What Is Financial Modelling? (With Benefits And Types)
By Indeed Editorial Team
Updated 14 December 2022
Published 8 November 2021
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
Financial modelling is an essential aspect of business accounting and management. It allows businesses to view their current revenue, predict future expenses and make financial decisions based on the financial information it collects. A company may use various types of financial modelling depending on their professional goals, whether that is financial analysis or data management. In this article, we discuss what is financial modelling, the benefits of such a process and some common types of financial modelling to understand their functioning.
What Is Financial Modelling?
To understand "What is financial modelling?" it refers to summarising a company's expenses and earnings as a spreadsheet to calculate the impact of future financial decisions or events and use this data to analyse finances. A financial analyst uses the financial modelling process to present a company's financial information in an organised manner to help with business decisions. A financial model has many uses for company executives in a business setting. For example, financial analysts use these models to analyse and predict a company's stock performance and how it can get affected by future events or business decisions.
Basics Of Financial Modelling
The process of financial modelling involves a numbered representation of a company's past, present and future operations. These models help business executives in decision-making regarding a company's finances and brand positioning. Company executives use it for several reasons other than financial analysis, such as estimating the costs and profits of a proposed new project.
Financial analysts determine the valuation of a company or business using financial models. They also use this data to understand their competitors' performance in the market. A company's finance executives may also employ financial modelling during strategic planning to test various scenarios, allocate corporate resources and decide on a company's financial budget. Some examples of financial modelling may include discounted cash flow analysis, in-depth appraisal and sensitivity analysis.
Uses Of Financial Modelling
Some principal uses of financial modelling in a business setting include:
Evaluating capital, equity and debt
Making asset or business acquisitions
Understanding organic growth and development
Selling off assets
Creating financial forecasts
Allocating capital assets
Determining business value
Benefits Of Financial Modelling
Some of the prime benefits of financial modelling include:
In-depth business understanding
Financial analysts use critical thinking and analytical skills to offer deep insights into a business's operations and economic events and decisions. This analysis allows them to understand their business model and safeguard it from potential risks while managing it to meet their business objectives. As financial analysts, understanding your business and finances can help you predict changes in the internal and external economic environment and take steps to prevent any decisions that may affect your business operations.
Periodic performance review
Financial analysts perform variance analysis to understand the functioning of a business in an economic environment. Financial models help analysts perform variance analysis by comparing a business's actual results with the budget. Periodically conducting a performance review allows financial analysts to receive feedback on their business operations and make necessary adjustments using variance analysis to maximise profits.
Determining fund strategy and requirement
A financial model helps to determine a company's expected cash inflows and outflows. Financial analysts use these models to identify and assess the source of funding for their business objectives, either debt or equity. Their understanding of the financial model helps them determine the cash flow position after the repayment of loans and the interest expenses. It also helps determine the extent to which a business can take debt and the level of equity financing.
Financial analysts use financial models to understand a company's worth. They calculate a business's overall value by identifying the sources of free cash flows of a business that they expect to occur at different points of time. This process becomes especially helpful where a company performs any restructuring, such as selling the stake to external parties or investors.
Financial models help carry out a business's due diligence by suggesting the economic impact of particular business activity. This practice allows the analysts to locate any potential threats or risks in a business and helps them in providing solutions. For example, suppose a company wants to enter a new market. A financial analyst can use a financial model to guide their business executives with essential information regarding the costs of entering that market, changes in price and marketing effects to help them prevent risks and improve their performance.
Generate quick outputs
Businesses can take months to get answers to specific financial questions and pending business decisions. A financial model helps speed up this process by providing quick outputs and results by analysing the impact of economic decisions. These models can also help business executives in quick decision-making while supporting a business's overall growth trajectory.
Accurate financial prediction and budgeting
The business data generated from financial models is a significant source for building financial budgets and predicting the impact of economic decisions or events on a business. Businesses can use these budgets and financial predictions to ensure that they conduct structured business operations. A financial model allows the analysts to follow all budget and prediction strategies to cut extra costs and risks.
A financial model helps in a business's growth by recommending areas that may generate higher profits. These models also enable financial analysts to conduct a cost-effective analysis of new projects and save a business from investing higher costs in a low-budgeted project. A company can benefit from its financial models, as these can help them identify areas of improvement and investment that offer more growth opportunities and profits.
Some Common Types Of Financial Modelling
Companies use various types of financial modelling to collect data in a spreadsheet that analyses their financial decisions and objectives. They may use specific financial models for different business purposes and operations. Some common types of financial modelling include:
Three statement financial modelling
A financial analyst includes a company's income statement, balance sheet and cash flow analysis in a three statement financial model spreadsheet. To achieve this, they use spreadsheet software to link the three financial statements and format them using the application of formulas so that they can easily connect each account within the programme. The companies can then use the highlighted information on the three statement financial model to evaluate and improve strategies and methods that can positively affect the income and cash flow.
Discounted cash flow finance model
Discounted cash flow finance model adds to the findings of a three statement financial model to determine and display a company's present net value. This value helps investors and partners to understand how a business's future cash flows may affect equity, shares or other holdings that contribute to the valuation of a company. This type of financial modelling can also help to analyse and assess a company's total equity.
Budget financial modelling
Financial analysts can use budget financial modelling for economic analysis and plan a company's annual budget. This type of modelling shows quarterly or monthly values that a company may use to direct the financial processes related to its business operations. Budget financial modelling also employs a business's income statement, an important reference point in this type of financial modelling format.
Forecast financial modelling
The forecast financial modelling uses planning and analysis to predict costs within a company's budget. Businesses also use this type of financial modelling with budget models to determine the projected expenses incurred through their business operations. Forecast financial modelling can allow a company to predict future costs associated with producing a product or service.
Merger financial model
This type of financial modelling helps calculate a company's pro forma accretion or dilution when planning for an acquisition or a company merger. This financial model is crucial for companies that are evaluating their investment options. Knowing a company's pro forma value or income and stock shares can help determine their overall financial capacity to merge with another business or build on investments.
Public offering financial model
The public offering financial model helps to place value on businesses before their initial public opening. This type of financial model also employs a data analysis of comparable companies in the market. It can also help in analysing the assumed value that investors may pay for a new business.
You can use leveraged buyout financial modelling to evaluate a leveraged buyout (LBO) transaction, which refers to the acquisition process of a company that gets its funding using a significant amount of debt. This model requires the input of different finance values, including cash flows, revenue and liability values. An LBO model can also help assess the relationship between a company's accumulated debts and its cash flow processes.
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