What is Financial Modeling And How Does It Work?

Businesses often employ the use of financial modeling as a guide for better decision-making and financial planning. Financial models deliver data-driven analysis to help your company know where it stands. That said, businesses need multiple types of financial modeling suited for different business cases.

What Does the Term Financial modeling Mean?

Financial modeling or data-driven analysis entails combining finance, accounting, and other vital business metrics to have a vivid and abstract model or representation of a business’ financial situation. This model helps a business visualize its financial position in the market and predict financial performance in the future.

Financial modeling is vital for multiple reasons. It can help companies make informed investment decisions and plan well for corporate situations such as mergers and acquisitions. Overall, most companies use financial models to guide them in making financial analyses and business decisions. Executives often use financial modeling to make plans regarding:

• Organic business growth
• Forecasting and budgeting
• Prioritizing projects
• Acquiring businesses or new assets
• Distributing the company's financial resources
• Selling or divesting business units and assets
• Raising capital or equity

While there are multiple areas in a business that need financial models, most companies usually create Excel templates for financial modeling to expedite their decision-making process. Learn more about what a financial model is and the two approaches to building a financial model here.

Who Creates Financial Models?

Financial models have a broad scope in business, and financial professionals like investment bankers, accountants, corporate development analysts, and equity research analysts assist in creating these business models. Primarily, in any modern business or company, those dealing with financial analysis and planning (FP&A) are likely to build and utilize these financial models to steer the company toward sustainable growth.

The FP&A department thereby plays an essential role within the company. Aside from its involvement in creating a budget and performing financial analysis, this team also helps in forecasting. Other roles include supporting decision-making for market research projects.

Financial Modeling is Critical for Strategic Analysis

In the context of the current Covid pandemic, most businesses face unique challenges. Even so, we live in an era shaped by technological improvements in business practices. Today’s businesses have more tailored solutions that focus on ensuring they’re agile and better equipped to make quick, strategic, and data-driven decisions.

To forecast the company's financials, companies must analyze and understand key trends that impact the future of their business. More importantly, they should understand accounting and business operations as well as sales and marketing. This gives your company insights into what decisions to make using data-driven information.

How to Set up a Financial Model

How can you design a financial model? Well, most finance executives often create financial models using Excel. However, creating a realistic financial model isn’t a simple task. First, you have to learn the key Excel hacks and tips. Next, remember that financial modeling entails more than just chugging and plugging equations and data.

You have to consider factors such as your financial model's design, layout, plus formatting. For instance, separating assumptions and historical data from calculations can help minimize input mistakes. A vivid design with well-planned data can highlight the significant takeaways of the model. Importantly, you must have an understanding of accounting in order to acc

Financial Modeling Examples

While financial modeling plays an essential role in any business success, no one model suits every business. Financial models should match your business needs.

Let's look at some of the common financial modeling examples you can implement in your business:

Top-down model – The top-down model helps separate a good business from a profitable one. Using this model, you work from a micro or outside perspective toward a micro view. In essence, the top-down model helps define a forecast based on a market share you want to capture within a reasonable time frame.

Bottom-up approach model – Unlike the top-down model, the bottom approach is less dependent on external factors. Instead, it leverages company-specific data and business drivers including but not limited to sales, financing, unit volume, cost of goods, and operating expenses.

Unlike the top-down model, the bottom-up approach starts with an inside view and builds towards an outside perspective.

For example, imagine you own and operate a specialty coffee shop and want to model its performance over the next 12 months. Let's assume the main driver to your coffee shop is foot traffic. So, one effective strategy you can use is selecting a prime location with high-level foot traffic and demand for specialty coffee. You can now estimate the daily foot traffic, rate at which those passing by enter your shop to make a purchase (i.e. conversion rate), and and average ticket price. Now that you have the fundamental drivers established, you can model the shop’s sales as depicted below:

Daily Foot Traffic x Conversion Rate x Average Ticket Price = Daily Sales

Model of Assumptions

Modeled assumptions produce outputs such as financial statements. This includes a Profit & Loss (P&L) Statement, Balance Sheet, and Cash Flow Statement. Each financial statement serves a unique purpose - the P&L shows income and expenses over time; the balance sheet depicts your assets (what you own) versus your liabilities (what you own) at a point in time; and the cash flow statement conveys the inflows and out flows of cash across your core operations, investment, and financing events.

Bottom line

It is vital for businesses to create financial models in line with their changing business needs. Above all, companies need to invest in professionals who understand how to work with different financial models.

If you need advice on building a financial model, we are here to help. Check out our services or contact us today!