Financial modeling definition
/What is Financial Modeling?
Financial modeling involves the use of a spreadsheet to project the impact of various future events or decisions. Such a model is a mathematical representation of the key variables impacting an organization. It is used to estimate how future scenarios will impact the performance and financial position of a business. This model is usually constructed on an electronic spreadsheet, using summary-level revenues and expenses, and employing formulas that change the results of the model when certain variables are altered. For example, variables could be used to model the impact of an increase in energy prices, a decline in product prices, a product recall, a change in the rate of sales growth, or a successful employee strike that results in increased compensation and benefit costs.
How to Use Financial Models
A financial model is useful for estimating the effects of a number of scenarios within a short period of time, though its effectiveness depends on how well the model mimics the business. An analyst can use a financial model in several ways, as noted below.
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Acquisitions
Financial modeling can be used for acquisitions, to determine the range of possible outcomes that an acquirer can expect with an acquiree, depending on the actions it takes after the deal has been closed. Each outcome results in different cash flows and a different valuation for the acquired business.
Budgeting
Financial modeling can be used for budgeting, to develop several scenarios as part of the budgeting process, to decide which scenarios to pursue when a detailed budget is constructed. This is also a useful way to model the costs that will be incurred at different activity levels.
Capital Budgeting
Financial modeling can be used for capital budgeting, to determine a range of outcomes that might impact the cash flow return related to a prospective fixed asset purchase.
Risk Analysis
Financial modeling can be used for risk analysis, to determine which variables can have the greatest negative effect on a firm, as part of a formal risk analysis.
Problems with Financial Models
There are three potential problems with financial models. One is that a model may not properly account for the variables that will impact the model's projected future results. Second, a more complex model is at risk of having calculation errors built into it, which can be difficult to detect. And finally, the preconceived notions of the person designing the model may have an adverse impact on how well the model relates to actual results - thus, someone favoring an acquisition might create a model that is unduly optimistic about the outcome to be achieved.
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