Loading the player...

What is 'Financial Modeling'

Financial modelling is the process by which a firm constructs a financial representation of some, or all, aspects of the firm or given security. The model is usually characterized by performing calculations and makes recommendations based on that information. The model may also summarize particular events for the end user such as investment management returns or the Sortino ratio, or it may help estimate market direction, such as the Fed model.

BREAKING DOWN 'Financial Modeling'

It is the goal of the analyst to accurately forecast the price or future earnings performance of a company. Numerous valuation and forecast theories exist, and financial analysts are able to test these theories by recreating business events in an interactive calculator referred to as a financial model. A financial model tries to capture all the variables in a particular event. It then quantifies the variables and creates formulas around these variables. In the end, the model provides the analyst with a mathematical depiction of particular business event. The primary software tool used to do this is the spreadsheet. Spreadsheet language allows the financial modeler to reconstruct almost any cash flow or revenue stream.

Users of Financial Models

Financial models are used for many different reasons. The most common of which are business valuation, scenario preparation for strategic planning, cost of capital calculations for corporate finance projects, capital budgeting decisions and the allocation of corporate resources. Financial models are also used in the creation of projections and trends for forecasts and many other uses related to industry comparisons, ratio analysis and common size financial statements.

Financial Modeling Example

There are myriad variables at play in the determination of a forecast or valuation. Analysts can isolate the most sensitive of these variables by creating models and then testing the model with different inputs. The inputs are then used to create a set of outputs that determine the impact of a change in one variable on another. The best financial models are simple and provide users with a set of basic assumptions. As an example, one commonly forecasted line item is sales growth. Sales growth is a function of current sales and prior quarter sales. These are the only two inputs a financial model needs to calculate sales growth. The financial modeler creates one input cell for the prior year's sales, cell A, and one input cell for the current year sales, cell B. In the third cell, cell C, the analyst creates a formula that divides the difference between cell A and B by cell A. This is the growth formula. Cell C is a formula and hard coded into the model. Cells A and B are considered input cells for the user. The purpose of the model is to automate the calculation of sales growth.

RELATED TERMS
  1. Model Risk

    A type of risk that occurs when a financial model used to measure ...
  2. Stochastic Modeling

    A method of financial modeling in which one or more variables ...
  3. Robust

    A characteristic describing a model's, test's or system's ability ...
  4. Protected Cell Company (PCC)

    A corporate structure in which a single legal entity is comprised ...
  5. Hull–White Model

    A single-factor interest model used to price derivatives. The ...
  6. Multistage Dividend Discount Model

    An equity valuation model that builds on the Gordon growth model ...
Related Articles
  1. Investing

    Understanding Financial Models

    A financial model is a representation of some aspects of a firm or given security. It uses historical numbers to create calculations that inform financial recommendations or predict future financial ...
  2. Investing

    Financial Models You Can Create With Excel

    The relatively modest amount of time it takes to build these models can pay for itself by leading you to better investment decisions.
  3. Small Business

    What is a Business Model?

    Business model is the term for a company’s plan as to how it will earn revenue.
  4. Small Business

    Calculating (Small) Company Credit Risk

    Determining creditworthiness of smaller and medium-sized corporations isn't as easy as for larger companies, but these tips can help.
  5. Personal Finance

    DCF Vs. Comparables: Which One To Use

    DCF and Comparables models are widely used in equity valuation. We explain the pros and cons of each method.
  6. Small Business

    Getting To Know Business Models

    Learning how to assess business models helps investors identify companies that are the best investments.
  7. Investing

    The Basics Of Business Forecasting

    Discover the methods behind financial forecasts and the risks inherent when we seek to predict the future.
  8. Investing

    Style Matters In Financial Modeling

    If you're looking to get a job as an analyst, you'll need to know how to work it.
  9. Personal Finance

    The Best Financial Modeling Courses for Investment Bankers

    Obtain information, both general and comparative, about the best available financial modeling courses for individuals pursuing a career in investment banking.
  10. Insights

    The Fed Model And Stock Valuation: What It Does And Does Not Tell Us

    Learn about this popular stock market valuation model and how accurate it has been over the years.
RELATED FAQS
  1. What is the difference between financial forecasting and financial modelling?

    Understand the difference between financial forecasting and financial modeling, and learn why a company should conduct both ... Read Answer >>
  2. How can I calculate the value of a stock as per the Gordon Grown Model, using Excel?

    Learn about the Gordon growth model, also known as the dividend discount model; see how to use Microsoft Excel and value ... Read Answer >>
  3. How do I calculate how long it takes an investment to double (AKA 'The Rule of 72') ...

    Find out more about the rule of 72, what the rule of 72 measures and how to calculate the rule of 72 for investments using ... Read Answer >>
  4. What is the formula for calculating the capital asset pricing model (CAPM) in Excel?

    Find out more about the capital asset pricing model (CAPM) and the formula for calculating it in Microsoft Excel. Read Answer >>
  5. What are some examples of ways that sensitivity analysis can be used?

    Understand the concept of sensitivity analysis and learn about the wide variety of disciplines to which it can be applied. Read Answer >>
  6. How do I calculate a price to sales ratio using Excel?

    Learn what the price to sales ratio is, how to calculate the ratio using a formula, and how to calculate the price to sales ... Read Answer >>
Hot Definitions
  1. Magna Cum Laude

    An academic level of distinction used by educational institutions to signify an academic degree which was received "with ...
  2. Cover Letter

    A written document submitted with a job application explaining the applicant's credentials and interest in the open position. ...
  3. 403(b) Plan

    A retirement plan for certain employees of public schools, tax-exempt organizations and certain ministers. Generally, retirement ...
  4. Master Of Business Administration - MBA

    A graduate degree achieved at a university or college that provides theoretical and practical training to help graduates ...
  5. Liquidity Event

    An event that allows initial investors in a company to cash out some or all of their ownership shares and is considered an ...
  6. Job Market

    A market in which employers search for employees and employees search for jobs. The job market is not a physical place as ...
Trading Center