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.

  1. Model Risk

    Model risk occurs when a financial model used to measure a firm's ...
  2. Business Model

    A business model is a company's plan for generating revenues ...
  3. Robust

    A characteristic describing a model's, test's or system's ability ...
  4. Stochastic Modeling

    A method of financial modeling in which one or more variables ...
  5. Protected Cell Company (PCC)

    A Protected Cell Company (PCC) is a corporate structure, a single ...
  6. Valuation Analysis

    A valuation analysis is a process to estimate the approximate ...
Related Articles
  1. 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.
  2. 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.
  3. Investing

    The Basics Of Business Forecasting

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

    Build a Profitable Trading Model In 7 Easy Steps

    Trading models can provide a powerful tool for building profit. Traders can use and customize existing trading models or build an original model. This article provides seven steps to building ...
  5. Insights

    Cell Phone Evolution

    Follow the evolution of cell phones from 20 pound bricks to the sleek smart phones of today.
  6. Personal Finance

    6 Tips For Getting A Good Cell Phone Plan

    Avoid overspending on cell service with this expert advice.
  7. 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.
  8. Investing

    Digging Into The Dividend Discount Model

    The DDM is one of the most foundational of financial theories, but it's only as good as its assumptions.
  9. Trading

    Stock Analysis Basics: How To Forecast Revenue and Growth

    Forecasted revenue and growth projections are important components of security analysis, leading to a stock’s future worth.
  10. Investing

    How to Choose the Best Stock Valuation Method

    Don't be overwhelmed by the many valuation techniques out there - knowing a few characteristics about a company will help you pick the best one.
  1. What is the difference between financial forecasting and financial modeling?

    Understand the difference between financial forecasting and financial modeling, and learn why a company should conduct both ... Read Answer >>
  2. 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 >>
  3. 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 >>
  4. What is the formula for calculating return on equity (ROE) in Excel?

    Find out more about return on equity, the formula to calculate it and how to calculate return on equity in Microsoft Excel. Read Answer >>
  5. What is the formula for calculating free cash flow in Excel?

    Find out more about free cash flow, the formula for calculating free cash flow and how to calculate a company's free cash ... Read Answer >>
  6. What is the formula for calculating the price-to-earnings (P/E) ratio in Excel?

    Find out more about the price-to-earnings, or P/E, ratio, the P/E ratio formula and how to calculate the P/E ratio in Microsoft ... Read Answer >>
Hot Definitions
  1. Federal Funds Rate

    The federal funds rate is the interest rate at which a depository institution lends funds maintained at the Federal Reserve ...
  2. Call Option

    An agreement that gives an investor the right (but not the obligation) to buy a stock, bond, commodity, or other instrument ...
  3. Standard Deviation

    A measure of the dispersion of a set of data from its mean, calculated as the square root of the variance. The more spread ...
  4. Entrepreneur

    An entrepreneur is an individual who founds and runs a small business and assumes all the risk and reward of the venture.
  5. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  6. Perfect Competition

    Pure or perfect competition is a theoretical market structure in which a number of criteria such as perfect information and ...
Trading Center