Finance 101 Series: What is Financial Modeling?
A business’ success is often marked by positive outcomes like revenue growth and profits. But these accomplishments are easier said than done. The road to success is often fraught with unknown variables, setbacks, and market shocks.
But what if you had a map to guide you through uncharted financial territory?
In the world of corporate finance and accounting, financial models are the atlas that business leaders leverage to inform their decisions and initiatives. However, a map is only as good as its cartographer (analyst). If the financial model is built on shoddy foundations, it could cause more harm than good.
What is a Financial Model?
Financial models are tools that businesses use to help forecast their company’s future financial performance. In most cases, models—even the more complex types—are built into spreadsheet software.
Financial models are created to help steer business decisions toward positive outcomes. At their essence, they are most often based on a combination of the company’s historical performance and assumptions about the future.
It’s worth noting that not all financial models will be built using historic numbers. For instance, a startup’s business plan will include a speculative financial modeling section which, according to management consultant James Kerr, presents the hypothetical numbers underlying the business:
It is here that you outline the total investment that you’re looking for, how you’ll use the capital and the projected value generated by the investment over time. These are the essential details from which potential lenders and investors make their decisions on whether to fund your business, or take a “pass.”
For a business plan, the financial modeling section will typically include:
- An overview of the long-term financial goals
- Investment uses and targets
- Break-even analysis
- Projected P&L, balance sheet
- Business ratios
- Financial assumptions
What are Financial Models Used For?
Each type of model provides a unique insight into the business’ possible financial future. As such, not all models have the same intended purpose. In which case, from a high-level perspective, financial models are created for one of three fundamental reasons:
- To make smarter financial decisions
- To choose the least bad decision in a situation where there simply are no positive outcomes
- To give investors, partners, or lenders confidence in the strength of the business
With the right type of model, you can better understand the company’s current state in the market, plan a strategy, and solve specific problems. According to Corporate Finance Institute, a financial model can help you with:
- Raising capital (debt and/or equity)
- Making acquisitions (businesses and/or assets)
- Growing the business organically (e.g., opening new stores, entering new markets, etc.)
- Selling or divesting assets and business units
- Budgeting and forecasting (planning for the years ahead)
- Capital allocation (priority of which projects to invest in)
- Valuing a business
- Financial statement analysis/ratio analysis
- Management accounting
Regardless of your desired end goal, most financial models will utilize your company’s historical performance data and financial statements.
The Fundamental Financial Model
The simplest and most commonly used financial model—known as the “three-statement model”—is built using a company’s three most important financial statements:
- Income statement – Also known as a profit and loss (P&L) statement, this shows a business’ profitability, detailing its net income growth or loss over a specified period.
- Balance sheet – This document captures a business’ net worth at a particular moment in time, showing its assets and debts for a given reporting period.
- Cash flow statement – This statement outlines how much cash you have on hand at a given period and demonstrates how much money is flowing into and out of the business during that time.
Oftentimes, the three-statement model serves as the foundation upon which more advanced models can be built. These higher-level financial models are abstract representations of real-world scenarios your company may face going forward, such as leveraged-buyout (LBO) or mergers and acquisitions (M&A).
Other Financial Models Types
In the world of business, there are many different types of financial maps, many of which service distinct purposes. To that end, a few popular financial models include but are not limited to:
- Discounted cash flow (DCF) model – A valuation model commonly used for equity research. It forecasts the company’s unlevered free cash flow according to the Net Present Value (NPV).
- Mergers and acquisitions (M&A) model – Another valuation model meant to ascertain the financial viability of a pro forma merger of two companies.
- Consolidation model – A reporting model that consolidates several business units into a single model for in-depth analysis.
- Budget model – A financial model used for financial planning and analysis (FP&A) to help build a 3- to 5-year budget, based on monthly or quarterly figures.
- Forecasting model – Similar to the budget model, a forecasting model is also used in FP&A to create a forecast that will then be used in comparison to the budget model.
CFO Hub—Financial Modeling and More
A business that operates without utilizing financial modeling is essentially flying blind. Although it may be possible to reach your desired destination without modeling guidance, chances are the journey will be much more arduous. As COVID-19 has demonstrated, you simply never know what market shocks are on the horizon. But one thing’s for certain—rigorous financial modeling can help you prepare for practically any circumstance.
Do you need help with financial modeling and planning?
That’s one of the reasons CFO Hub was created—to partner with businesses, helping them navigate tumultuous, murky, and exciting financial waters. Here, we provide outsourced CFOs, controllers, and accounting personnel to help alleviate the burden of financial management and create room for you to focus on what matters most—scaling.
Ready to create your own atlas? We are too.