website to learn more. Terms you should understand include:
- three statement model
- income statement and income statement forecasting
- operating profit and EBIT
- balance sheet and balance sheet forecasting
- cash flow statement
- linking three financial statements
- 10 steps in building a three statement model
- M&A or merger model
- DCF or discounted cash flow
The best way to learn to model is to complete our online financial modeling course that gives you an introduction to building models and developing multiple techniques for a comprehensive and practical understanding of the topic.
The Basics of Financial Modeling
Read our article titled “How to Build a Financial Model” which takes you through the basic steps.
Get a Free Download of a Simple Model
This article comes with free downloads. Have a go at building the simple model in the “empty” file and then review the answer using the “full” file.
Screenshot of the empty file
Screenshot of the full file