Financial Modeling Definition and What It's Used For

Financial Modeling

Investopedia / Michela Buttignol

What Is Financial Modeling?

Financial modeling is the process of creating a summary of a company's expenses and earnings in the form of a spreadsheet that can be used to calculate the impact of a future event or decision.

A financial model has many uses for company executives. Financial analysts most often use it to analyze and anticipate how a company's stock performance might be affected by future events or executive decisions.

Key Takeaways

  • Financial modeling is a numerical representation of some or all aspects of a company's operations.
  • Financial models are used to estimate the valuation of a business or to compare companies to their industry competitors.
  • Various models exist that may produce different results. A model is only as good as the inputs and assumptions that go into it.

Understanding Financial Modeling

Financial modeling is a representation in numbers of a company's operations in the past, present, and the forecasted future. Such models are intended to be used as decision-making tools. Company executives might use them to estimate the costs and project the profits of a proposed new project.

Financial analysts use them to explain or anticipate the impact of events on a company's stock, from internal factors such as a change of strategy or business model to external factors such as a change in economic policy or regulation.

Financial models are used to estimate the valuation of a business or to compare businesses to their peers in the industry. They also are used in strategic planning to test various scenarios, calculate the cost of new projects, decide on budgets, and allocate corporate resources.

Examples of financial models may include discounted cash flow analysis, sensitivity analysis, or in-depth appraisal.


Understanding Financial Models

Real-World Example

The best financial models provide users with a set of basic assumptions. For example, one commonly forecasted line item is sales growth. Sales growth is recorded as the increase (or decrease) in gross sales in the most recent quarter compared to the previous quarter. These are the only two inputs a financial model needs to calculate sales growth.

The financial modeler creates one cell for the prior year's sales, cell A, and one cell for the current year's sales, cell B. The third cell, cell C, is used for a formula that divides the difference between cells A and B by cell A. This is the growth formula. Cell C, the formula, is hard-coded into the model. Cells A and B are input cells that can be changed by the user.

In this case, the purpose of the model is to estimate sales growth if a certain action is taken or a possible event occurs.

Of course, this is just one real-world example of financial modeling. Ultimately, a stock analyst is interested in potential growth. Any factor that affects or might affect that growth can be modeled.

Also, comparisons among companies are important in concluding a stock purchase. Multiple models help an investor decide among various competitors in an industry.

What Is Financial Modeling Used For?

A financial model is used for decision-making and financial analysis by people inside and outside of companies. Some of the reasons a firm might create a financial model include the need to raise capital, grow the business organically, sell or divest business units, allocate capital, budget, forecast, or value a business.

What Information Should Be Included in a Financial Model?

To create a useful model that's easy to understand, you should include sections on assumptions and drivers, an income statement, a balance sheet, a cash flow statement, supporting schedules, valuations, sensitivity analysis, charts, and graphs.

What Types of Businesses Use Financial Modeling?

Professionals in a variety of businesses rely on financial modeling. Here are just a few examples: Bankers use it in sales and trading, equity research, and both commercial and investment banking, public accountants use it for due diligence and valuations, and institutions apply financial models in private equity, portfolio management, and research.

How Is a Financial Model Validated?

Errors in financial modeling can cause expensive mistakes. For this reason, a financial model may be sent to an outside party to validate the information it contains. Banks and other financial institutions, project promoters, corporations seeking funds, equity houses, and others may request model validation to reassure the end-user that the calculations and assumptions within the model are correct and that the results produced by the model are reliable.

Article Sources
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  1. PWC. "Financial Modelling Services."