What is a financial model?
A financial model allows you to input a set of assumptions about a company’s future and will project the company’s future financial performance from them.
As a minimum this is usually in the form of an income statement, balance sheet and cash flow statement. In addition they also often include calculation sheets and also sheets of further analysis and graphs.
What is a financial model used for?
Using Excel to create financial models is everyday work for finance professionals as they are the basis for most financial decisions.
Potential uses of financial models include:
- Business Valuation:
When buying, selling or floating a business on a stock market a financial model will be used to help determine what a fair value for the company would be.
- Debt Affordability:
When a business borrows money from a bank a financial model will be used to look at how affordable the proposed debt will be in future under a number of different scenarios.
- Strategic Decision Making:
A financial model will be a key part of all strategic decision making. They give decision makers a clear projection of the likely financial implications of the strategic decisions that they are looking at. This might include geographic expansion of the business, entering new product lines, divestment of an existing asset or business unit.
- Cashflow & Capital Budgeting:
Most businesses have a cashflow forecast that they update either monthly or quarterly. This allows them to project their future cash balances and manage their cash accordingly.
This will also feed into the decision making process for future capital expenditure.
- Scenario planning:
Strategic planners will frequently use a financial model to run scenarios which look at how future changes in the business environment might impact the future profitability of the company.
Handle With Care
“The first principle is that you must not fool yourself and you are the easiest person to fool” – Richard Feynman.
Financial models need to be handled with care. The financial crisis of 09 proved this. Just because a financial model forecasts the future one way, that doesn’t mean that that is how the future will turn out.
They are based on data which is at best an educated guess as to how the future might turn out. Your output is only as good as the quality of your inputs, the old computer science maxim of “Garbage in Garbage out” applies.
Equally a financial model can be a very useful business tool when handled correctly.
If you remember that a financial model is nothing more than simplified projection of one potential future you’re unlikely to go too far wrong.