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.
- Financial modeling is a representation in numbers of some or all aspects of a company's operations.
- Financial models are used to estimate the valuation of a business or to compare businesses to their peers in the industry.
- Various models exist that may produce different results. A model is also only as good as the inputs and assumptions that go into it.
The Basics of 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 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 cell 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. Multiple models help an investor decide among various competitors in an industry.