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Financial modeling is the process of forecasting financial numbers.

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 performance.

For example, business owners use financial models to determine how today’s pricing decisions will impact future profits. Banks analyze them to see if a company will be able to pay back a requested loan. Investors study them to estimate their investment returns, or to determine a company’s profits and estimate its growth prospects.

Financial analysts only need to know the model that best serves their organization’s specific interests.

One investor may use a discounted cash flow model to estimate a company’s total value, and therefore the returns on its stock.  Another investor may use the Sortino ratio to weigh an investment’s risk. The Sortino ratio is a risk-adjusted measure of investment performance that uses returns that fall below a minimally acceptable target.

Financial models are created using sales volume, sales growth, fixed and variable costs, and production cost information. Sound financial modeling requires practice and experience to master.

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